Introduction

Terra is a public chain built through Cosmos SDK, which aims to create a modern financial system for blockchain. It issued LUNA and stablecoin UST; the latter was once the fifth-largest stablecoin with a market cap of over $10 billion. The Terra ecosystem grew rapidly in 2021, and LUNA even made it into the top 10 in terms of market cap, surging by a hundred times.

But no one expected that the Terra Empire worth tens of billions would collapse within two days, and the trigger was the LUNA-UST mechanism designed by itself. Holders were panicked about the sharp de-pegging of UST and chose to sell at all costs. At the same time, someone burnt USTs at a cost much lower than $1 to mint LUNA and sold them in the spot market for profits, resulting in a rapid increase in the issuance of LUNA tokens and dumping in the spot market.

The balance between LUNA and UST, which was originally maintained through the arbitrage mechanism, was suddenly lost, resulting in a 99% plunge due to LUNA’s unlimited issuance and the de-pegging of UST, which in turn affected institutions with long positions in the project and caused a series of liquidation crises. Everyone witnessed this absurd historical event. Subsequently, the Luna Foundation Guard (LFG) proposed to fork a new chain to improve the UST mechanism and rebuild the ecosystem. As a result, LUNC (Terra Classic) and the new forked LUNA were born.

What is LUNA？

LUNA is the native token of Terra blockchain and the basis of its ecosystem, allowing users to stake and participate in transaction verification, receive rewards based on the amount of staked LUNA, initial governance proposals (software upgrades, technical modifications, fee structures, and currency policies), pay on-chain fees, and facilitate the pegging of the decentralized stablecoin UST to the U.S. dollar through a burning and minting mechanism.

The total supply of LUNA is 1 billion. The Terra agreement will start burning tokens once it exceeds this amount to achieve a market circulation of 1 billion. At inception, LUNA tokens were allocated as follows.

Private Sell Investors (26%): Terraform Labs held three token sales to fund the development of Terra projects.

• In May 2018, $10 million for $0.1
• In October 2018, $23 million for $0.23
• In an undisclosed private sale, $14.5 million for $0.8

Stability Reserves (20%): To maintain the pegging of the stablecoin.

Terra Alliance (20%): To popularize the Terra Ecosystem through incentives and marketing and to increase the number of partners. These tokens were held by the Terraform Labs and allocated based on community opinions.

Employees & Contributor Pool (20%): These tokens were unlocked linearly over time to reward developers.

Terraform Labs (10%): To facilitate the research and development of Terra projects. The Terraform Lab also collected an additional 4.5% on behalf of the investors who were not KYC certified and were able to apply for retrieval.

Genesis Liquidity (4%): To allow the market to create liquidity quotes and allow users to start trading.

The Development of Terra

The Terra protocol was created by South Korean blockchain company Terraform Labs, one of 15 e-commerce companies of the Terra Alliance grouped by South Korean and Southeast Asian enterprises, and co-founded by Daniel Shin and Do Kwon, who also serves as the CEO.

Terra is known for stablecoin UST and LUNA-based pegging algorithms. Following the launch of the Terra mainnet in April 2019, its development was switched to the Luna Foundation Guard (LFG), a non-profit organization based in Singapore.

According to the white paper and the founding mission of LFG, the popularity of cryptocurrency requires the attributes of decentralization, trustless, permissionless, and the stability of fiat currency as well. LFG is committed to becoming an important hub for emerging DEFI technology to help establish a decentralized economy through community management, innovation promotion and open-source software.

To put it simply, Terra is a decentralized stablecoin network, with UST being the most popular one, whose value is linked to the US dollar. It also supports more than a dozen decentralized stablecoins pegged to other fiat currencies. Both the names of Terra and LUNA cover special meanings as they refer to the goddesses of the Earth in ancient mythology while Luna stands for the Moon in Latin, symbolizing complementary to each other.

It is worth noting that the daughter of Do Kwon is also named Luna, which expresses his personal belief in the success of this protocol.

In contrast to centralized stablecoins such as USDC and USDT, Terra’s decentralized one is not backed by cash or government bonds but by its native token LUNA. The TerraUSD (UST) was issued in September 2020, and at the end of March 2021, the web-end cross-chain bridge Terra Bridge, connecting Terra, Ethereum and Binance Smart Chain, was established.

