Explain how TerraUSD lost its peg and why Luna went down with it.
A coin or account that calls itself stable and also pays well above any bank rate is making two separate promises. You can test each one before you put money in, and a bigger yield is a reason to test more carefully. The five failures from 2022 in this module all cost ordinary investors money. Terra is first because its fall triggered much of what came after.
TerraUSD, usually written UST, was issued by Terraform Labs, a Singapore company co-founded by Do Kwon. Since the firm was based here, plenty of real people in Singapore owned the coin.
UST was an algorithmic stablecoin. A stablecoin of this kind keeps no reserve of dollars or treasury bills; its price depends on a swap arrangement with another token. For UST, that second token was Luna.
Mei Ling is an invented example: a 31-year-old accountant living in Tampines. Early in 2022, Mei Ling had part of a savings pot in UST, held on a crypto app. The thinking was that a stablecoin sits at one US dollar, and this one paid much more than any bank. To Mei Ling it was a high-interest savings account carrying a crypto label. The attraction was the yield, paid through an app called Anchor, and the technology underneath played no part in the decision.
The peg was UST's target price of one US dollar. Lesson 2.2, "Stablecoins: what holds the peg and what breaks it", introduced algorithmic designs like this one. UST had nothing like a vault of cash behind it. Its defence was a standing offer: any holder could trade one UST for a dollar's worth of Luna, created fresh for that trade, and could also trade Luna back into UST at the same rate.
Picture UST changing hands at 98 cents. A trader buys some at that price, swaps each coin for a full dollar of new Luna, then sells the Luna. On each coin the trader keeps a two-cent profit, one dollar less 98 cents. The UST handed in is destroyed, and the buying of cheap UST is meant to push its price back up to a dollar. When UST sat above a dollar, traders did the reverse, and the Luna handed in was destroyed.
All of this depended on one condition. Luna had to be worth a large amount in total, and people had to believe it would keep that value. If either failed, the swaps could no longer hold the price.
Anchor was a lending app running on Terra. Depositors who put UST into it earned a yield well above what banks offered, and above most crypto platforms of the time. Money poured in, and a large share of all UST in existence ended up sitting in Anchor.
The app did collect interest from borrowers, but that income fell short of the rate promised to depositors. Reserves made up the difference, and those reserves needed regular topping up. Lesson 2.3, "Tokens, DeFi and the questions to ask any of them", gives you the question "where did the yield come from?" Asked of Anchor, it shows a payout larger than the lending could fund, and that was a warning sign anyone could see.
In May 2022, holders pulled large amounts of UST out of Anchor and sold it, and the price dropped below a dollar. The swap then did what it was built to do: traders exchanged UST for newly made Luna and sold that Luna on the market.
Those sales drove Luna's price down. At a lower price, every swap had to mint more Luna to make up a dollar, so even more Luna reached the market and its price fell further. People holding UST saw both tokens falling and hurried to get out, which led to more swaps, more Luna and more selling. Reserves kept for defending the peg were sold, and the decline continued anyway. Within days the supply of Luna had grown enormously, both tokens had lost almost all their value, and UST was trading for a few cents.
This pattern is known as a death spiral: each round of selling to support the peg creates more of the backing token, which pushes its price and people's confidence lower again. Lesson 2.2 warned that algorithmic designs can fail this way, because a mechanism that runs smoothly while people trust it can start feeding on itself once that trust is gone.
By the middle of May, the coins in Mei Ling's account were worth almost nothing. Do Kwon was later charged with crimes in South Korea and in the United States, and none of that changed what Mei Ling or any other retail holder had lost.
The flaw in the design was that UST's sole backing was Luna, a token from the same project. A loss of faith in one became a loss of faith in both, and there was nothing of value outside Terra for a holder to fall back on. The warning sign was the yield.
No holder could have known the date UST would break. Mei Ling could still have seen the risk without any inside information, by asking three questions:
What backs this stablecoin? For UST, a mechanism and no reserves. Where does the yield come from? For UST, a rate higher than the lending activity could pay. What happens if many people want out at once? For UST, the swaps would mint more Luna, and in May 2022 that is what happened.
Lesson 1.2 of the course "How money works", "How a bank earns the interest it pays you", shows you how to read a bank's advertised rate against its conditions. Apply the same check to any claim of "stable" or "yield", and be stricter the higher the yield goes.
A good test of whether you understand a collapse is being able to explain it briefly to someone who has never heard of it. Write a short account that Mei Ling could have read in early 2022 and acted on. Cover what the coin was, how it was supposed to work, what broke, and which sign was visible beforehand, and name the flaw and the warning sign plainly.
In five sentences of your own, explain how Terra collapsed. Name the design flaw and the warning sign a holder could have seen.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).