Crypto-Chernobyl: the "avoidable disaster, not (quite) a Ponzi" perspective
Next up: bankruptcy reorg.
The implosion of Terra is the worst thing that could’ve happened to our industry short of a coordinated, multinational crypto crackdown. What’s more, it didn’t even have to happen (imo).
If you read this blog, there’s a decent chance you suffered severe personal losses as a result of this. I know I did.
But that doesn’t matter. What happens now?
Speculations & observations (subject to constant change, etc.)
Terra is bankrupt. It has $11.5B of UST (liabilities), offset by 7 trillion LUNA now in circulation ($2.5B market cap still, amazingly) and an unknown quantity of the $3.5B BTC reserve which Do Kwon (unbelievably) has still not disclosed.
The first $1.5B deployed in the early innings of the meltdown is presumed lost; it should hold a minimum of 1.5 billion UST ($300M).
It’s extremely unlikely that the remaining BTC was stolen or funneled out. “Mixing” (washing X into millions of untraceable transactions in Y and Z) at $1B+ scale is very difficult unless it’s done over a very long period of time. The BTC won’t be hard to find.
The only LUNA that has any value right now is the 633m that was staked before the network halted further validator staking.
The halt was ostensibly for network security (which was a real issue), but the protocol owners could’ve also secured the network by buying the newly minted LUNA, which they refused to do.
Your influence over the future of UST/LUNA today is your most recent amount staked divided by the total amount staked at that time. For me, it’s 2500 / 633m or .000395%, although I bought thousands more which I later discovered I couldn’t stake.
Which means the voting power of Kwon & Co has been diluted by only 50% despite taking their entire ‘country’ down the drain.
The only path to Terra’s protocol solvency lies in the protocol buying back UST at the rate at which assets equal liabilities, which would be (I guess) $.10-.20 of UST.
Terra is in the same situation as an EM currency/debt crisis, where there are too many USD bad debts relative to native-currency assets. The only path to viability is for bondholders (UST holders) to get a haircut.
Earlier in the week, Terra said it wanted to be much closer to the FRAX model going forward, i.e., maybe 50-75% collateralized with non-LUNA collateral. (FRAX is at 88%.) This model would be basically impossible at this point.
Some TFL elements have been pushing a totally unproven “institutional attack” conspiracy theory, presumably to justify re-denominating LUNA based on pre-attack ownership, and censoring all transactions that occurred after time X. In which case, LUNA bought after whenever that snapshot takes place will be worthless.
At 7 trillion LUNA of supply (it’s not hyperinflating anymore, that was halted), LUNA would be worth 1/7,000 (.000143) USD, or .0007 UST, to have a USD $1 billion market cap. On Astroport, it has a .0022 UST exchange rate: LUNA still has $3 billion of actual market cap! Nuts.
I don’t care that Kwon was involved with a prior failure, Basis Cash. Terra was so striking to so many because its failsafe mechanisms seemed orders of magnitude better thought-out than other protocols. Most crypto projects are strung together with spaghetti and duct tape, with obvious lack of consideration given to edge-cases. Terra seemingly had a ready answer for every imaginable edge case and every implausible edge case.
I just don’t understand why Kwon literally overrode his own failsafe (via off-chain UST) … after already having one stablecoin blowup. That takes even more hubris than Kwon showed in his “never miss an opportunity to punch down” social demeanor.
Kwon’s prioritization of unsustainable growth over real-world use beyond any rational point (by keeping Anchor rates as high for as long as he did) and prioritization of extremely high-risk UST growth (by listing UST on off-chain venues) were fatal, protocol-destroying decisions for which not just TFL, but also the LFG Multisig owners, must take full responsibility.
Retrospectives / chronology
Anchor, in its initial conception, was no “Ponzi.” It was the equivalent of Jeff Bezos selling a convertible bond in AMZN in the late 90’s to fund marketing costs and growth. It was a way for Terra to simultaneously rent capital at scale (at a high price) while onboarding new users into its protocol, and helping Terra scale its broader network. Bets on growth that don’t pan out are always termed “Ponzis” by journalists and other professional critics who never actually built anything.
However, by December 2021, with the launch of the Degenbox, Anchor had strayed far from its original mission (as a clever user marketing hook to onboard new DeFi users), when Daniele Sestagalli took advantage of Anchor’s ambitious aUST composability to “loop” a couple hundred million dollars of deposits into $1.2B of UST at a 100%+ annual yield. This was ridiculously parasitic.