In March 2022, Twitter trader Algod accused Terra and UST of being scams, and the price of LUNA would fall a year after Do Kwon’s one-million bet. Interestingly, UST and LUNA did collapse in just two months, which caused the Terra blockchain to stop temporarily, and its ecosystem to lose nearly $45 billion in a week. The community voted to fork at the end of May, creating two blockchains: LUNC (a continuation of the original chain) and LUNA (the new chain).

What is UST?

UST is a stablecoin pegged to the U.S. dollar. Stablecoins can be divided into off-chain-backed stablecoins, on-chain-backed stablecoins and algorithmic stablecoins according to the method of maintaining a stable price. USTs are generated by burning LUNAs while burning LUNAs can also generate USTs. The price of UST is maintained through arbitrage of market spreads. Since no asset backs UST, but UST uses algorithms to regulate supply and demand, it belongs to an algorithmic stablecoin to this end.

The Terra protocol adopts a novel minting and burning mechanism. Users can mint 1 UST for every $1 worth of burned LUNA, and conversely, users can burn 1 UST to mint $1 worth of LUNA. This unique burning/minting mechanism stabilized UST’s $1 pegging through changes in supply and demand caused by price differentials.

For example, if the price of UST exceeds $1 for some reason, such as a 50% spike to $1.50, LUNA holders can burn $1 worth of LUNA to get 1 UST since UST is priced at $1.50, it can be exchanged for another stablecoin pegged to the U.S. dollar and immediately make a 50% profit. Therefore, when the UST price is higher than $1, arbitrageurs will have an incentive to burn LUNA and mint UST, resulting in the fall of the total supply of LUNA and the rise of its price. In contrast, the total supply of UST increases and its price drops to $1 eventually.

So what happens when the price of UST falls below $1? If it plummets to $0.5, holders can buy 2 USTs with another stablecoin pegged to the U.S. dollar and burn the 2 USTs for $2 worth of LUNA. Then the $2 worth of LUNA can be exchanged to 2 other stablecoins, making a 100% profit. Therefore, when the UST price is lower than $1, arbitrageurs will have an incentive to burn UST and mint LUNA, resulting in the increasing of the total supply of LUNA and the falling of its price while the total supply of UST decreases and its price rises to $1 eventually.

The operation of UST and LUNA shows that the change in the total volume of UST is accompanied by an increase or decrease in the market value of LUNA. The ability of UST to be fully converted into fiat currencies at the price of $1 depends on whether the market value of LUNA is sufficient to support the total volume of issued UST.

This peg algorithm can theoretically work normally, but when the UST price falls and the market value of LUNA shrinks, there is a risk of a so-called “death spiral” that could make the UST price no longer capable of maintaining $1.

The Well-known Projects of the Terra Ecosystem

Terra is committed to becoming a global cryptocurrency payment protocol, and its transaction fees, typically less than 1% of the total trading amount, areis cheaper than most credit card companies or payment processors. The Terra ecosystem contains applications such as stablecoin, lending, and decentralized exchanges with the following ones as examples:

Fiat Stablecoin

The Terra Alliance and its partners are actively using stablecoins in the Terra ecosystem to popularize the blockchain and retail payment services. In addition to the best-known TerraUSD (UST), which is pegged to the USD, there are RMB-pegged TerraCNY (CNT), yen-pegged TerraJPY (JPT), pound-pegged TerraGBP (GPT), won-pegged TerraKRW (KRT) and euro-pegged TerraEUR (EUT).
Before the collapse of UST and LUNA, these diverse stable coins successfully provided seamless cross-border and real-time payments to many people worldwide. However, since they all adopted algorithms to adjust token supply flexibly, they also suffered depegging after the collapse.

Anchor Protocol

Anchor is a decentralized currency market and lending protocol built on Terra. When it went live on March 17, 2021, it promised users an annualized return of up to 20% on UST. As users have a great need for low-risk and stable returns, Anchor Protocol is one of the main reasons for the growth of the Terra ecosystem.

The Anchor protocol also enables lending and liquidity staking, allowing users to stake their LUNA and receive the derivative of bLUNA. This derivative can, in turn, be used as collateral for lending in various decentralized financial protocols.

