Anatomy of a Run: The Terra Luna Crash

Jiageng Liu is a PhD student at MIT Sloan School of Management, Antoinette Schoar is the Stewart C. Myers-Horn Family Professor of Finance at MIT Sloan School of Management, and Igor Makarov is Associate Professor of Finance at the London School of Economics and Political Science. This post is based on their recent paper.

The collapse of Terra in May 2022 marked the first major run in crypto and contributed to the collapse of several other key players in the eco-system. We provide a detailed analysis of the run and the economics of the Terra network prior to the run. The Terra crash offers valuable insights into the dynamics of runs in the absence of regulatory oversight and reveals several important fault lines in the typical decentralized finance (DeFi) architecture.

Using detailed data from the Terra blockchain and trading data from on-chain centralized exchanges (CEX), we show that the run on Terra happened across multiple chains and assets. Our analysis suggests that it was not the result of targeted market manipulation by a single entity, but rather stemmed from growing concerns about the sustainability of the system.

At the center of the collapse was Terra’s algorithmic stablecoin, UST, and a blockchain-based borrowing and lending protocol, Anchor. UST was marketed as the first genuine crypto-native stablecoin and was a distinguishing feature of the Terra network. Unlike other major stablecoins such as Tether or Circle, which are backed by off-chain liquid assets, e.g., treasuries, UST was not supported by off-chain collateral but by a smart contract that allowed an exchange of one unit of UST to $1 worth of Terra’s native currency, LUNA, and vice versa. In economic terms, UST was like infinite maturity convertible debt with a face value of $1 backed by LUNA.

To incentivize the adoption of UST, the Anchor protocol offered a very high yield of 19.5% to UST depositors, which generated significant inflows of deposits and led to a large increase in UST issuance. We show that both the deposit and lending rates on Anchor were heavily subsidized. The newly issued UST were used to pay the interest on Anchor deposits and fund other activities. However, as the volume of deposits skyrocketed, the level of subsidies required became increasingly unsustainable. By April 2022, a daily subsidy level reached $6 million, prompting the Terra community to pass a proposal to gradually decrease the 19.5% interest rate to a more sustainable and market-driven level, starting on May 1, 2022.

Contemporary with these developments, there were additional indications of declining network fundamentals. First, following its peak value of $119.18 on April 5, 2022, the value of LUNA experienced a decline in conjunction with a general downturn in the value of cryptocurrencies, thereby diminishing the relative market valuation of LUNA compared to UST. Second, during the latter half of April 2022, there was a substantial decrease in the entry rate and an increase in the exit rate from Anchor.

The first signs of the run appeared on May 7, 2022, when two large addresses withdrew 375M UST from Anchor. Blockchain technology enabled investors to closely monitor each other’s actions and amplified the speed of the run. However, the complexity of the system put less sophisticated and poorer individuals at greater informational disadvantage. We show that wealthier and more sophisticated investors were the first to run and experienced much smaller losses. Poorer and less sophisticated investors not only ran later and had larger losses, but a significant fraction of them attempted to buy into the run, hoping to “buy the dip.”

The UST peg design also allowed users to exit UST by either selling UST directly or exchanging UST for LUNA and then selling LUNA at the market price. As users exchanged UST for LUNA, the price of LUNA precipitously fell leading to increasing dilution, which further depressed the price of LUNA and resulted in a dramatic “death spiral” where over just three days, the LUNA supply increased from 1 billion to 6 trillion and the LUNA price decreased from $80 to almost zero. Interestingly, we find that Alameda Research, a cryptocurrency trading firm closely affiliated with the FTX exchange, conducted the largest amount of UST-LUNA swaps among Anchor depositors. The swap fees and uncertainty about the execution price of LUNA on exchanges seem to have discouraged other Anchor depositors from utilizing the native swap contract as an exit strategy. But Alameda Research, with its preferential access to the FTX exchange, had a competitive advantage over others.

Our results demonstrate that observability and free access to the blockchain alone do not level the playing field for investors if substantial differences exist in their ability to process and interpret information. They also highlight the limitation of transparency, especially for complex systems like Terra-Luna. The subsidies to the Anchor protocol were recorded on the Terra blockchain and, in principle, observable to all investors. But it is unclear to what extent especially small investors understood the precarious nature of UST claims and the possible impact of UST conversion on the LUNA price. By aggressively underplaying the risks that were building up in the system on social media and other outlets, Terra insiders likely contributed to the false belief about the safety of the system. Ultimately, the sustainability of the DeFi ecosystem will depend on the ability of investors to make informed decisions and hold projects and their promoters accountable for their actions.

Download the full paper here.

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