Terra – a Year in Review Since its Collapse
26 June 2023
A year ago, the crypto world witnessed one of the most devastating events in its history: the collapse of Terra Luna and its stablecoin UST. What started as a promising project that aimed to create a decentralized and scalable platform for stablecoins and DeFi applications ended up as a nightmare that shook the entire industry and caused billions of dollars in losses. In this blog post, we will review what happened, why it happened, and what were the consequences of this event for the crypto ecosystem. We will also look at where we are now in terms of recovery and innovation, and whether we can prevent another disaster like this from happening again.
What happened?
Terra Luna was a blockchain network that used a dual-token system to maintain the stability of its algorithmic stablecoin UST. UST was supposed to be pegged to the US dollar, meaning that one UST should always be worth one dollar. However, unlike other stablecoins that are backed by real assets or fiat currencies, UST was backed by its sister token Luna, which was used to pay for transaction fees, stake in the network, and participate in governance.
The mechanism behind this system was that whenever there was more demand for UST than supply, new UST would be minted and sold for Luna, which would increase the price of Luna and decrease the supply of UST. Conversely, whenever there was more supply of UST than demand, UST would be burned and Luna would be minted and sold for UST, which would decrease the price of Luna and increase the supply of UST. This way, the market forces would always keep UST close to its $1 peg.
However, this mechanism relied on two assumptions: that there was enough liquidity in the market to facilitate these transactions, and that there was enough confidence in the system to maintain the demand for UST. Unfortunately, both of these assumptions were violated on May 7th, 2022, when a massive sell-off of UST triggered a downward spiral that eventually led to the collapse of Terra Luna.
According to various reports the sell-off was initiated by a large whale who unstaked over $2 billion worth of UST from Anchor Protocol, a DeFi platform built on Terra that offered high interest rates for depositing UST. The whale then proceeded to liquidate hundreds of millions of UST for other cryptocurrencies, creating a huge imbalance in the market. This caused UST to lose its peg and drop below $0.9.
As UST fell below its peg, more and more users started to panic and sell their UST for other stablecoins or cryptocurrencies, creating even more selling pressure. This also triggered a massive amount of Luna to be minted and sold for UST, as per the protocol's design. However, this only flooded the market with more Luna tokens, which drove down its price even further. At one point, Luna was trading at less than $0.1, down from its peak of $118 in April.
The situation was exacerbated by several factors that contributed to the lack of liquidity and confidence in the system. First, there was a lack of arbitrage opportunities due to high transaction fees and network congestion on other blockchains such as Ethereum and Binance Smart Chain, where most of the liquidity for UST and Luna was located. Second, there was a lack of transparency and communication from Terraform Labs , the company behind Terra Luna, which failed to address the issue or provide any reassurance to the community. Third, there was a lack of regulation and oversight from authorities , who later issued an arrest warrant for Do Kwon , the co-founder of Terraform Labs, on charges of fraud and market manipulation.
The result was a total meltdown of Terra Luna and its stablecoin UST, which lost 99% of their value within a week . The collapse also had a ripple effect on other cryptocurrencies and DeFi platforms that were connected or dependent on Terra Luna . According to some estimates , over $60 billion worth of value was wiped out from the crypto space due to this event.
Why did it happen?
The collapse of Terra Luna exposed several flaws and risks inherent in algorithmic stablecoins and DeFi platforms. Algorithmic stablecoins are essentially experiments that try to achieve stability without relying on any external collateral or authority. They rely on complex mathematical models and game-theoretical incentives to maintain their pegs. However, these models and incentives are not foolproof and can be easily disrupted by external shocks or malicious actors.
DeFi platforms are also highly experimental and innovative, but they come with their own challenges and trade-offs. They offer high returns and opportunities for users, but they also entail high risks and vulnerabilities. They are often unregulated and untested, and they operate in a highly volatile and competitive environment. They are also subject to various technical issues, such as network congestion, bugs, hacks, or exploits.
The combination of algorithmic stablecoins and DeFi platforms creates a powerful synergy, but also a dangerous dependency. When one of them fails, the other one suffers as well. This creates a positive feedback loop that can amplify the effects of any shock or disturbance. This is what happened with Terra Luna and its stablecoin UST, which were both heavily integrated with other DeFi platforms such as Anchor Protocol, Mirror Protocol, or Curve Finance.
What were the consequences?
The collapse of Terra Luna had several consequences for the crypto ecosystem, both positive and negative. On the negative side, it caused a huge loss of value and trust for many users and investors who were holding or using UST or Luna. It also damaged the reputation and credibility of algorithmic stablecoins and DeFi platforms in general, which were already under scrutiny and criticism from regulators and skeptics. It also created a liquidity crunch and a market panic that affected other cryptocurrencies and DeFi platforms that were connected or dependent on Terra Luna.
On the positive side, it also created a learning opportunity and a catalyst for innovation and improvement for the crypto community. It exposed the flaws and risks of algorithmic stablecoins and DeFi platforms, and prompted many developers and researchers to find solutions and alternatives. It also stimulated the demand and adoption of other stablecoins and DeFi platforms that were more reliable and resilient. It also inspired new projects and initiatives that aimed to create more decentralized and scalable platforms for stablecoins and DeFi applications.
Where are we now?
A year after the collapse of Terra Luna, the crypto ecosystem has shown remarkable signs of recovery and innovation. Many projects and platforms that were affected by the event have managed to bounce back or reinvent themselves, this shows the resilience of the decentralised crypto ecosystem.
Other projects and platforms that were not affected by the event have also thrived and expanded their offerings and user bases. For example, MakerDAO , the oldest and largest algorithmic stablecoin platform, has maintained its dominance and stability in the market with its Dai stablecoin , which is backed by various types of collateral such as cryptocurrencies or real-world assets . It has also launched new features
and products such as Maker Vaults , Maker Oracles , or Maker Improvement Proposals . It has also integrated with other blockchain networks such as Polygon
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