The Anatomy of a Stablecoin crash: How Terra LUNA UST Collapsed [$45 BILLION]

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Originally published on May 21, 2022 (updated February 11, 2023)

Terra LUNA UST stablecoin crash: What caused it?

One of my TikTok viewers asked me to deconstruct what happened in the LUNA UST collapse. The collapse was directly linked to the Curve 3pool War. And, I think that it boils down to arrogance or a lack of humility.

First, Do Kwon was behind an earlier failed stablecoin, called Basis Cash. This was an algorithmic stablecoin project that was founded by the anonymous “Rick” and “Morty” in 2020. According to an article on Coindesk, Do Kwon is reported to be “Rick.” Do Kwon did not know whether or not Basis Cash would work, but he wanted to test it. The test was a failure. Basis Cash was never able to hold its peg to the USD. Read more.

So, Do Kwon knew the fragility of algorithmic stable coins. So, earlier this year, he proposed to back UST with a “Luna Foundation Guard” (or LFG) composed of $10 billion in Bitcoin reserves. If the LFG could buy Bitcoin at a low price and if the price of Bitcoin rose, the LFG could have a powerful reserve asset in the event that UST began to lose its ped to the USD. In late March, the LFG started buying BTC to help back UST.

The War Against DAI

Next, the arrogance comes to a head. On March 15, Do Kwon makes a $10 million bet that the LUNA price would be higher than it was on March 15, 2022, a year later (March 15, 2023), followed by another $1 million bet. Second, Do Kwon announces a Curve 4pool with FRAX and UST. Now, this was a frontal assault against Curve 3pool and against the DAI stable coin.

UST had already surpassed DAI in terms of market cap. Now, Do Kwon was trying to put additional pressure on DAI. The new heavily incentivized 4pool would exclude DAI; rather, it would only contain UST, FRAX, USDC, and USDT. The explicit goal of Terra’s aggressive move was to “starve the 3pool” (composed of DAI, USDC and USDT) of liquidity, which could prove a damaging blow to DAI’s stability and attractiveness. On March 23, 2022, Do Kwon tweeted, “By my hand $DAI will die.”

Attacking DAI was a big mistake. On April 1, Terra Labs announced, “Terra and Frax will concentrate stablecoin liquidity across 4 pools on every major chain via Curve.” They also announced, “Frax and Terra are the two largest protocol holders of CVX (over 3.65m CVX cumulatively).” Through partnerships, Terra Labs was going to offer much higher CRV rewards than on the Curve 3pool. The goal was to ensure deep liquidity for the now-allied algorithmic stablecoins UST and FRAX (and the new 4pool) and starve DAI (and the 3pool) of liquidity.

The Attack Against UST

On May 8, 2022, in anticipation of the 4pool, the LFG removed $150 million in UST from the UST plus 3pool, this was a factory liquidity pool which pairs 3pool with UST. On the same day, an attacker used about $350 million of UST to drain the curve UST-3pool of liquidity. Unaware of the attack, the LFG removed another $100 million in UST from UST-3pool. This starts the de-pegging of UST from the USD. On coinbase, UST fell to $0.94.

With the Curve liquidity drained of UST, the attacker started selling UST on Binance. Binance tried to take action, but soon withdrawals from Anchor started. Very soon after that, there was panic in the system. The major de-peg happened on Monday, May 9, as people fled for the exits. By Wednesday, May 11, UST was $0.30, and investors had lost confidence.

UST and Terra LUNA Failed

“Onchain Wizzard” on Twitter speculates that the attacker probably had a huge short position on Bitcoin, knowing that the LFG would have to sell $3 billion in Bitcoin to defend the UST peg. That is entirely possible.

But, it seems clear that the reason for the failure of LUNA and UST was due to arrogance and a lack of humility. If Terra Labs did not have enough UST to kick off the Curve 4pool without draining the UST-3pool, then they should have shutdown the UST-3pool before they launched the 4pool. On May 8, removing $250 million dollars in UST liquidity from UST-3pool was a mistake. And, it enabled an attacker to launch an attack on UST liquidity.

So, basically, before UST and FRAX could team up and launch an attack on DAI and the 3pool, UST was attacked in the same way that they were planning to attack DAI, namely, by draining the liquidity on UST-3pool and draining the liquidity of UST on Binance. The attacker was able to start the depegging of UST from the USD. And, the attacker was able to start a bank run on UST and on LUNA.

Is this Karma? I do not know, but I will close with a Proverb: Pride goes before destruction, and arrogance before a fall. It is better to be humble than to divide the spoils with the arrogant.

On Friday, May 13, 2022, Terra UST and Luna was delisted from Binance and OKX.

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