The Collapse and Rebirth of Terra

TL;DR

• New Terra blockchain has been launched with its token, $LUNA; the original Terra blockchain and token have been rebranded as Terra Classic and $LUNC
• Both Terra Classic’s AUM and $LUNC’s price have dropped 99% after the collapse
• Terra Classic’s collapse started with a huge sell-off of $USTC from CEXs and DEXs and ended with $USTC depeg and $LUNC hyperinflation
• Terra ecosystem revival plan passed and new blockchain launched on 28 May with new $LUNA token airdrop
• Bull Case for Terra: A more decentralized and community-focused blockchain
• Bear Case for Terra: Lacks a unique positioning to differentiate

A new Terra blockchain was launched on 28th May with its native token, $LUNA. The original Terra blockchain has been renamed as Terra Classic and its native tokens, $LUNA and $UST have been renamed $LUNC and $USTC. Given there is an overwhelming amount of updates for Terra in the past month, 21Shares will aggregate and analyze the collapse and rebirth of the Terra blockchain.

Background and Market Size of Terra Classic

Terra Classic (originally known as Terra) is a smart contract platform similar to Ethereum and Solana, on which developers can build decentralized applications.

The key differentiation of Terra Classic is the monetary policy of its native currency ($LUNC). It is dynamically centered around algorithmic and uncollateralized stablecoins pegged to fiat currencies, of which the most popular is $USTC. Originally known as $UST, it was pegged such that its value would always be equal to $1.00.

$USTC can be purchased in the primary market (minted) through the mint-burn mechanism, where users can always mint (increase circulating supply) 1 $USTC via burning (decreasing circulating supply) $1 of Terra Classic’s native token, $LUNC (previously known as $LUNA). Conversely, users can always mint $1 worth of $LUNC by burning 1 $USTC. By using this algorithmic model, $USTC can scale up exponentially within a short period of time. However, the key risks are the uncollateralized nature of $USTC and the uncapped supply of $LUNC token. For a more detailed explanation of the mechanism, please refer to our previous statement.

Terra Classic was once a market leader in Decentralized Finance (DeFi) behind Ethereum. Its native token $LUNC and $USTC were also within the top 10 cryptoassets by market capitalization. Below is a comparison of Terra Classic’s market size before and after the collapse.

Source: 2nd June Data from Coingecko and DeFi Llama

Timeline of Terra Classic’s Key Events

State of Terra Classic before the collapse

Terra Classic experienced successful performance in 2021 and early 2022. Its algorithmic stablecoin, $USTC, had been widely adopted by more than 12+ blockchains. One of the contributing factors to its success was the 20% interest on $USTC deposits offered by Anchor Protocol, a lending and borrowing application built on Terra Classic. The high yield had attracted a lot of demand for the $LUNC token and brought a huge amount of liquidity into the ecosystem. Anchor Protocol had over $17B AUM at its peak, which accounted for more than 50% of the AUM under Terra Classic.

To further solidify the position of being the leading decentralized stablecoin in the market, the team behind Terra Classic, Terraform Labs, had 3 key initiatives:

1. (25 March) Purchase $10B Bitcoin as the reserve for $USTC
2. (1 April) 4Pool with Frax Finance on Curve Finance
3. (7 April) Partnership with Avalanche

Once these 3 major initiatives were accomplished, $USTC would be a stablecoin fractionally collateralized by Bitcoin, have more concentrated liquidity and be the default stablecoin on Avalanche. Following the announcement of these initiatives, $LUNC hit an all-time high of $119 and $USTC emerged as the 3rd largest stablecoin after Tether’s USDT and Circle's USDC in early April.

The Collapse and Rebirth of Terra

Shortly after the tremendous traction gained by Terra Classic in April, the storm arrived on 7 May. Below is a brief timeline of the key events:

The triggering point started off with an immense sell-off on both centralized and decentralized exchanges on 7 May. One of the largest transactions involved the swap of 85M $USTC for another stablecoin on Curve Finance, the largest DeFi stablecoin exchange. The sell-off caused a liquidity imbalance of the swap pool. The percentage of $USTC jumped from 54% to 95%. In light of the depeg, Luna Foundation Guard deployed their 80,394 Bitcoin reserve to buy $USTC. According to the on-chain analysis by Glassnode, Luna Foundation Guard’s Bitcoin address was emptied on 9 May. 52,189 Bitcoin was sent to the crypto exchange, Gemini and 28,205 Bitcoin was sent to Binance. Later on 16 May, Luna Foundation Guard tweeted that their Bitcoin had been used to buy $USTC in order to stabilize the peg. The remaining reserves left in Luna Foundation Guard’s wallet as of 7 June were 1.87M $AVAX, 1.85B $USTC, 39.9K $BNB, 313 $BTC, and 222M $LUNC, which amounted to a total of 93 million dollars.

Source: Luna Foundation Guard Dashboard

While the price of $USTC was still deviating from the $1 mark, holders started to lose trust towards the $USTC stablecoin and the Terra Classic ecosystem. The largest DeFi protocol on Terra Classic, Anchor Protocol saw a $5.5B AUM drop on 10 May, which was mostly due to withdrawals and escalating panic selling.

