Back in December, I wrote a story about a blockchain called Terra and why I thought it was the most promising blockchain around. In that story, I included a section on how Terra could fall apart in a theoretical black swan market event, and it seems my worst fears have come true.

At the beginning of February, I wrote another story about why crypto winter was around the corner, though I didn’t know exactly when it was going to happen. My fundamental concern at the time was that crypto was lacking a consumer economy and therefor its whole valuation was way over-blown. Unlike the stock market which is primarily dominated by core human needs like food, housing, utilities, natural resources, etc., crypto seemed like it was trying to build a financial services economy without a consumer economy to base it on top of.

With Terra specifically though, there were some fundamental concerns.

For the uninitiated, TFL = Terraform Labs, the creators of the Terra blockchain who are still very actively involved with its day-to-day operations. And Do Kwon is one of the co-founders of TFL and by far the most well-known (he fashions himself for crypto what Elon is for the business world in this writer’s opinion).

UST Was Never a Great Currency

I won’t go into detail, as I covered all this in my prior story about Terra (linked again), but UST — an algorithmic stablecoin pegged to the USD — was the focus of the TFL team and Do Kwon in proving the value of Terra and LUNA.

To be a good (and valuable) currency, you need basically two things: a relatively stable value and wide usage/transaction volume in a large and diverse economy.

UST had the first part, as its value is based on USD which is a very stable currency in the grand scheme (don’t let recent inflation blind you, USD is quite stable when you zoom out compared to most other currencies).

It seems like Do Kwon and TFL’s plan to satisfy the other requirement of wide usage centered around making UST a standard stablecoin for crypto trading and other cross-chain DeFi use-cases.

That sounds nice in theory, but was that really ever going to be enough?

Take one more step and ask: why would I store my blockchain cash (say if I sold some ETH and wanted to keep the profits on-chain) in a potentially-unstable algorithmic stablecoin when I could store it in a fiat-backed stablecoin which guarantees I could always redeem for fiat dollars (like $USDC)? The answer on its face is obvious that you wouldn’t. So making $UST a standard among traders and DeFi was never going to happen on its own.

Bitcoin isn’t a great currency either, but I’ll save that for another story. Photo by olieman.eth on Unsplash.

TFL’s answer to this dilemma: Anchor Protocol. A way that TFL could inject capital into a extreme-yield savings account to make holding UST more valuable than holding other stablecoins that couldn’t get that kind of yield. Basically, a decent reason to use UST over USDC or other fiat stablecoins. We’ll circle back to that in a minute.

Terra Lost Sight of its Multi-Currency Premise

TFL’s plan to bring value to Terra was to focus almost exclusively on UST, even though Terra’s original (and I would argue primary) value proposition was the fact that it’s an ecosystem of stablecoins all pegged to different fiat currencies.

This multi-currency setup could allow for Terra stablecoins to power eCommerce and other payments solutions in multi-national currencies, including facilitating nearly frictionless international payments (which is a major problem that many tech startups have tried and failed to address). And everyone could transact in their own currency that they’re already familiar with. This is the power of stablecoins.

This promise is far more revolutionary than an algorithmic USD-pegged coin, but it’s obviously much more of a long-tail, slow-burn strategy.

Stablecoins are still the most important asset in crypto, I firmly believe that. And Terra’s algorithmic stablecoins were a really interesting take on this important asset class that was totally unique. That’s why I invested so heavily in it in 2021 (and thankfully made good money on it too). I also sold in January once I realized the market wasn’t going to sustain this hype much longer and that Terra had strayed very far from its original premise.

Anchor Protocol: Unsustainable Yield = Unsustainable Results

20% APY on stable deposits (crypto savings account)? I don’t think anyone was under any impression that that was going to be sustainable, but with the overwhelming majority of UST deposited in Anchor (nearly 80% right before this crash), it was obviously the single most important part of the Terra ecosystem (I would argue basically the only important part, maybe aside from Astroport).

The money was in Anchor. Photo by Alexander Mils on Unsplash.

Thing is, there was a fundamental issue:

Anchor Never Had Real Borrow Demand

In order to create the 20% yield, Anchor needed some revenues from borrowers. Only thing is, why would anyone want to borrow stablecoins in crypto today? Well the answer was basically just to access leverage to buy more LUNA (since again, there’s no consumer economy that you might want to borrow money for). But since that was inherently very risky, Anchor subsidized borrowers with $ANC token emissions such that you could even get paid to borrow money. This was the only way they could actually bootstrap some borrow demand in order for the protocol to make money and be able to pay its deposit rate.

Without getting too wonky, that should clearly seem odd at first glance. What ended up happening was that you could farm the yield like this:

1. Borrow money on Anchor using your LUNA as collateral, get paid a net APY return in ANC tokens. You pay 15% APR to borrow but are rewarded with 20% APR in ANC for instance (the real numbers are dynamic based on market factors).
2. Deposit the borrowed UST back into Anchor to get 20% yield on the amount you borrowed, creating a loop.
3. Alternatively, buy LUNA with the borrowed funds, then deposit that as collateral to increase your borrow limit and borrow more, increasing your LUNA exposure and increasing your ANC rewards.

There was even a yield product called Nexus Protocol explicitly designed to automate this process and optimize the borrowing amount to maximize the yield in this circular borrow/deposit cycle. I even made some money on this scheme myself in April/May/June 2021 (pre-Nexus Protocol).

Well, borrower incentives have been dropping (as a result of falling ANC prices and rising platform usage), and as a result, the gap between borrow amount and deposits has been growing steadily over the last handful of months. In December, there was 1.67x the amount of deposited UST compared to borrowed UST. Right before this crash, that ratio had widened to 4.67x. Borrow interest rates had also declined considerably given the lower borrow demand relative to deposits (this is algorithmically controlled).

Those two factors meant that Anchor was bringing in far less in revenues compared to how much it had to pay out in yield compared to even just a few months ago. This was, of course, exposing the fundamental issue that there was just little reason to borrow on Anchor and therefore the deposit side was going to keep progressively outpacing the borrowing side until that deposit rate got dramatically slashed.

Turns out, we didn’t even need that to happen for things to come crashing down though.

And with Anchor unraveling, the entire Terra blockchain started unraveling, because of how much of Terra’s capital was locked up in Anchor.

What Happens Now?

Originally, I was hoping Terra would be able to regain the peg without totally decimating LUNA, but it seems that’s not going to happen. LUNA will end up being nearly worthless, and all the promise and work that went into Terra will be wasted. Hopefully some of those Terra projects manage to migrate somewhere else or rebuild on another chain.

This was a rough one, far more violent and quick than I had expected.

RIP Terra Luna.

As I am not a registered fiduciary agent, none of my advice is legally binding in any way, and choosing to follow or not follow it is a responsibility that lies squarely on your shoulders. Crypto is a volatile market, and a significant crash in values is a normal event in this space, just as a significant increase in values is. Treat the market as an irrational actor (which is what it is), buy the proverbial dip when possible, take some profits along the way, and enjoy the ride.