Thought Leadership: What happened with Terra (LUNA), and can it happen again?

This article, written by Rutgers Business School FinTech Professor Merav Ozair, was originally published 6/1/2022 on Nasdaq.com.

TerraUSD (UST) is a stablecoin built on the Terra blockchain and was designed to always retain its value of $1, or sometimes known as being "pegged" to the U.S. dollar. The idea is that no matter what, the value of a UST should always be worth $1, regardless of market conditions or any macro event.

It didn't quite work out that way.

It was de-pegged on May 9, drastically losing its value in a matter of days, and is now almost worthless as of this writing, hovering around 2 cents per UST. Echoing the 2008 Financial Crisis, those who invested in UST have lost most of their funds.

A South Korean law firm, LKB & Partners, is suing Do Kwon and Daniel Shin, the founders of Terraform Labs, the company which developed Terra blockchain, on behalf of five investors with an accumulated loss of around 1.4 billion Korean won ($1.1 million) on several charges including fraud. Other investors are also organizing to launch their own lawsuits, centering on whether Terraform Labs has represented its products and risks of investing accurately.

How could a “stablecoin” become so unstable? To answer that question, we need to cover what a stablecoin is, why they even exist in the first place, how they work, and then finally, what exactly happened here. We'll end with general guidance for people considering buying stablecoins in the future.

What is a Stablecoin?

A stablecoin is any cryptocurrency pegged to a price of a stable asset, such as a commodity like gold or a fiat currency like the U.S. dollar. Depending on its mechanism, some stablecoins are linked to a Decentralized Autonomous Organization (DAO) which controls issuance and pricing.

Why would there be a need for stablecoins?

Cryptocurrencies have been very volatile. In 2018 the entire crypto market lost roughly 70% of its top value in beginning of 2018, entered a bear market until late 2020, rallied for about a year, reaching its peak in mid-November 2021, and has been tumbling down again. Since that mid-November 2021 peak, all major cryptocurrencies (e.g., bitcoin, ether) are down 50% on average. Intraday swings can also be high; cryptocurrencies can move more than 10% in a span of a few hours.

With such high volatility, that makes it difficult, if not impossible, to use cryptocurrency as a reliable medium of exchange. Merchants cannot afford being paid with a coin that may lose half its value the next day. Stablecoins attempt to solve this problem by stabilizing the value of the coin, making it less volatile. By pegging it to the price of another asset, the value of the coin remains steady relative to that asset.

There are different mechanisms used to stabilize the value of stablecoins. We'll cover three of the major methods:

Centralized, fiat-collateralized stablecoins:

A centralized company maintains reserves of the assets in a bank or trust (e.g., for currency) or a vault (e.g., for gold) and issues tokens (i.e., stablecoins) that represent a claim on the underlying asset. They create stablecoins equivalent to the amount of the underlying asset that they have. The digital token has value because it represents a claim on another asset with a defined value. The reserves for those assets are regularly audited.

Tether (USDT) was the first stablecoin to attempt this in 2014 and has the largest market share of all stablecoins. The top three stablecoins, in terms of both market capitalization and volume, are all centralized fiat-collateralized stablecoins – Tether (USDT), USD Coin (USDC) and Binance USD (BUSD) – which together account for about 90% of stablecoin market capitalization. This type of stablecoin has managed to maintain their peg to the U.S. dollar at all times since their inception.

When TerraUSD (UST) started to rapidly lose value, there was a flight to safety to the top three stablecoins as investors converted UST and similar algorithmic uncollateralized stablecoins (more on those below) to centralized fiat-collateralized stablecoins. This conversion may have also exacerbated the fall of UST.

Decentralized cryptocurrency-collateralized stablecoins:

In this mechanism, the stablecoin is backed by other decentralized crypto assets.

One example can be found in the MakerDAO stablecoin (DAI), which is pegged to the U.S. dollar and encapsulates the features of decentralization. While centralized stablecoins are controlled by a central organization, no one entity controls the issuance of DAI.

Instead, DAI is backed by Ethereum-based assets locked-up as collateral in an Ethereum smart contract. How does that work? The collateral is held in a smart contract, where it can be accessed by paying back the stablecoin debt or can be automatically sold by the smart contract code if the collateral falls below a certain threshold.

DAI uses the concept of a collateral debt position (CDP). A way to think of a CDP is as a secure vault used for locking collateral while having the ability to get liquid stablecoin, DAI. To reclaim their collateralized assets, the user must return the DAI that was loaned along with an additional fee. To prevent liquidation, DAI is overcollateralized (more on that below). Since this mechanism uses smart contracts – a self-executing code – it may also be considered as a crypto-collateralized algorithmic stablecoin.