Since the buyback of $USTC using Bitcoin did not succeed in saving the peg, Terraform Labs released another recovery plan, which increased the daily minting capacity of $LUNC from the mint-burn mechanism. By expanding the monetary supply of $LUNC and using it as the exit liquidity of $USTC holders, its circulating supply jumped from 377 million to 6.5 trillion units between 11 May and 14 May. It created huge selling pressure on the token and eventually crashed the price of $LUNC. Furthermore, since $USTC is essentially a derivative of $LUNC, both tokens are highly correlated and represent the ecosystem of Terra Classic. $LUNC’s price drop hurt the confidence of $USTC holders which increased selling pressure on both tokens. This vicious cycle is often referred to as the “death spiral” for algorithmic stablecoins.

In response to the collapse of $LUNC, $USTC, and the failure of the recovery plans, the team proposed a Terra Ecosystem Revival Plan. The plan was submitted for community voting on 18 May and passed on 25 May.

Rebirth of the Terra Blockchain

The revival plan created a new blockchain without Terra's algorithmic stablecoin. The new blockchain, which is named Terra, launched on 28 May. Its native token is called $LUNA. The original Terra blockchain has been rebranded as Terra Classic and its tokens have been renamed $LUNC and $USTC. The new $LUNA token has a maximum supply of one billion and has been airdropped to previous $USTC and $LUNC investors as well as projects that were on Terra Classic and will be launching on the new Terra blockchain. Below is the list of participants that will be supporting the new Terra blockchain.

Bull and Bear Cases for Terra

Bull Case

Terra appeared to be a more decentralized, community-focused blockchain. In terms of the core mechanism, Terra is not vulnerable to the risk of a collapse similar to that which occurred in Terra Classic thanks to the absence of an algorithmic stablecoin. While the blockchain is built on top of Cosmos Hub, it allows Terra to enjoy network synergy through Inter Blockchain Communication (IBC). Terra has evolved to be more decentralized since it will no longer be led by a centralized entity like Terraform Labs and the token genesis allocation is distributed only to community members and contributing companies.

From an ecosystem perspective, 20+ projects from Terra Classic will be launching their applications on the new Terra Blockchain. The DeFi projects constituted $4B AUM under Terra Classic before the collapse. In the meantime, most of the existing wallets, block explorers, analytics, and security firms will also support the new Terra Blockchain, which can help Terra Classic users to switch to the new blockchain with ease. Furthermore, major centralized exchanges such as Binance, FTX, and Kraken have listed $LUNA and airdropped the token to $LUNC and $USTC holders which can help the accessibility and liquidity of the new blockchain.

From the community standpoint, the revival proposal was supported by over 59% of the stakers from Terra Classic, which could be a positive sign that the existing Terra Classic community is willing to migrate to the network. Airdropping the token to existing $LUNC and $USTC holders may also help to attract more users to try out the new ecosystem.

Bear Case

Terra lacks a unique positioning to differentiate from other smart contract platforms. After the collapse of Terra Classic, the confidence and trust of projects, users and VCs have been damaged. The previous focus on algorithmic stablecoin $USTC together with the 20% yield was the key fuel to attract liquidity into the ecosystem. Without the high yield, it could be hard for Terra to scale up exponentially and attract liquidity in the absence of a killer application with sustainable user adoption.

For the ecosystem, even though 20+ projects from Terra Classic have decided to migrate to Terra, some protocols have alternative options. The largest liquid staking platform, Lido, and staking companies Figment and Chorus One have decided not to support the new Terra Blockchain. Projects such as Kujira have decided to launch a separate sovereign blockchain. On the other hand, Mars Protocol has decided to launch on Osmosis and Tracer has decided to launch on Near Protocol. With huge competition for talented developers, smart contract platforms like Juno, Fantom, BNB Chain and Polygon are offering incentives for the developers to port over their projects from Terra Classic. Since the token has been allocated to the community and users, the ecosystem will not be able to raise funding from VCs to grow the network. Without funding, Terra may not be able to attract developers and projects in the long run, especially when other smart contract platforms such as Near Protocol, Avalanche, and Fantom are launching major incentive programs.

From the community point of view, 10% of the stakers voted “no with veto” on the revival plan, which means they didn’t agree with the proposal and suggested burning the deposits locked by the proposer. The airdrop allocation has been one of the most controversial aspects of the revival plan. There were concerns about large entities getting most of the airdrop tokens, which could result in centralization of the ecosystem and potentially create huge selling pressure. The price of $LUNA tumbled in the first few days after the listing. Terra being non-EVM-compatible (Ethereum Virtual Machine) could also be a stumbling block for new users to enter the ecosystem. EVM-Compatible chains such as Avalanche, Fantom and Harmony make it easier to bring in existing blue-chip applications from Ethereum. These applications can then act as a gateway for new users to enter the ecosystem.