Terra Luna Collapse

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= significant event in the 'crypto' and blockchain world


Blockchain Technology and Polycentric Governance:

"The Terra/Luna collapse presents an example of how the failure of a particular component in the DeFi ecosystem can have a cascading effect, impacting the broader cryptocurrency market. The failure led to the insolvency of numerous projects and inflicted significant financial losses on investors, amounting to billions of US dollars.

In 2018, Kwon Do-hyung, a South Korean businessman, co-founded Terraform Labs, a company focused on the development of a stablecoin (Terra) that used a secondary cryptocurrency (Luna) as a governance token (Kereiakes et al. 2019). TerraUSD/UST was a stablecoin pegged to the U.S. dollar. Like other algorithmic stablecoins in the DeFi ecosystem, TerraUSD was not backed by fiat assets. Instead, it relied on the Luna governance token to absorb volatility by facilitating the swap between Terra and Luna at Terra’s target exchange rate (Kereiakes et al. 2019). As the market value of Terra and Luna were highly dependent on each other, the inefficiencies of either one meant a considerable risk to the entire Terra/Luna ecosystem, eventually leading to its rapid collapse. In May 2022, right before Terra UST lost its peg to USD, UST reached its peak market capitalization by surpassing $18 billion. Being the third largest stablecoin at the time, the depegging event triggered immediate investor panic, leading to a surge in UST withdrawal and swap activities, with almost no market demand for the Luna cryptocurrency. Multiple factors may have been responsible for the crash. In addition to the algorithmic stablecoin design vulnerabilities and allegations of a coordinated attack targeting the Terra ecosystem, it was concluded by several sources that the Anchor Protocol funds outflow put increased pressure that eventually broke the UST peg (Barthere et al. 2022).

Anchor was introduced in 2020 as a savings protocol on the Terra blockchain (Platias et al. 2020). It quickly became one of Terra’s most popular projects, offering nearly 20% annual percentage yield (APY) for UST deposits. The introduction of Anchor resulted in the increase of the circulating UST in the market, along with a rising number of lenders and a relatively small number of borrowers, which is believed to have caused the reserves to decrease over time. By April 2022, more than 72% of all USTs were deposited in Anchor, which underlined the critical state of UST’s dependency on Anchor’s success (Kelly 2022). On-chain analysis performed by the Nansen research team showed that a few players moved the funds out of the Anchor protocol prior to the depeg. Specifically, from 7-10 May 2022, the top 20 addresses collectively withdrew 2 billion UST from Anchor through a total of 5,051 transactions (Barthere et al. 2022). Whether the substantial unstacking and selling were a reaction to market volatility, vulnerability exploits, or a deliberate attack is a subject of ongoing debate.

Even the Luna Foundation Guard (LFG), established in February 2022 to support and uphold the UST peg, proved unsuccessful in mitigating the consequences of the market crash. The whole Terra ecosystem suffered from a liquidity crisis where the entire value of Luna could not balance out the value of UST. The efforts to defend the depeg involved liquidating reserves totaling billions of US dollars in various cryptocurrencies such as BTC, BNB, and USDT. However, those efforts were unsuccessful and may have contributed to a subsequent decline in the broader DeFi ecosystem, negatively affecting projects like Alameda Research, a quantitative cryptocurrency trading firm closely linked to the FTX crypto exchange."