The high yield attracted a large amount of arbitrage capital. The strategy of revolving collateral stablecoins to increase interest leverage (MIM-UST) emerged, causing Anchor to fall short of its budget and UST’s market value to over-inflate, which laid a foreshadowing for the collapse of UST and LUNA. \

Source: Anchor

Mirror Protocol

Mirror is a decentralized financial (DeFi) platform that allows users to create and trade so-called “mirrored assets” named mAssets, which are derivative tokens. Their prices are pegged to other cryptocurrencies or stocks of well-known companies, such as TWTR (Twitter), TSLA (Tesla), PYPL (Paypal), NKE (Nike), NFLX (Netflix), BABA (Alibaba Group), AAPL (Apple) and so on, allowing users to trade them without buying the underlying assets. However, the mirrored assets were quoted using UST through the BAND’s oracles, and the derivative tokens were also affected by the collapse of UST and LUNA. The development team is still rebuilding in the absence of a stable stablecoin.

Source: Mirror

Astroport

Astroport, a decentralized exchange, features an automated market maker quoting algorithm that supports different algorithms for liquidity pools, allowing for customizsed services for different liquidity providers to improve capital efficiency and reduce slippages for traders. Despite being devastated by the collapse of UST and LUNA, it is currently operating normally thanks to the efforts of its community and developers.

The types of liquidity pools currently supported by Astroport are:

• Constant Product Pools: The most common type of on-chain liquidity pool that applies the constant product market maker algorithm.
• Stableswap Invariant Pools: Adopting the StableSwap Invariant algorithm eliminates anomalous losses within a certain range, providing near-zero slippage.
• Liquidity Bootstrapping Pools: The Liquidity Bootstrapping algorithm allows teams to create liquidity with a small amount of capital while avoiding arbitrage by on-chain trading robots when setting up liquidity pools.

Source: AstroPort

The Depegging of UST

It is hard to forget what happened after May 9, 2022 for holders of UST and LUNA. The the Terra protocol, which kept growing in Total Value Locked and was once in the top 10 cryptocurrencies with a peak market cap of over $20 billion and a peak price of over $100, suffered a plummet over a few days and even a -99.97% drop in a single day. UST also depegged and dropped from $1 to less than 1 cent, while LUNA was on its way to zero. \

Source: DeFi Llama

A lot of investors lost all of their money before they could react since the turnaround was so dramatic, including institutions or conservative participants who did not trade but only earned interests. So, how did all this happen? The answer is simple: Bank run.

The massive increase in squeezing USTs created an excessive “false market value.” Although the price of UST could have been pushed back to $1 by the arbitrage mechanism of burning UST to mint and sell LUNA, LUNA’s market dominance in the Terra ecosystem was too low for all the USTs to be converted back to other dollar-pegged stablecoins, thus leading to the collapse of LUNA and UST. What is a false market value, and what is a true one? The simplest way to calculate it is to multiply the current price of the asset by its quantity, as shown in the diagonal part below：

However, multiplying the quantity of an asset by a fixed price does not objectively give a true market value. There is a so-called demand curve for assets in economics (see the red line in the graph below), where the price of a commodity is inversely related to its quantity demanded. When there is an oversupply of quantity, the price must be lowered to attract more buying; conversely, when there is an undersupply, the price will rise. Here comes the question: how do you determine the true market value of a cryptocurrency such as Bitcoin (BTC)? Well, sell all of the Bitcoins and see how much can be earned at the end.

Therefore, the value of a Bitcoin = selling price * the number of quantities sold at this price. After adding up the value of all the Bitcoins sold at different prices, it can be found that this is exactly the diagonal part under the demand curve, so the total amount sold is the true market value.

It follows that the true market value is much smaller than simply multiplying a quantity by a single price as it is impossible to sell the same asset at a fixed price indefinitely and the difference between the two is the false market value. What can be realized must be the true market value, while what exists in the figures but cannot be realized is the false market value.

In the early hours of May 8, the Luna Foundation Guard removed $150 million of UST from the UST-3Crv pool in preparation for the 4Crv pool, leaving the UST-3Crv pool with about $700 million, at which point only $300 million would be enough to cause a liquidity crisis.

The opportunity was certainly not missed by big players who wanted to profit from short selling, and a new address suddenly sold $84 million of USTs, unbalancing the UST-3Crv pool seriously.

