Terra collapsed because it used hubris for collateral — Knifefight

The rise and fall of the Terra blockchain and family of related tokens is both one of the most convoluted and one of the most important stories happening in crypto right now.

Assembled here is a plaintext explanation of what Terraform Labs built, why it got so big, why it imploded, what it means for the markets, and what you need to know to keep yourself safe from similar projects in the future.

What exactly is Terra?

That’s a great question, and we will answer it. But first, let’s found a bank.

Our bank will do all the usual bank things like take deposits, pay interest, enable payments and make loans. Obviously, we could restrict ourselves to only loaning out money we actually have, but that is tedious and unprofitable. So, like any bank, we will make more loans than we receive in deposits and keep only a fraction of our customers’ deposits available as cash to withdraw when they need it. The amount we will keep available as cash is 0%.

It will be fine! Since we are loaning out 100% of our reserves, we will be very profitable; and since we are very profitable, we will be able to pay very high interest rates. No one will want to withdraw! If we ever do need money, we can sell stock in our very profitable bank. When demand for our deposits grows, we can use the new money to do stock buybacks. Since everyone is confident in the value of our stock, they will know we can back up our deposits; and since everyone is confident in the demand for our deposits, they will value our stock. Nothing could go wrong.

Okay. One thing that could go slightly wrong is that this is all illegal for a variety of reasons, so we’ll need to run our bank on a blockchain and issue our deposits as stablecoins — but that’s fine. The difference between a bank deposit and a stablecoin is mostly regulatory optics.

That’s roughly the business model of the Terra ecosystem. Terra is a blockchain built by Terraform Labs that uses a stablecoin, TerraUSD (UST), and a reserve token, LUNA, to stabilize the stablecoin’s price. You can think of Terra as a digital bank, with UST representing deposits and LUNA representing ownership in the bank itself. Owning UST was like making a deposit in an uninsured bank offering high interest rates. Owning LUNA was like investing in one.

What makes a stablecoin stable?

Stablecoins themselves are not necessarily all that hard to build. There are a lot of them, and for the most part, they work in that they largely trade for around $1. But most surviving stablecoins are collateralized, meaning they represent a claim of some kind on a portfolio of assets somewhere backing the value of the coin. UST, on the other hand, was not backed by any independent collateral — the only thing you could exchange it for was LUNA.

To keep the price of UST stable, the Terra protocol used a built-in exchange rate where anyone could exchange 1 UST for $1 worth of LUNA. When demand for UST exceeded its supply and price rose above $1, arbitrageurs could convert LUNA into UST at the contract and then sell it on the market for a profit. When demand for UST was too low, the same traders could do the opposite and buy cheap UST to convert into LUNA and sell at a profit. In a sense, the Terra protocol tried to eliminate price movements in UST by using the supply of LUNA as a shock absorber.

The trouble with this arrangement (and with algorithmic stablecoins generally) is that people tend to lose faith in the deposits (UST) and the collateral (LUNA) at the same time. When Terra most needed LUNA to prop up the value of UST, both were collapsing, and the result was like offering panicking customers in a bank run shares in the failing bank instead of cash.

You could convert your deposit into ownership of the bank, but you couldn’t actually withdraw it because the bank itself didn’t own anything at all.

A brief history of catastrophic failure

TerraUSD was not the first attempt at building an uncollateralized stablecoin. The streets of crypto are littered with the bodies of previous failures. Some prominent examples include Ampleforth’s AMPL, Empty Set Dollar, DeFiDollar, Neutrino USD, BitUSD, NuBits, IRON/TITAN, SafeCoin, CK USD, DigitalDollar and Basis Cash. (Remember that last one in particular for later).

These arrangements “work” in a bull market because it is always possible to lower the price of something by increasing the supply — but they fall apart in bear markets because there is no equivalent rule that says reducing the supply of something will cause the price to go up. Reducing the supply of an asset nobody wants is like pushing a rope.

Beware of protocols with cyclical economic pressures. If they reward richly during upcycles when lots of people buy in, they also likely punish quickly during downcycles when most are looking to exit.

— Do Kwon