Analysis of the Events Leading to the Collapse of TerraUSD and Luna

The collapse of TerraUSD (UST) and its sister token Luna was a significant event in the cryptocurrency world, marked by a rapid loss of value. The crisis began when UST, a stablecoin pegged to the US dollar, started to de-peg, leading to a loss of confidence among investors and users. The algorithmic mechanism designed to maintain UST’s stability through the minting and burning of Luna could not cope with the sudden and massive withdrawals, exacerbating the de-pegging issue.

As UST’s value continued to decline, the automated system responded by minting an increasing amount of Luna to absorb the shock, which in turn flooded the market with Luna and drastically reduced its value. This spiraling effect led to a catastrophic loss in market capitalization for both tokens, wiping out billions of dollars in value within a short period. The speed and magnitude of the collapse were unprecedented, catching many in the crypto community by surprise. The events happened as follows:

• May 8th: UST declined to $0.985.
• May 9th: Luna Foundation Guard (LFG) planned to deploy $1.5 billion in Bitcoin (BTC) to defend the UST peg to the US dollar.
• May 11th, 10 Proposal 1164 to increase minting capacity from $293 million to approximately $1.2 billion was put forward.
• May 12th, 14 Binance announced it would delist LUNA/UST if UST’s value fell below $0.005.
• May 12th, 16 Terra validators decided to halt the blockchain to prevent governance attacks.
• May 13th, 12 Terra blockchain resumed, and the Wormhole bridge was back online.
• May 13th, 21 Trading for LUNA/BUSD and UST/BUSD resumed on Binance.
• May 13th, 23 Do Kwon, the founder of Terraform Labs, revealed a Terra Ecosystem Revival Plan.

The underlying causes of the collapse were multifaceted, involving both technical vulnerabilities in Terra’s design and broader market dynamics. Critics pointed to the inherent risks associated with algorithmic stablecoins, which lack the physical reserves that back traditional stablecoins. Additionally, the broader market conditions, including declining confidence in cryptocurrencies and external economic pressures, contributed to the rapid unraveling of UST and Luna.

The event served as a stark reminder of the risks associated with innovative financial technologies, especially those that seek to disrupt traditional monetary systems without the same level of regulation or oversight. The Terra collapse highlighted the need for more robust mechanisms to ensure stability and security in algorithmic stablecoins and the importance of investor education regarding the risks involved in such assets.

The Community and Developers’ Response to the Crisis

In the aftermath of the collapse, the Terra community and its developers rallied to address the crisis and salvage what remained of the ecosystem. Initial responses focused on stabilizing the situation and assessing the extent of the damage, with open communication channels being established to keep the community informed. The developers and core team proposed several measures to restore confidence and provide a path forward for Terra’s users and investors.

One of the first steps taken was to halt the Terra blockchain temporarily to prevent further damage and assess the technical vulnerabilities that had led to the collapse. This pause allowed the developers to implement emergency measures and plan for more sustainable long-term solutions. During this period, the community engaged in intense discussions and debates about the best course of action, reflecting the decentralized nature of blockchain governance.

Efforts to compensate affected users were also discussed, with proposals ranging from creating a compensation fund to forking the Terra blockchain to reset the ecosystem. These discussions were marked by a strong sense of solidarity within the Terra community, with many members expressing a willingness to contribute to recovery efforts despite their losses.

The developers proposed a plan to fork the Terra blockchain, creating a new version without the algorithmic stablecoin that had caused the collapse. This proposal, known as “Terra 2.0,” aimed to preserve the innovative aspects of the Terra ecosystem while removing the elements that had led to its downfall. The plan was put to a community vote, demonstrating the commitment to a democratic decision-making process even in the face of crisis.

Terra has initiated a second LUNA airdrop as part of its ongoing efforts to address the aftermath of the ecosystem’s crash earlier this year. This airdrop is designed to provide additional compensation to holders of the native LUNA token or UST stablecoin, which both faced significant devaluation. The airdrop aims to rectify the allocation discrepancies from the initial “Phoenix” airdrop. Eligible holders of Terra Luna Classic who didn’t receive the correct number of LUNA tokens during the first airdrop have the opportunity to claim their share from this second distribution, which began on September 4 and will run until October 4, 2022. About 19.5 million LUNA tokens have been allocated for this purpose.

The compensation is subject to a two-year vesting schedule with a six-month cliff, intended to mitigate potential liquidity instability. This follows the earlier airdrop, which took place at the end of May, aimed at compensating users after the significant loss in market capitalization following the de-pegging event.

The new LUNA token, introduced after the crash, experienced volatility post-launch, with prices fluctuating significantly since May. While these airdrops are an effort to compensate for losses, the value of LUNA and USTC remains substantially lower than their pre-crash prices.

Efforts to Rebuild and Lessons Learned for Future Blockchain Projects

The efforts to rebuild the Terra ecosystem following the collapse have been marked by a focus on transparency, community engagement, and technical robustness. The launch of Terra 2.0, approved by the community vote, represented a fresh start for the ecosystem, free from the algorithmic stablecoin mechanism that had proven to be its Achilles’ heel. The new blockchain aimed to retain the innovative features and community spirit of Terra while learning from the past mistakes.

The Terra collapse served as a cautionary tale for the broader blockchain and cryptocurrency communities, highlighting the importance of rigorous testing, risk management, and contingency planning in the development of financial technologies. The event underscored the need for a balanced approach that combines innovation with stability and security, especially when dealing with assets that aim to function as money.

The reliance on an algorithmic mechanism without sufficient backing exposed Terra to a level of risk that ultimately proved unsustainable. Future projects are likely to take a more cautious approach to stablecoin design, potentially incorporating a mix of algorithmic and reserve-backed elements to ensure stability.

The rebuilding efforts and the lessons learned from the Terra collapse are likely to influence the development of future blockchain projects, particularly those involving stablecoins and decentralized finance. The experience has highlighted the need for a more mature and responsible approach to innovation in the crypto space, with an emphasis on user protection and systemic stability.

Highlights

• The collapse of TerraUSD (UST) and Luna was triggered by a failure in the algorithmic stablecoin’s pegging mechanism, leading to a rapid devaluation and loss of market confidence.
• The Terra community and developers responded by halting the blockchain, opening communication channels, and discussing compensation and recovery strategies, emphasizing transparency and solidarity.
• A community-approved plan led to the creation of Terra 2.0, which excluded the problematic algorithmic stablecoin feature, aiming for a more stable and secure ecosystem.
• The Terra collapse highlighted the risks of algorithmic stablecoins and the need for rigorous testing, risk management, and the inclusion of reserve assets for stability.
• The incident serves as a cautionary tale for the crypto industry, underscoring the importance of balancing innovation with stability and security in future blockchain projects.