To keep the UST-3Crv pool in balance, LFG then withdrew another $100 million, which was only able to maintain an apparent stabilization of price. The liquidity depth became shallower, indicating that it would be easier to depeg UST, and whales began to collectively sell off USTs on Binance, with each transaction amounting to over a million dollars.

Souce: Twitter

The depegging of UST panicked holders quickly and the Anchor protocol began to see a massive withdrawal of USTs, adding to the domino effect of the sell-off.
Due to the algorithmic arbitrage mechanism of burning UST to generate LUNA, there was a huge increase in the supply of LUNA tokens, which caused its price to fall rapidly, resulting in a death cycle of UST price falling → LUNA issuance increasing → LUNA price falling → UST withdrawing → UST price keeps falling.

LUNA recorded a -99.97% drop on 12 May, while the token quantity increased from 300 million to 6 trillion in days. On-chain data showed that only $7.4 billion of USTs out of nearly $20 billion were successfully converted to other stablecoins, while the remaining $11.3 billion of over-issued USTs failed by LUNA’s market cap shrinkage, leaving it as an uncashable token.

The Aftermath of the Death Spiral

The overnight zeroing of LUNA and UST shocked the whole market.

LFG was forced to liquidate its Bitcoin reserve up to 80,000 to stop UST from collapsing, which in turn caused Bitcoin to fall by over 20% in a single day and the crypto market to lose $400 billion in terms of market value within a week. The Terra blockchain also paused when LUNA was zeroed to prevent it from becoming a tool for governance attacks.

The sudden collapse of LUNA and UST has thrown the cryptocurrency market and community into chaos, with major exchanges stopping LUNA and UST withdrawals, and even delisting the relevant trading pairs.

On-chain decentralized protocols were also affected, such as Venus, a lending protocol on the BNB Chain, enabled to swap $100,000 of other assets with $10,000 of LUNA due to an error in the LUNA minimum price limit in Chainlink, a well-known oracle, leaving the vault with a large amount of unliquidated LUNA collateral and over $10 million in bad debt expense.

However, the impact was not limited to this, as the butterfly effect brought more issues. Firstly, Three Arrows Capital, a hedge fund with over $10 billion in assets under management, was found to have withdrawn over 120,000 stETH from the Curve protocol and sold them frequently on FTX and Bitmex. Despite this, it eventually declared bankruptcy due to insolvency.

This was followed by troubles with other management platforms and exchanges such as BlockFi, Voyager Digital, and Genesis Trading, all of whom were creditors of Three Arrows Capital and had issued loans to it, some of which were unsecured credit loans. It was also revealed that Celsius had privately diverted client funds for risky leverages, thus lacking enough assets for withdrawal. The huge losses and depleted liquidity have caused successive failures of many institutions and centralized exchanges.

Despite the devastation of the Terra ecosystem and the loss suffered by investors who believed in LUNA UST, the community did not give up. After days of silence, Do Kwon tweeted that he intended to hard-fork Terra and rebuild it with the help of developers.

The Terra 2.0 mainnet (Phoenix-1) went live at the end of May, after the community quickly voted and passed the proposal. Terra 2.0’s token was named LUNA, while the previous one was renamed LUNC, and tUST was renamed USTC.

But the Terra community was still divided as Do Kwon was disclosed by a former engineer at Terraform Labs being one of the pseudonymous co-founders behind the failed algorithmic stablecoin Basis Cash while cashing in tens of millions of dollars monthly before the collapse of LUNA and UST.

In addition, investors were reluctant to trust Do Kwon and the new Terra 2.0, and they wanted to burn the excess LUNC tokens on the old Terra Classic chain. At the same time, the community started to spontaneously send tokens to the blackhole address, laying the foundation for a potential increase in on-chain transaction taxes following the upgrade of the Terra Classic mainnet in September.

Although major exchanges had indicated their support for voting, the influence of the 1.2% burning tax on the Terra Classic mainnet, LUNC, and UST remains to be observed.

Terra 2.0

Officially launched on May 28, 2022, LUNA 2.0 is rebuilt based on Terra Classic. Discarding the old chain’s data and value, the new token is recreated through an entirely new blockchain. Terra 2.0 no longer supports stablecoins but focuses on rebuilding ecosystem applications and infrastructure.

