The Fall of Luna: Revelations and Implications

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As someone who entered the crypto space in the summer of 2017 there have been several days that have left me with permanent memories of the crypto space. The January 2018 rally and subsequent bear market of alts is something I can still recollect perfectly now. The collapse of LUNA and UST are going to be similarly hard to forget in years to come. Although I was far less exposed personally this time around (I’ll chalk that up to five years of gained wisdom) there is no doubt this is one of the biggest events in the history of crypto. To see a project with two assets in the top ten by market cap have their valuations effectively turned to dust in a couple of days is not something any of us are going to forget in a hurry. One of my initial thoughts upon hearing the news was of how this is going to affect investor confidence moving forward. Coins with market caps in the billions should not be dropping to, effectively, zero in short periods of time. What this represents is a huge misunderstanding of tail risk that many smart people (including employees of crypto research firms, VC’s and market makers) failed to mitigate properly.

To many “sophisticated” retail users Terra felt very much like any other L1 chain. Using Terra Station Wallet and the many interweaving protocols built on the network was a similar (and sometimes superior) experience to using something like Solana or Cosmos. UST was probably of little concern to most users, BUSD exists in the Binance ecosystem and the likes of USDT and USDC have been used for years successfully on multiple chains. However, only giving such an important aspect of the project a passing glance allowed the failure of one ecosystem to become one of the most important teachable moments in the history of the crypto market — understand the risk you own.

The mechanics of the LUNA/UST dynamic are well described elsewhere so I won’t retread that ground now. However I will note that I think LUNA could have been a fine addition to the growing number of L1’s without UST. It would have been harder to distinguish itself and it certainly wouldn’t have garnered such a large user base but it could have competed. Instead, the team attempted to grab as much of the market as possible in one swoop and inadvertently caused financial devastation to its community in the process. Fundamentally, UST needed high demand in order to survive. Enough sell pressure and it doesn’t just fall in value, the whole house of cards collapses.

I don’t believe that Terra was ever meant to be a ponzi scheme or scam. It sits somewhere in the middle of the continuum between something like Bitconnect at one end and Ethereum at the other. There was some interesting innovation occurring within the ecosystem with protocols like Prism offering the splitting of assets into principal and yield bearing components. And there was the usual trappings of other L1 protocols like NFT marketplaces, IDO launchpads, DEX’s and so on. I think this speaks to the broader crypto market; there are so many creators, developers and innovators in the space at the moment that new ideas and creations can come from almost anywhere. Even if these things turn out to be built on foundations of sand in the case of the Terra ecosystem.

In terms of its place in broader DeFi, Terra was seen as one of if not the most exciting places to look for yield. The unsustainable nature of the Anchor Protocol’s yield was well known. However there are other tricks when looking for yield that should also be recognised. For example, staking is thought of as an easy way to earn additional tokens of a particular project. However, many users never take into account the inflationary rate of the token they are collecting. This is most obvious with projects with enormous APY’s (TIME, OHM, TITANO etc.) where the tokens supply is increased continuously in order to fund staking rewards. However in other cases it is less obvious. A legitimate project like DOT has an annual inflation rate of approximately 10% but many DOT staking platforms offer yields lower than this. So excluding speculative price movement, you are making a net loss on such a position.

I have seen some theorising that yield farming is going to become significantly more profitable after the Terra collapse due to decreased institutional risk appetite. The idea is that lower TVL in staking protocols and in liquidity pools will keep yields higher than in the past. However I don’t think in the medium to long term this will be the case. I have heard of several (very large) institutions that have been put off investing in crypto this year due to regulatory and macroeconomic concerns. The collapse of Terra certainly will not help these matters in the short term. However I think the broader macro landscape remains the biggest determining factor in terms of new inflows. The level of VC investment in the last couple of years has been enormous and although I would expect this to subside to some extent over the next year, I think the genie is out of the bottle now. Institutions know the level of returns crypto can generate and they aren’t going to forget that because of the failure of one (admittedly very large) project. In five years we will be able to look back on this as an unfortunate blip, the same way 2018 feels now. And the next time a new L1 appears that you want to invest in, give its underlying mechanics more than a cursory glance. It just might save you a lot of money.

CM