Terra Update: The Spiral

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This week, a coordinated selloff from a single large address (referred to as a “whale”) created downward pressure on the market, which resulted in a flood of subsequent sales of UST, de-pegging Terra’s primary stablecoin ($UST) from the US dollar. 

This sell off caused UST to drop below $0.99, and led to a low of $0.26 per UST on Wednesday, May 11th, 2022. Terra has since recovered from this low, but has still been unable to regain its peg. The price of LUNA, the “sister coin” to UST, has fallen over 95% to a current low of pennies on the dollar.

What Happened: A Play-by-Play

Speculation is that this event was coordinated by an actor that predicted the steps Terra would take to maintain peg, and exploited these remedial steps to make money on a short-sale. The “attacker” would go on to make over $800 million as a result of their actions, perhaps irreparably undermining the viability of algorithmic stablecoins in the minds of the public. 

These are the steps Terra and the attacker took in tandem, as far as we understand them:

  1. The Luna Foundation Guard (i.e. “LFG”), meant to protect the UST peg with a reserve of collateral like Bitcoin and Avalanche, starts accumulating BTC on March 22. 
  2. On April 1, the 4pool was announced, which would be a massive trading pool of UST-FRAX-USDC-USDT on Curve.
  3. The LFG managed to accumulate approximately 15,000 BTC between then and April 15, which allowed the attacker to build a ~$4.2 billion short position and $1 billion OTC positions in UST.
  4. On Monday, Terraform Labs (i.e. “TFL”) removed $150 million of UST liquidity from the Curve 3pool, in order to prepare it for the 4pool. 
  5. Less than one minute later this address bridged $84 million UST to Ethereum. 
  6. Four minutes later, the same address used $350 million UST to drain liquidity on the Curve 3pool, which began a broader sell-off. 
  7. Next, TFL removed another $100 million UST from the Curve 3pool, resulting in a de-peg down to $0.972. 
  8. Predictably, the LFG started selling BTC to defend the peg, causing downward pressure on the price of BTC.
  9. Now that the Curve 3pool was drained, the LFG continues to sell BTC to protect the peg, and the attacker starts dumping what was left of their $1 billion in OTC UST to Binance. This causes a panic for Anchor depositors, tanks the price of BTC, and Centralized Exchanges suspend withdrawals of UST further fueling panic.
  10. The extreme descent of UST price was enough to overwhelm the entire Terra network, since it has a $293 million soft cap on UST/LUNA redemptions per day built into the protocol design. Even with these limitations, the price of LUNA was decimated.
  11. Today, as a result of these disruptions to the network, volatile price of tokens, and fears of a governance attack, the Terra blockchain was halted at block height 7603700.
  12. The chain was later restarted, with the key change disabling delegations and an announcement of new parameters coming soon.

Due to UST’s supply contraction, the supply of LUNA has increased by over 7 billion, dropping the price to less than $1 and is now hovering at an all time low of pennies on the dollar. Currently, there are two governance proposals up for LUNA holders to vote on to increase the cap to 100 million SDT (~$120 million) or, alternatively 1 billion SDT (~$1.2 billion). This would allow LUNA to absorb the supply of UST and potentially restore the peg. However, the effect on the price of LUNA could continue to be devastated due to the resulting increase in supply and ultimate lack of faith in Terra’s sustainability.

Aggressive Expansion: When Does Stimulated Adoption Compromise Decentralization?

The parameters and direction of UST are centrally controlled and managed by Terra insiders/Terraform Labs (TFL) and the Luna Foundation Guard (LFG). Terra only has 130 validators in the active set, with the top 12 validators having 33% of voting power on the network. Centralized control of this kind, along with a high frequency of public disclosure about financial movements, enables those with high capital capabilities to strategically plan attacks against the protocol. 

This is how the “attacker” was able to drain the 3pool with only $350 million UST, and remains a cautionary tale about protocols that delay progressive decentralization in the interest of protecting the protocol with quick fixes. 

TFL has been on a war path toward aggressive expansion of UST and Terra’s suite of other stablecoins. The early stages were directed toward mainstream adoption through Korea’s CHAI app (using $KRT) and Mongolia’s MemePay ($MNT), but have recently been directed toward providing liquidity, incentives, and asserting UST’s dominance on multiple DeFi platforms. The idea is simple: keep pushing adoption across multiple platforms, and the money keeps moving in multiple directions in such a broad way that a depegging scenario becomes less and less feasible. 

