Beansprout logo
Receive expert insights you can trust
Fresh Takes

Cryptocurrency

How did LUNA collapse and what can we learn from it

18 May 2022

Like us, you probably know someone who has been impacted by the LUNA collapse. What lessons can we learn, and where do we go from here?

how did luna collapse

TL;DR

  • Terra (LUNA)’s fall was caused by a collapse in confidence essential in the financial markets.
  • The use of the algorithmic stablecoin TerraUSD (UST) also made the system vulnerable.
  • As we enter a potential “crypto winter”, questions have been raised about the stability of other stablecoins and whether we might see more regulations.
  • Key lessons for all investors – always find out what may go wrong, spread out your investments, and survive!

By now, you’d probably have read and heard enough about LUNA. 

Just a week ago, Terra (LUNA) and its stablecoin TerraUSD (UST) were seen by many as the success story in the world of cryptocurrency.

Now, they are worth almost nothing. 

It’s big because there’s probably someone we know affected by the episode. 

Even my mum who can’t pronounce stablecoins asked if I lost money from it. 

While a lot has been said about LUNA, some of you have reached out saying that there are things you don’t understand. 

Hence, we thought it might be useful to explain abit more about:

  • How does an algorithmic stablecoin work?
  • How did LUNA fail?
  • Where do we go from here?
  • What we learnt from the episode 

Firstly, what is LUNA?

To understand LUNA’s downfall, we must start by understanding what a stablecoin is. 

There are two cryptocurrencies here that you need to know.

  1. Terra (LUNA) is the token
  2. TerraUSD (UST) is the stablecoin

Most of us here probably know what a cryptocurrency is (at least roughly). But a stablecoin might be abit more complex. 

Conceptually, a stablecoin is a crypto version of the US dollar. And you can use it to make transfers across the crypto network.

More importantly, it is supposed to be tied to a “stable” reserve like the US dollar. That’s why it is called a stablecoin. 

However, there can be many ways to create a stablecoin. 

For example, a fiat-based stablecoin such as Tether (USDT) and USD Coin (USDC) are backed by the US dollar assets. 

On the other hand, algorithmic stablecoins such as TerraUSD  (UST) are not backed by the USD. Instead, their value is decided by computer programmes.

What the algorithm does, is to keep the value of 1 UST equivalent to 1 USD of Luna.

If demand for UST is high driving the price of 1 UST above 1 USD, more UST is created to keep the peg of 1 UST  = 1 USD. 

The price of LUNA goes up, as LUNA is burnt (supply is removed) to keep the peg.

This was the case for most of the past year, and holders of LUNA were happy. In fact when I asked my friends who were into crypto which coin they were more positive on, the answer is often LUNA. 

Unfortunately, the opposite is also true. And it is important to realise this as it will help to explain LUNA’s spectacular decline later. 

If demand for UST falls and the price of 1 UST falls below 1 USD, UST is burnt to keep the peg of 1 UST = 1 USD. 

The price of LUNA goes down as more LUNA is created (supply is increased).

Here comes Anchor 

Clearly, the price of LUNA would go up when the demand for UST increases. 

What would drive up demand for UST? More uses for UST that would make people want to hold it. 

Think of it as your iPhone (or Samsung Galaxy) operating system. 

The Terra blockchain is the operating system that your phone would use. And demand for the operating system would go up when there are more applications like Facebook that you can use on your phone.

Here comes Anchor protocol, which allows users to deposit and borrow UST. Users that deposited UST were told that they would get stable yields of approximately ~19.5%.

I recall seeing many ads back then comparing the interest rates that can be earned staking in crypto versus the interest rates that can be earned in traditional finance.

And I can see why many were convinced to put their money into Anchor.  

The LUNAtics community was growing, and most importantly, there was confidence in the Terra ecosystem

I asked a friend why he left his money in Anchor even though he was aware of the depegging risks. 

He felt that it was unlikely that the UST would depeg “as long as there was a steady stream of products that required the use of UST”. 

Besides, the people behind LUNA found ways to raise confidence. 

$1bn was raised earlier this year to set up a reserve stored in Bitcoin and to stabilise the UST during periods of market uncertainty.

But clearly this was not sufficient when events took a turn for the worse this week. 

A run on LUNA 

On the morning of 10 May, I woke up seeing a sea of red across stocks and crypto. But what really stood out, was the LUNA had plummeted. 

Out of concern, I checked in with a few friends that I knew had LUNA. 

“Depressed. Don’t know what to do.”

“Was liquidated coz I borrowed some money on Anchor but couldn’t repay back in time.”

“Need to process this for awhile. Tough time.”

Over the course of a few days, events unfolded as follow:

  1. Anchor protocol saw large withdrawals
  2. UST is sold off and exchanged for US dollar following these withdrawals
  3. More LUNA is created to maintain the UST peg, causing downward pressure on the price of LUNA. 
  4. UST is depegged from the dollar as there are insufficient reserves to meet dollar withdrawals
  5. With lower confidence, more people withdrew their UST from Anchor
  6. Repeat 1-5

In other words, a run on LUNA occurred. This is just like a run on a bank.

Remember we said earlier that the success of LUNA was driven by confidence in the system. The opposite has now occurred. Withdrawals led to lower confidence, which then led to even more withdrawals until the whole system collapsed. 