Kwon’s implicit support of this was a massive red flag that showed no regard whatsoever for sustainable growth. I exited my Terra positions at this point in time.
The crypto-crash of January/February 2022 killed off the Degenbox, reducing stress on Anchor and offering Terra a golden opportunity to a) cut deposit rates to more sustainable levels and b) eliminate the parasitism of “looping” aUST (leveraging Anchor deposits up 5-7x).
The deprecation of the Degenbox, combined with LUNA’s resiliency during the January/February crash gave me, and probably others, a very false sense of security that the aUST looping games were over, or at least heavily cut back. I bought back in, and thought I’d be fine by generally avoiding the Anchor Protocol and its ballooning asset/liability mismatch. Wrong.
During 1Q22, Anchor became a growing systemic risk for the Terra protocol. Bigger and bigger sums of UST were parked there, doing nothing else within the broader ecosystem. That wasn’t “user onboarding for real-world use cases.” Not only was it parasitic, it was primed to run for the exits at the first sign of systemic stress. It was pointed out, debated, and discussed inside and outside of Terra at length. Everyone agreed that it was going to be a problem before long, soon, sooner, or very sooner.
Less discussed, and even less defensible, was how Anchor’s high deposit rates also sucked capital out from more productive projects on Terra (Mars) and other Terra-integrated L1s (AVAX).
Who needs to take big risks funding binary-but-maybe-productive assets when you can just get paid 23% per year for doing nothing?
This became a major complaint from Terra’s closest partners. Kwon never cared.
UST deposits put to real world use (eg, lending to a small business for 3 months, or being locked up in a smart contract as duration collateral against some other digital asset) couldn’t have just run for the exits when something went wrong.
Unproductive UST deposits on Anchor, by contrast, had every flexibility to run for the exits — and run they did.
By early March, industry heavyweights such as Polychain and Arca were muscling into Anchor’s governance with corrective proposals that were sensible on the margin, but didn’t go nearly far enough in correcting Anchor’s bad incentives.
I was told on good authority that the Anchor team wanted significantly deeper cuts than what was ultimately approved: a 150bps per month cut to a 15% deposit rate floor. Kwon was the ultimate veto on these decisions.
Many, probably a large majority, of “independent protocols on Terra” employees were always either direct employees of Terraform Labs, or dependent on being in good standing with TFL to survive on Terra. The centralization of the network was far more acute than widely understood. Everyone ultimately depended on Kwon.
Anchor would’ve been profitable, in a flat market, at 7-8% deposit rates by my estimate. But Kwon wanted the customer acquisition hook so badly.
To finance the unproductive Anchor deposits, Terra had to dump (first) $600M of LUNA onto the market. After that was burned through in 3 months, an additional $1-2B dump was imminent. Terra was, in effect, shorting its own governance token to subsidize the growing systemic risk of idle Anchor deposits. This is the “Ponzi” that everyone refers to, and at this point, it had become a Ponzi because it was completely disconnected from productive-user acquisition cost.
As Terra decided on moving from a zero-collateralization model to a diversified-collateralization model, it needed to sell more LUNA for the preferred diversified collateral (BTC). This was a very debatable move, as it radically centralized the network’s potential future solvency (management of the reserve) at the expense of current LUNA holders. At the same time, it held indisputable diversification value up to a subjective point.
Now, in bankruptcy, the “LFG Council” most responsible for bankruptcy has sole control over whatever assets remain. Centralized currency reserves on crypto are a stupid idea that should never be repeated.
To create corresponding "LUNA burn” to offset this second wave of LUNA issuance, Do Kwon made his most critical mistake: listing UST on centralized, off-chain venues (FTX, Binance, etc). This created huge pools of “FTX-wrapped UST” and “Binance-wrapped UST”, trading at its own price, not subject to Terra’s exit tax failsafe mechanism.
What was Terra’s exit tax failsafe mechanism? Terra foresaw the risk of capital flight events, and thus implemented a soft capital control system, whereby any capital fleeing the system exceeding around $100M per day (later grown to $300M) would face a rapidly increasing “swap fee” (exit tax).
This tax revenue would accrue to LUNA stakers, the critical loyalists of the network, and would be denominated in UST, which under the protocol’s design would always be much more stable than the price of LUNA — thus giving LUNA stakers a rapidly increasing source of stable revenue at a time of rapidly increasing systemic stress. Again, risk symmetry creatively solved a previously intractable problem, with a robustness that dealt with very significant edge-cases.
