What happened to Terra, LUNA and UST?

Down markets have their share of challenges. And one of those challenges is blowups. 

If a company, project, or protocol is badly designed or vulnerable, it will be revealed under market uncertainty and distress. 

Small blowups happen all the time. But when you get a good sized one, it will wake up a bunch of people, including some hungry regulators. 

Terra’s mushroom cloud is one for the books.

As a trader, these events give you an opportunity to examine an event in detail and find useful insights to profit from. You can do this even if you aren’t trading the specific instrument. 

Blowups are in many ways unique, but they often have similarities. 

In the case of Terra, we’re going to go through the timeline and look at specific events and their implications. We will look for red flags and translate those into useful ways of reflecting on other projects. 

We’ll start with some basics about the protocol. Then we’ll look at why you pay attention to trolling and critiques. Then we’ll explore executive hubris. And through the timeline, we’ll look at why you should pay attention to unusual behavior. 

But first, let’s take a quick detour to emphasize why this type of exercise is so important. 

How a suit transformed failure into a unicorn

Back in 2019, I was at an event featuring a fintech founder. He was in town setting up the Canadian office for their rapidly growing company. He stopped by to tell us about his journey. 

The biggest takeaway from the whole talk was about examining past blowups. 

This founder and his buddy had started, built and sold a fintech in their home country of Brazil. They followed this up by getting accepted to Stanford and heading to California, where they promptly dropped out to go to YCombinator. 

They were interested in getting into the VR space and discovered it was a bigger challenge than they anticipated. He said it was too hard for them to figure out, so they returned to the fintech theme, where they had a strong background. 

As they explored their idea, they discovered that lots of YC founders had tried something similar and failed. So they looked up these founders and interviewed them.

Through these interviews, they discovered that when these other companies showed up to a meeting with a bank or financial institution, something was missing. 

It was the suit. 

Not their clothing, but a reference to the compliance executive that was absent when every one of these fintechs sat down with a bank. Every bank expected this key area to be covered, and none of these companies had the compliance pro at the table which demonstrated that they weren’t serious. 

As a result, the co-founder of Brex told us the very first hire was a compliance executive right out of the financial industry. That’s how they overcame the hurdle the others didn’t. That one insight turned them from a potential failure into a unicorn. 

Now, exploring Terra’s meltdown won’t turn you into a trading unicorn, but it might help you avoid other hazardous situations.

Let’s have a look at Terra.

What was Terra?

Coindesk had a terrific piece with a history of the Terra protocol. The history showed some key moments that contributed to their demise. These are things you should keep in mind as you trade. 

Terra was founded on Cosmos SDK in 2018 by Do Kwan and Daniel Shin. You can see their whitepaper here. If you haven’t read this document, I recommend that you read this short 16-page document in its entirety. There are lots of things in here to show you where the problems will be. 

Terra was backed by a group of 15 large Asia-based e-commerce companies

The native coin on Terra was the LUNA token which acts as a governance, mining reward, and volatility buffer. Terra has several algorithmic stablecoins, including UST, that are pegged using the LUNA token. Over the three years from inception, they added a number of products, including their algorithmic stablecoin UST. 

UST is an algorithmic stablecoin with no reserves. The stablecoin is pegged using LUNA tokens, the mining system, network effects, and smart contracts. LUNA is minted and burned to offset the supply with a portion of minted LUNAs added to the treasury. The system uses the Tendermint Proof-of-Stake protocol from Cosmos. 

Sounds pretty cool.

Except for the fact that the “stablecoin” will have additional volatility due to the speculative nature of the stabilizing asset. And, of course, there was an implicit assumption of an ongoing flow of users who would help make the job of market-making relatively seamless. 

Which is a significant vulnerability, especially if the flow gets one-sided. 

Reading the Terra white paper, one might get the sense that there is a misunderstanding of the complexity of the thing they were trying to recreate. 

Sometimes critics get it right

Back in 2018, a post by Cyrus Younessi called out the problems with the protocol and made reference to Maker. In this case, he said UST would fail because using LUNA as the stabilizer was the equivalent of Maker using MKR to back its offering. This post was both prescient and ironic. 

Ironic because Maker blew up spectacularly in March 2020 when ETH crashed, and their leverage system wiped everyone out. It was also a prescient concern because he turned out to be correct. Although he was early on this one. 

Computer-generated death spirals are nothing new. They happen in legacy finance too. The one that came to mind was the crash of 1987. 

There were a number of factors in the 1987 crash, but a big one was portfolio insurance. Which was automated program trading that sold futures to manage the risk in the portfolio as the market declined. The DC Fed put together an excellent paper on the event. Portfolio insurance had a design flaw exposed by extreme events at the time.

Another might be the Flash crash of 2010, which eventually recovered. This was also a structural algorithmically driven issue that was precipitated by extreme events in the post-GFC environment. And there are others. 

Every project has its share of trolls and naysayers. Sometimes they will be right. Other times they won’t, but these critics are out there. And sometimes, they make a lot more sense when you take the time to reflect on them. 

Somebody was obviously thinking about the structure of Terra LUNA and UST because they posted a trade idea about it in 2021. 

The cost of executive hubris

In late November 2021, Freddie Raynolds posted a thread on Twitter showing how LUNA could be thrown into a death spiral. This was the point raised by Cyrus back in 2018 and it relates to an imbalance of flows. 