The problem with this type of mechanism is that the collateral backing the stablecoin could be volatile because it is backed by crypto assets, which might lose their value too quickly. For that reason, most projects that use this mechanism are overcollateralized to protect against sharp price movements.

MakerDAO's stablecoin requires a 150% Liquidation Ratio – the minimum required collateralization level for each vault type before it is considered undercollateralized and subject to liquidation. For example, a vault with a 150% Liquidation Ratio will require a minimum $1.50 of collateral value for every $1 of DAI generated. If the value of the collateral falls to or below $1.49, it will be liquidated to cover the generated DAI in addition to a fee called the Liquidation Penalty. In case of a black swan event (such as a financial crisis), this may not provide sufficient protection. 

MakerDAO, created in 2017, is the oldest decentralized stablecoin. It is the fourth largest stablecoin, in terms of both market capitalization and volume. It has survived the crypto winter of 2018 and the tribulations of the Covid lockdown of 2020, and when UST collapsed, investors viewed DAI as a flight to safety.

Decentralized, uncollateralized stablecoins:

This mechanism ensures the stability of the coin’s value by controlling its supply through an algorithm, executed by a smart contract.

In some ways this is no different from central banks, which also don't rely on a reserve asset to keep the value of its currency stable. The difference is that central banks, like the Federal Reserve, set a monetary policy publicly based on well-understood parameters, and its status as the issuer of legal tender provides the credibility of that policy.

Stablecoins do not possess this level of credibility, and TerraUSD (UST) is an example of such a stablecoin.

How does UST in particular work?

UST has a built-in arbitrage mechanism between UST and the Terra blockchain native coin, Luna. To create UST, you need to burn Luna.

The arbitrage works as follows: 1 UST can always be exchanged for $1 worth of Luna. If UST slips to 99 cents, traders could profit by buying UST and exchanging it for Luna – profiting 1 cent per token. The effect works in two ways: People buying UST drives the price up, and UST being burned during its exchange to Luna deflates the supply.

In addition, the Luna Foundation Guard, a consortium whose job it is to protect the peg, had about $2.3 billion in bitcoin reserves, with plans to expand that to $10 billion worth of bitcoin and other crypto assets.

If UST dipped below $1, bitcoin reserves would be sold, and UST bought with the proceeds. If UST goes above $1, creators will sell UST until it goes back to $1, with the profit being used to buy more bitcoin to increase the reserve value.

To entice traders to burn Luna and create UST, the creators of Terra blockchain offered a 19.5% yield on staking, which is crypto terminology for earning 19.5% interest on a deposit, through what they called the Anchor protocol.

Such a high interest rate is simply not sustainable. Someone has to borrow at such a rate or above for the lender to receive 19.5% interest. This is how banks makes their profit: they charge high interests on borrowing (such as mortgages or loans) and provide low interest on savings (such as a traditional savings account or a certificate of deposit (CD) account). Analysis on the Anchor protocol in January already showed that it was at a loss.

One of the allegations in the lawsuits against Terraform Labs’ founders is that the Anchor protocol was a Ponzi scheme.

What went wrong with Terra (Luna)?

On May 7 over $2 billion worth of UST was unstaked (taken out of the Anchor protocol), and hundreds of millions of that was immediately sold.

The reason why this happened has yet to be determined. There is speculation that this might have been a malicious attack by someone attempting to break UST in order to profit from shorting (i.e., selling) bitcoin. Whether this is true or not, it's irrelevant: the responsibility is on the developers of the platform to create more secure and compliant system.

Regardless of exactly how it happened, the result from these huge sells pushed the price down to 91 cents. Traders tried to take advantage of arbitrage, exchanging 90 cents worth of UST for $1 worth of Luna. However, according to Terra’s protocol, only $100 million worth of UST can be burned for Luna per day. Investors panicked and flocked to sell their UST when the stablecoin couldn't retain its peg. It bounced between 30 cents and 50 cents in the week following the initial de-peg and currently it’s hovering around 2 cents.

It's worse for Luna holders. The value of Luna has completely disappeared – after reaching a high of just under $120 in April, it is now effectively zero (as of this writing, it is worth $0.000105).

Lessons to investors:

The old adage – “there’s no such thing as a free lunch” – rings true. Vigilant investors should understand that:

• A mechanism built on arbitrage is bound to break. No arbitrage is sustainable
• High interest on staking is not sustainable (think about how banks make their profit)
• Do your due diligence. Study how the mechanism works and whether it can be exploited

Stablecoins continue to come under scrutiny by regulators, especially considering this latest event. As investor and consumer protection is imperative, stablecoin regulation is on the horizon. In the meantime, investors should act with caution and learn the lessons from Terra.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.