However, the Anchor protocol still accounted for over 50% of all UST across all sources, making it a major centralizing factor for the entire Terra ecosystem. This centralization  is still a major pain point, as UST and LUNA holders are withdrawing their assets from this flagship dApp, as the bank-run continues. No longer allured by the approximately 20% APY estimated on protocol accounts, deposits on Anchor have fallen by approximately $7.8 billion. 

Based on the above, it seems that Terra’s true present strategy could be summed up as “aggressively expand now, progressively move to decentralization later.” This has been a troublesome orientation, and not only because it undermines the primary stated objective of Terra to create decentralized fiat-based crypto. It is a double-edged sword because on the one hand, TFL and LFG can unilaterally act in an attempt to save the peg and/or fix the protocol if needed, but on the other, the amount of centralized control required to avoid systemic collapse should concern anyone who has seen the widespread adoption of Terra across DeFi. Unfortunately, despite their centralizing power, TFL and LFG cannot completely restore the peg on their own.

The Road to Stability: Crypto Will Become More Antifragile, Not Less, After Events Like This

Although the events surrounding Terra have had far-reaching effects across multiple ecosystems, there is no sovereign savior like the Fed that can solve a “too-big-to-fail” situation on-chain, even while control of the protocol remains this centralized. The stablecoin sector, comprising approximately $180 billion in total value, is still highly concentrated among assets like USDC, USDT, and BUSD, and it is unclear with time how the market will segment itself as less concentrated or more decentralized. Understandably, decentralization has taken a major hit with the attack on UST, but there is much we can learn about asset health from its makeup and example. 

Janet Yellen mentioned Terra in her recent comments to the Senate Banking Committee about stablecoins, referring to the loss of its dollar peg which “illustrates that this is a rapidly growing product and there are rapidly growing risks.” Despite her fears and caution that “these risks are not hypothetical,” events like these are leading to more resilient markets and a more diverse set of products as it becomes clear that projects will be allowed to fail if they are not up to the task. This relates back to the ultimate goal of many blockchain projects inspired by the decentralized principles of Bitcoin: build it so that you can walk away, and anyone with an internet connection can use it without asking permission. 

Baseline: Where Do We Go From Here?

According to the Luna Foundation Guard, which hosts strategic reserves of BTC and AVAX to back UST/LUNA, the LFG Council has voted to: 

  1. Loan $750 million in BTC to OTC trading firms to help protect the UST peg; and
  2. Loan $750 million UST to buy BTC as market conditions normalize.

This will bolster liquidity surrounding the UST peg, and allow traders to stabilize the market in a way that supports both initiatives. However, this is only half the equation, and LUNA will have to bear a portion of the recovery as well. 

There are two pending governance proposals that validators and LUNA holders can vote on, which would increase the base pool cap and decrease the reset window by varying degrees of intensity. 

  • Proposal #1164 would increase the base pool by approximately $120 million and decrease the Pool Recovery Block time from 36 blocks to 18. 
  • Proposal #1169 would increase the base pool by approximately $1.2 billion and decrease the Pool Recovery Block time from 36 blocks to 1, making it much more aggressive. 

Given the timeframe, it is unclear whether this parameter change could be exploited by an attacker (or even according to plans by the same one), which is why we are choosing to abstain from #1164 and vote “No With Veto” on #1169, as it simply magnifies the effects of the first. 

Other chains like Osmosis are currently pursuing their own fixes to ensure the Terra contagion doesn’t affect their own protocols. With so much interconnectivity through IBC and the functionality built-into Cosmos SDK chains like Osmosis, these steps will be necessary to protect the realm from further instability. Figment is currently championing such fixes, like the one posted to Osmosis’s Commonwealth forum above.

Final Remarks

There are several factors that make the decline of Terra interesting. The first is that Terra managed to keep roughly 50% of its BTC reserve intact. The other positive is that the Terra community and LUNA stakers have remained fairly optimistic about the future. However, given the mobilization of Anchor account holders against the protocol, it is clear that more drastic measures will have to be taken for Terra to have a chance at regaining its footing.

Regardless of what steps taken to restore UST’s peg to the dollar, it is likely that LUNA prices will continue to drop. Now that the chain has restarted, delegations have been disabled and other remedial action will be taken. It is likely that the supply of LUNA will rapidly increase or the delay in pool recovery block time will make the decline a slow burn. Sadly, there is very little chance of recovery, despite Terra’s noble experiment in decentralization.

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