The LUNA coin had risen from .69 cents at the beginning of the year to the mid-forties when this post came out. It finished the year at around $89. 

This call is a perfect example of why you should not simply take someone else’s trading idea and execute it. Following this trade idea at the time would have been very expensive. However, it gave you clues on what to look for if the event started to unfold. 

The response of the company? Do Kwon basically told him to bring it on.  

As a social media user, you know that any time a leader responds to something, they elevate it. Whenever you see this, look closely at what the post or thread was. Then look at the response. 

Then in March 2022, two crypto traders publicly said they were betting against the protocol. One claimed to bet $1 million, the other $10 million. These public statements on their own can be trash-talking and if executed, can go badly if the timing is wrong. 

LUNA responded by going higher yet again. 

But in conjunction with the 2018 statement and the way Kwon dismissed Freddie’s “Soros style” attack plan was a warning. 

If you’re unfamiliar with the Soros reference, it was when he and Stan Druckenmiller broke the British pound. They made a billion on that short sale trade and solidified Soros’s reputation as the master speculator of his generation. 

In the meantime, Kwon ironically makes a statement that looks like he is threatening to destroy Maker’s DAI. Another warning. When founders are talking like this about a competitor, your ears should perk up. 

And Terra was doing something else. 

Building reserves while Terra secretly burns

Coindesk’s timeline shows the founding of Terra’s foundation in January 2022, which was followed by a series of transactions. 

The foundation was there to help build reserves to support the peg. Their coin offering held a portion to help manage the peg in volatile conditions. And then they do a classic placement by selling $1 billion in expensive LUNA tokens to buy BTC. 

The recipients? Two well-known trading houses. 

Remember, trading houses can carry inventory if they have to, but in general, they are in the moving, not the storage business. This transaction could have been a cover or hedged out using any number of instruments. Those shops didn’t get where they are by being nice or wrong often. 

As the foundation buys BTC, LUNA is making new highs. The BTC war chest swells to 39,897.98 Bitcoins. 

LUNA issuance grows to its maximum and UST becomes the number 3 stablecoin. 

This is the end of April 2022. 

Then a couple of signals indicate the death spiral is starting. 

Look for unexpected signals

Now part of your risk management should include thinking about things that happen outside of the norm. These would be actions or activities outside what you would expect. These started happening in early May. 

A big swap out of UST into USDC was first. 

Then a series of big UST sales hit the market. The Terra ecosystem starts to take on water with these sales, and people watching the ecosystem start to bail. 

You can see through the May timeline a bunch of countermeasures, and an aggressive long futures bet that blows up. 

In two weeks, the Terra ecosystem evaporated. Gone. 

And that war chest? Well, it was supposedly spent unsuccessfully defending the peg.

We probably won’t know for a little while what happened.

A lot of people lost a lot of coin in this one. High-profile meltdowns like this attract undue attention on other projects from regulators. And even though Terra’s design was flawed from the start, the press and some regulators are now conflating all stablecoins as being like Terra. 

Which, of course, is false.

Now, I recognize that it’s nice to have a nice roadmap of events laid out to draw from. And that this gives all of us 20/20 vision into events. 

But there are numerous lessons that can be applied elsewhere. 

Some lessons from Terra

Crypto is an exciting space to be involved in. It’s new. Potentially very profitable and a great learning experience. 

But you can avoid some downside by simply paying attention to the nuances of the market. 

A bad protocol design doesn’t mean you can’t make money. But knowing when to leave after being profitable isn’t always easy. 

Great short sales often rise before they are revealed, and traders can lose a lot trying to time these moves. And when they happen, the unraveling is fast. Algorithmic trading accelerates the demolition process. 

Pay attention to criticisms and evaluate whether they have merit. Some trolls and critics can be right on the money. 

Public pronouncements by founders and protocol leaders should be watched closely. The more bombastic, aggressive, or childish, the more you should pay attention. 

And don’t follow other big traders without knowing what their objectives are. They may have hedged out all of their risks in advance or sold into the lift that followed. You have no idea what they are doing and why. You should be focused on what you are doing and why instead. 

You don’t have to be a rocket scientist to evaluate Twitter comments and news on a crypto news site. 

Where there are risks, there are opportunities.

Shortly after this epic failure, Do Kwon started LUNA2, which was destroyed in short order. No idea who was trading this, but I suspect a lot of “I gotta make it back” trading was taking place. This kind of trading is lethal to your account and psychologically devastating, especially in a soft market. 

Trading is tough. And messy markets have a way of humbling everyone eventually

Crypto has been developing in a largely unregulated environment, with a wild west approach. Nothin’ wrong with that. That’s sometimes where great opportunities can be found. 

But down markets in speculative assets require more attention, more risk management and more thinking. 

So take the time to think more carefully about your trading in periods of uncertainty. And that includes reading everything with a more critical eye. There are lots of things that end up on forums and in the press that are intended to create action that isn’t in your best interest to follow. 

Terra is a reminder that trading is a very human activity. And this is where things like risk management and trading rules come in. 

Learning from experience is important to staying afloat, but it’s even better if you can learn some things from the mistakes of others

That way you can keep your trading tuition to a minimum and be ready for new opportunities in the future. 




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