Terra in 2024: The Spectacular Fall of a Stablecoin Giant

TerraUSD (UST), once the third largest stablecoin and darling of the crypto yield-hunters, collapsed in dramatic fashion in May 2022. This wiped out $40 billion in market value in a week, set off industry-wide contagion, and inflicted heavy losses on retail investors seduced by unsustainable 20% yields.

The Rise and Fall of Terra

Launched in 2018 by Korean developer Do Kwon, Terra (LUNA) and its algorithmic stablecoin TerraUSD (UST) formed a rapidly growing crypto ecosystem. Leveraging a complex mint/burn mechanism to maintain UST‘s dollar peg via LUNA, it attracted over $20 billion in total value locked on Anchor protocol alone promising up to 19.5% yields on UST deposits.

This fueled massive supply inflation in LUNA, with circulating supply rising from 350 million in 2020 to over 6.5 trillion at time of UST’s collapse. As crypto analyst @0xHamz puts it:

“Terra was one of the most obvious Ponzi schemes in crypto”

Despite red flags, Terra boasted a market cap crossing $40 billion in early 2022, making UST the third largest stablecoin behind Tether and USDC.

But this house of cards came crashing down when UST lost its 1:1 peg to the dollar in the first week of May 2022. From $60 billion market cap, Terra plunged to near zero in value over 7 days of carnage, Gregory Maxwell compares it to:

"Watching a plane crash in slow motion"

Let’s analyze what factors caused this spectacular stablecoin failure.

The Core Reasons for Terra‘s Crash

While the precise trigger is debated, consensus agrees the root causes were:

Unsustainable Anchor Yields

Anchor protocol offered up to 19.5% APY on UST deposits, funded by a combination of staking yields, borrowing interest and most importantly – fast declining reserves.

Declining Anchor Reserves

As the above chart shows, Anchor’s reserves rapidly dropped from over $4 billion in December 2021 to just $100 million by May 2022. This indicated that depositor yields were being subsidized and were unsustainable without large reserves.

Bank Run Due to Losing Peg

Seeing rapidly declining reserves, Terra investors started losing trust that the 1:1 peg and high yields were sustainable. This triggered bank run-like behavior with a spike in UST withdrawals from Anchor:

Terra deposits on Anchor crashed as UST lost peg

As UST fell below $1, expectations of further decline led to agressive unwinding of UST positions.

Death Spiral with LUNA

The increased UST supply being dumped crashed its price further. To maintain the peg, LUNA was rapidly minted and sold, diluting its value. With broken trust in the ecosystem, LUNA entered a classic death spiral.

LUNA supply expanded from 350m to 6.5b in 2 years

As the above chart indicates, LUNA supply expanded over 60X in 2024 alone before collapsing to near zero value.

This combination of unsustainable yields, loss of trust, and "printing money" to save the peg proved lethal for Terra.

Detailed Timeline of Terra’s Collapse

While Terra’s troubles had been brewing for months with declining reserves and minting billions of new LUNA, the final capitulation occurred in a matter of days:

  • May 7 – Early warnings emerge as UST briefly loses peg, trading as low as $0.98 amid broader crypto market weakness. This leads to increased minting of LUNA to balance.

  • May 8 – Concerns grow as LUNA drops ~20% in a day, UST stablizes around $0.98. Tokenomics start breaking as LUNA mints hundreds of millions of new tokens.

  • May 9 – The dam breaks as both LUNA and UST crash, LUNA price drops below $40 and UST hovers around $0.70 amid a full-blown bank run.

  • May 10 – Desperate measures as LFG loans $1.5B in BTC to market makers to defend the peg, but run continues. LUNA drops below $20.

  • May 11 – Delisting fears emerge as UST falls to $0.30. Hyper-inflation kicks in wiping nearly all LUNA value.

  • May 12 – Capitulation day, as LUNA drops 99%+ to near zero value. Terra ecosystem collapses with no recovery in sight.

In less than a week, the Terra complex was comprehensively wiped out in a run that will go down in history as one of crypto’s most notorious crashes.

Impacts on the Crypto Industry

Terra‘s failure raises existential questions about unbacked algorithmic stablecoins. It also had wider repercussions:

  • Retail investors suffered heavy losses chasing unsustainable yields without understanding the risks.

  • Legal action kicked off with South Korean police launching a formal investigation into Terraform Labs and Do Kwon. Class action lawsuits are also underway.

  • Investors shifted funds to "safer" stablecoins like USDC, with Tether‘s dominance decreasing.

  • Global regulators renewed calls for stablecoin legislation, with urgent Congressional hearings organized to discuss standards.

  • The cryptomarket was shaken although shock was partially absorbed, Bitcoin dropped below $30K but did not collapse.

Though painful, Terra‘s failure may ultimately strengthen the crypto ecosystem by shifting investor focus to truly decentralized assets and real utility – rather than unstable greed-fueled speculation.

Evaluating Fundamentals of Stablecoin Models

Terra‘s crash provides a stark case study in the fragility of unproven algorithmic systems. Let‘s compare some core models:

Algorithmic (eg. Terra)

  • Relies on mint/burn mechanisms to maintain peg
  • No real reserves backing, only perception
  • Fragile – prone to death spirals if confidence lost
  • Unproven long-term viability

Overcollateralized (eg. USDT)

  • Backed by reserves (albeit opaque for USDT)
  • More resistant to bank runs
  • Long track record of maintaining peg
  • Still carry risks of mismanagement

Crypto-Collateralized (eg. DAI)

  • Backed by crypto overcollateral (typically ETH)
  • Programmatically transparent
  • Battle-tested through market volatility
  • More decentralized than corporate-issued

While not without risks, crypto-collateralized models have so far proven more robust than pure algorithmic stablecoins. However, heavy transparency and auditing is still essential to manage peg stability.

Key Takeaways for Investors

Terra provides sobering lessons for crypto investors:

  • Avoid "too good to be true" yields – Extremely high returns subsidized by declining reserves are fundamentally unsustainable.

  • Scrutinize fundamentals – Analyze tokenomics, reserves, team reputation. Don‘t just chase hype.

  • Favor audited and time-tested – New projects with revolutionary claims often don‘t live up to promises. Proven platforms with transparency are safer bets.

  • Diversify across assets – Don‘t put your life savings into crypto. Balance with stocks, real estate etc.

While Terra‘s crash caused deep losses, wise investors take both ups and downs as opportunities to learn. If we can absorb these lessons, the innovative power of crypto can still build a better financial system.

This article presents my own analysis as a blockchain data researcher. It is not investment advice. Please do your own due dilligence before investing in any asset.