Consensus Mechanism

Terra 2.0 cryptocurrency blockchain validates transactions by using a standard Proof-of-Stake consensus algorithm. At any given time, 130 validators participate in network consensus, with their voting power determined by the amount of Terra 2.0 staked to their nodes. Gas fees and a fixed annual inflation rate of 7% reward grants.

Terra 2.0 token holders contribute to consensus by delegating their tokens to validators, who typically stake their own money along with delegated tokens. Validators retain a commission in this system and distribute rewards to delegators.

Key Features and Changes

Decoupling from Stablecoins: Terra 2.0 is no longer pegged to stablecoins like UST, aiming to avoid systemic risks associated with algorithmic stablecoin models. The new network focuses entirely on supporting smart contracts and decentralized applications.

Community-driven Growth: The launch of Terra 2.0 heavily relies on community support. Existing project teams in the Terra ecosystem commit to supporting the new chain and developing new applications. The rebooted network aims to maintain its decentralization and transparency through community governance.

Token Distribution: New LUNA tokens are distributed through airdrops to original LUNA and UST token holders. Airdrops occur in several phases to ensure that regular holders in the new ecosystem obtain compensation and re-engage in the system.

New Governance Mechanism: Governance in Terra 2.0 emphasizes community participation, aiming for more transparent and democratic project decision-making processes. Holders can participate in on-chain voting to determine the direction of developments.

Differences Between Terra 2.0 and Terra Classic

Despite significant similarities, Terra Classic and Terra 2.0 are distinct. Under the new governance plan, the Terra network has split into two chains. The old one is Terra Classic with the LUNC token, while Terra with the LUNA token is designed as the new chain called Terra 2.0.

Instead of being replaced completely, old LUNA will coexist with LUNA 2.0. Any Terra Luna DApps will prioritize LUNA 2.0, and the development community will start building DApps and create practical applications for the new tokens. However, this excludes algorithmic stablecoins.

Terra Classic retains its community, as many investors and traders opposed Do Kwon’s recovery plan and the new chain. Terra Classic still has a large fan base, and its community has agreed to burn as many LUNC tokens as possible to reduce currency supply and increase individual token prices.

Conclusion

Cryptocurrencies have brought new possibilities for traditional, financial and economic models. The absence of third-party intermediaries and being permissionless allows people to exchange freely and easily at low cost, but the volatility has also limited their ability to store value and mass adoption. \
Therefore, the development of stablecoins, which are regarded as a new and safer form of cryptocurrency investment, has become an urgent need. The market value of stablecoins has grown by more than 100 times in a few years and Terra was launched following the trend, establishing the LUNA kingdom which once had a market value of tens of billions of dollars based on the algorithmic stablecoin UST. \

Source: The Block

LUNA is highly expected while UST is seen as a combination of the stability of fiat currency with the benefits of smart contracts, decentralization and trustlessness of cryptocurrencies. The high and stable returns of the Anchor protocol also meet the need for an investment portfolio, leading to the rapid success of Terra while attracting more and more investors. However, it ignores the risk of liquidity crises behind the algorithmic stablecoin, and some people even invested in it without fully understanding the minting mechanism.

While its unique burning/minting mechanism is open and transparent and allows some flexibility in adjusting supply and demand to keep the UST price pegged to the fiat currency, the collapse proves it is impossible to expand unlimitedly without value support. The ultimate stabilization of a stablecoin remains dependent on its ability to sustain cash.

The over-issued stablecoin would not survive a bank run. Not only did the collapse deal a severe blow to the cryptocurrency market, but a list of prominent institutions and exchanges were among the victims due to excessive credit expansion or mismanagement of assets.

On the other hand, the collapse of LUNA and UST was a testament to the indestructibility and potential of cryptocurrencies. Other lending collateral markets such as bETH, bATOM, and bSOL under the Anchor protocol still run normally even though Anchor itself is seriously affected. Despite the difference in perception, the Terra community and developers have also started rebuilding on Terra 2.0 and Terra Classic. In the wake of this collapse, the lessons of LUNA and UST highlight that high interest rates carry high risk, which requires investors to remain cautious and developers to be more comprehensive in thinking and designing to prevent all possible accidents.