By the end of the week, the value of Luna had fallen to close to zero. The Terra blockchain was turned off. And many major exchanges stopped allowing the trading of Luna. 

Where do we go from here?

Quite evidently, this is not the end of the story.

Even if you might have dodged the LUNA collapse, it could still impact you in other ways. 

1. Cryptocurrencies were sold off sharply

The selloff in LUNA spread to other cryptocurrencies, as confidence towards digital assets was shaken. 

Bitcoin fell sharply to below US$28k at one point, and altcoins saw even sharper declines. 

This led to headlines about the collapse of LUNA being the “Lehman Brothers” moment for cryptocurrencies. 

Many started questioning their assumptions around cryptocurrencies.  

Can cryptocurrencies act as a store of value when we have just seen a collapse of LUNA? 

Will adoption of cryptocurrencies slow down as a result? 

And more importantly, is a stablecoin really “stable”? 

2. Are other stablecoins “stable”?

The selloff in UST also led many to question how “stable” a stablecoin is actually.

Stablecoins are supposed to be stable because they are pegged to a fiat currency (eg USD). 

However, as we have seen above, there can be different ways that each stablecoin is backed. Different stablecoins also have different amounts of reserves to back them up.

This naturally led to renewed scrutiny on Tether (USDT), the largest stablecoin with a circulating supply of around US$80 billion. 

Fears around Tether came back when it sunk to as low as $0.95 shortly after the LUNA collapse (remember it is supposed to be close to $1)

Unlike UST, Tether is backed by cash and short term investments which are held as reserves.

3. More regulations?

Right on cue, US Treasury Secretary Janet Yellen said that risks related to stablecoins are “growing very rapidly”, even if they are not yet a real threat to financial stability.

She also called for more coordinated regulation on digital assets. 

Closer to home, the Monetary Authority of Singapore (MAS) reiterated its warning that cryptocurrencies are highly risky and not suitable for retail investors. 

At the same time, MAS is also looking at how stablecoins will be regulated in Singapore. 

Naturally, many would perceive that more regulation might mean that the development of cryptocurrencies would be slowed down. 

You can read more about the protection you get as a crypto investor in Singapore here.

What we learnt from this episode

Losses are always painful. There’s no way around it. 

What would we say to anyone who has lost his/her hard earned money through LUNA?

Firstly, do not be too hard on yourself.

As Warren Buffett said “Everyone makes mistakes. There is no question that you are going to make mistakes in your life. I’ve made a lot, and I’m going to make more. That’s the nature of making a lot of decisions.”

“Being able to make them work out anyway is one of the abilities of those who are successful.”

Really, it’s about the lessons we take away from this episode and become better at investing the next time.

1. Find out where things might go wrong

When I decide on whether to invest in something, I not only think about all the things that could work in its favour. 

It is also important to ask yourself what might go wrong. 

And no, this is not about being pessimistic. It is understanding your risks. 

Here, you can let your imagination run wild and think about all the things that could make cause your investment to lose money. 

What would happen if there were significant withdrawals from a stablecoin suddenly? Could the government announce new regulations? What if the founder disappears? 

2. Do not put all your eggs in one basket

You may have done your homework around what may go wrong. But regardless of how good anything may sound, do not put all your eggs in one basket. 

This is the idea behind diversification, which is really just means spread things out.

After all, black swan events can happen when you least expect them to. Even if it were not a run on a stablecoin, it could be a global pandemic. It could be a natural disaster. 

This is especially important in the crypto world, where nothing is known to be too large to fail.

If I invest in 20 assets with each asset representing 5% of my portfolio, I would just be losing 5% of my net worth even if one asset gets wiped out.

It’s still a big deal, but it’s more manageable as I just need the remaining 19 assets to generate a 5% return for me to get back to square one. 

That sounds reasonable and not really a biggie. 

But if I were to invest all my money in just one asset, my portfolio would go to zero if something catastrophic were to happen to the asset. 

 Asset 1Asset 2Asset 3Asset 4Asset 5Asset 6Asset 7Asset 8Asset 9Asset 10Total value (S$)
Allocation10%10%10%10%10%10%10%10%10%10% 
Purchase cost10101010101010101010100
Latest price011111111111111111199
Return-100%10%10%10%10%10%10%10%10%10%-1%

3. Stay in the game! 

This brings us to the final point – which is to stay in the game. 

Financial writer Morgan Housel put it very well when he said that “If I had to summarise money success in a single word it would be survival

Sticking around for a long time, without being wiped out or giving up, is what makes the largest difference. 

Not by being the smartest person. Not by taking the most risk. 

Warren Buffett is a role model for many because of what he is known to be able to do – achieve great returns over time by finding good companies that are valued attractively. 

That seems difficult for most of us to be able to do (especially since we have our day jobs). 

What is also worth pointing out is what he didn’t do. 

He didn’t take on too much debt. 

He didn’t burn himself out or sacrifice his health (physical and mentally). 

In other words, he survived. And survival gave him longevity.  

The truth is, money can always be earned back if we are around to fight another day. 

That is the power of long term investing. That is the power of allowing your money to compound and grow. 

But to be able to do that, we all need to stay in the game. Here’s to all who survived the LUNA crash. 

May we only emerge stronger from this.