Breaking down Terra’s breakdown

This is an event the crypto community will never forget. Let’s dive in.

What is Terra ($LUNA) and $UST?

Terra is a Layer 1 blockchain with an algorithmic “decentralized” stablecoin called UST. UST aims to maintain a $1 peg, theoretically making it suitable as a store of value and a medium of exchange across the crypto ecosystem.

Terra had hoped $UST would become the reserve currency for the DeFi ecosystem. $LUNA, Terra’s native token, was up as much as ~25X in the past year, and UST became one of the top 5 largest stablecoins in the world with a market cap of ~$18B at its peak.

What’s going on?

Early Wednesday morning, UST fell from its usual $1 to below $0.30 and is trading at $0.68 as of the time of this writing. Usually, when a stablecoin loses its peg, traders quickly arb it back to $1 – not this time. Chaos ensued when The Luna Foundation Guard (LFG) began selling Bitcoin to buy $UST as a last-ditch effort to bring the peg back – Terra has been buying billions of $BTC for their reserve to make it “decentralized.” They failed.

$LUNA is down more than 90% in the last 24 hours, trust is broken and the ripple effects of this collapse are being felt across the entire crypto market.

Could this have been prevented?

In our view, yes. The decision to buy highly volatile crypto assets like $BTC and $AVAX to act as the backstop for $UST was risky – further amplified by the lack of diversification via stablecoins in the reserve. The team was unusually quiet, and this lack of communication allowed panic to overwhelm many investors causing congestion throughout the Terra ecosystem.

What do we need to hear from the Terra team?

To start, we need to know how much is left, if any, is left in the treasury. We want to know their plans to repeg $UST with such a large gap between the market cap of $UST and $LUNA. Is there any VC demand to step into this mess?

What are we doing about it?

We are continuing to do work as the facts unfold, volatility subsides and liquidity returns to LUNA. After a catastrophic drop like we’ve seen this week, the possibility of a sharp near-term bounce exists. We’re thankful we took gains in $LUNA and trimmed the weight from ~21% to ~4%* in January, but a 90%+ loss on a ~4% position can’t be sugarcoated.

We remain incredibly bullish on the long-term prospect for crypto. But days like today, remind us that innovation is never easy and a stomach of steel is required when investing in crypto. We’ll be closely monitoring the peg, speaking with contacts in the industry, and will keep clients updated on our thinking and actions.

Onward,

Gritt and the rest of the investment team

*Corrected as of May 31, 2022.