The project is infamous for its use of the widely controversial algorithmic stablecoin model. Algorithmic stables work to maintain dollar pegs through code rather than simply backing the coin with collateral like USDC or DAI.
How Terra Luna Works
Terra operates by creating an equilibrium between the UST and LUNA tokens through the incentives of arbitrage.
This is how that works. Say an investor wants to mint UST. To do that, LUNA must be purchased and swapped for UST with the LUNA being burned afterwards. This constricts the supply of LUNA, placing upwards price pressure on the token.
Opposite of this, LUNA can be minted by converting over UST tokens which are then burned. This puts upward price pressure on UST. The key here is the gains made through arbitrage, the core incentive for willing investors to take on the associated risks with the tokens.
Arbitrage is simply when a trader is able to profit from slight price discrepancies. For instance, if UST is trading at $0.99, traders have the incentive to burn LUNA for UST at 0.99. When the price of UST rises above $1, traders can then flip that small profit into buying more LUNA.
An additional Terra ecosystem incentive that encouraged traders to join the ecosystem in the first place was the extremely generous 20% APY on Anchor Protocol that UST holders could earn. This attracted a tremendous amount of growth to the protocol.
The problem here was that such a high APY was completely unsustainable long term. The Luna Guard Foundation (LFG), an associated organization, were managing Terra’s treasury fund to inject liquidity into Anchor to artificially keep rates high.
Why Terra Failed
The short answer to why Terra failed is nothing short of a rapid loss of confidence followed by a bank run on the protocol.
The UST stablecoin went through a major stress event in January 2022 after the unravelling of the Frog Nation DeFi ecosystem. This plunged the price of LUNA and forced UST from its dollar peg. The event actually prompted Terra to raise $1 billion in Bitcoin (BTC) to provide additional collateral to the UST peg. Additional purchases were also in AVAX.
On May 9th, the cryptocurrency market began experiencing more extreme selling pressure which led to a significant decline in LUNA and in Bitcoin. This created a massive problem for Terra. As selling occurred, it depegged the price of UST.
UST and LUNA achieve equilibrium through the redemption power of burning/minting tokens. If there are more UST tokens in circulation, there are less LUNA and vice versa. The problem that occurred here is because of the depegging and the price of LUNA falling, the redemption cost of gaining LUNA was high.
- Markets declines, causing LUNA to decline and UST to depeg
- Panic ensues and UST tokens are burned for LUNA
- The LUNA is immediately sold due to the collapsing price
- This further destabilizes the UST peg, creating more panic
A ton of LUNA tokens were being minted and then thrust back into the market as investors left UST. This made the supply expand rapidly, creating enormous downward pressure on price.
Even worse, LFG sold their Bitcoin at a substantial loss to inject more money into the protocol to help save the UST peg. This obviously failed and the protocol fell into a total meltdown.
The price of UST fell to as little as $0.19 at one point, with LUNA collapsing in price from an all-time high of $119 USD just one month ago to a price point of $0.90 – a 99% collapse in value. In total, Terra Luna saw some $20 billion disappear from the protocol in just 24 hours, making this the single largest cryptocurrency collapse of all time.