It’s thus no coincidence that the crash in UST started on off-chain venues.
Did it really matter that this happened before the 4pool’s deployment on Curve? Who knows. A big part of me thinks Kwon’s arrogance & Terra’s hyper-centralization would have fed more stupid risks like un-Anchor-ing deposit rates from any productive reality, or blowing a giant loophole in Terra’s key exit tax failsafe mechanism—and the final blast radius would’ve been 10x bigger than it actually was.
Pre-crash, Terra had around $3.5B of non-LUNA reserves. Seemingly $1.5B of it was lost defending Terra’s off-chain exchange rate when the bank run started on Sunday night at Binance.
Instead of working as an “on-chain UST redeemer of last resort” (ie, buying back UST at X% discount to par, after exiters were already being hit heavily with exit taxes), half of Terra’s reserve was blown as the buyer of first resort covering up an off-chain attack surface which TFL’s growth-at-all-costs decisions had created.
After the initial $1.5B wasn’t enough to save the off-chain pegs, the idle Anchor deposits exited en masse. This happened on Monday and Tuesday, crippling the on-chain peg to .73 and the off-chain pegs to lows of .60 or so.
By now, LUNA was trading in the $20s, but it wasn’t dead yet—inflows had still equaled outflows, and risk symmetry among buyers and sellers had been preserved. The peg gradually healed to around $.90 as markets awaited the “plan” of TFL and its deep-pocketed loyalists (Jump, Delphi, etc).
Kwon’s plan amounted to selling $1.5B of LUNA at a 50% discount to current prices and a one-year lockup. It was leaked by multiple parties and never denied by TFL, so the market justifiably interpreted it as fact.
This proposal was a disaster: it didn’t address any sources of systemic risk (Anchor etc), it treated all crisis-buyers of LUNA as suckers, and it created a huge incentive for institutions to short LUNA to hedge their bailout positions … just when the protocol most needed more funds to recapitalize.
The final panic began. UST’s peg crashed, and LUNA’s printing press went exponential. LUNA went from $20 to $4 very quickly, while the rate of UST “bad debt” retirement (LUNA inflows * LUNA price) slowed much more quickly than LUNA’s price fell. This was the moment, imo, when LUNA/UST was truly doomed.
Meanwhile, retail buyers had no reason to commit further capital inflows to the protocol while such a dilutive plan was being discussed.
Terra’s decision to suspend UST-LUNA linkage was the right one. The peg can’t be restored by algo-garbitrage, a la TITAN/IRON. It’s restored by capital inflows. As long as any incremental capital inflows were exponentially devalued (95% per day), Terra had no hope of closing a $7B bad debt.
Kwon surfaced 24 hours ago to advocate a proposal which basically tries to rewind time. The proposal would presumably wipe out Kwon (the LFG wallet), but it would be obscenely overgenerous to Kwon’s circle, who bear equal culpability.
The Terra Protocol still has unknown, but significant value, aside from its bad debt.
“Partially collateralized algostable” will be a very dirty term for a very long time. DAI abandoned this model in early 2020. Frax is in the process of abandoning it as well. I do not think decentralized money has any other chance of gaining real-world network effects, and I will patiently await its return, minus Terra’s Achilles heel of centralization.
With (say) $4 billion of UST in remaining circulation, Terra would need $2-3B of assets. So Terra would have to somehow retire $8.5 billion or so of UST (there are still $11.5B outstanding, per Smartstake) with $1B of BTC, and then get $1B USD of external bailout at 1:1 UST, to have post-bailout assets of $2B of non-LUNA assets, $1B of LUNA assets, and $3B-ish of liabilities (67% non-LUNA collateralization).
It’s not impossible, but very unlikely at this point.
Lots of interesting bullets.
One thing I'm not clear on is whether you believe uncollateralised or partially collateralised stables have a future. My view is that they don't.
Ultimately, even in fiat circles, moving to partial collateralisation tends to always preceed the downfall of a currency.
My view at present is that blockchains should each try to have their own native version of USDC.
I hold out some hope for DAI (although question the 50% that is issued backed by USDC) but I see DAI as in a different category than USDC. It inherently has worse collateral risk and DAI holders should earn an interest premium to USDC for that risk.