What the LUNA / UST collapse taught me


1. Know exactly why you are investing in something.

The Terra-Luna ecosystem was one of the most promising projects in the DeFi space. With all of the slick applications which were built on the Terra blockchain, such as payment system Chai and beta-released Alice, as well as Anchor with the high yields it provided to UST stakers, Terra-Luna was arguably the closest a project had ever gotten to widespread financial adoption.

Like many, I was a strong believer of Terra-Luna and its future. Many great developers and creators built on Terra, and the project was led by its bold and innovative founder Do Kwon, who was also known for his egotistic and braggish shoot-downs of Terra’s critics. The design of its mechanism was novel and innovative, allowing for Luna’s killer tokenomics. Luna tokens were burnt with every UST token that was minted, and the swapping mechanism of $1 worth of Luna tokens to 1 UST rewarded Luna holders for the growth of UST’s adoption. The project boldly championed the concept of an algorithmic stablecoin, and truly had the potential to reimagine payments systems as we know them.

If you are unfamiliar with what is Terra (LUNA) and how the LUNA/UST mechanism works, read this before going on: https://academy.binance.com/en/articles/what-is-terra-luna

Some critics, however, dismissed it as a ponzi scheme, by virtue of the simple fact that it was not backed by any true form of collateral. They do have a point; UST was not backed by USD, BTC or gold like other stablecoins such as USDC, DAI, or BUSD. Even when LFG purchased $1.5B in bitcoin earlier in May, this amount was not meant as collateral per se, but rather as capital for LFG to defend the peg through the Luna-UST swap mechanism. UST was backed by demand for the Luna token, which essentially translates to confidence in the Terra-Luna project and ecosystem. As the project continues to deliver on the introduction of more useful applications and increasing the use and adoption of UST, the demand for UST will increase, and more Luna will be burnt to mint more UST to maintain UST’s $1 peg.

At first glance, it seems ridiculous for a stablecoin to be worth $1 without there being $1 in collateral. This was essentially like creating a digital coin out of thin air, declaring that it was worth $1, and convincing the rest of the world that it was always going to be worth $1. How can a working currency not be backed by anything of value?

Yet, this concept is not much different from the US Dollar, or much of the fiat currencies that are in use today. The US Dollar abandoned the gold standard way back in 1971, and it is not backed by any form of commodity or currency today. What then gives it its value?

To understand this, it is crucial to understand what money really is. The concept of money and value is a social construct. It’s the most successful narrative and story in the history of mankind. The value of anything is rarely determined by what it is backed by. Rather the value of something is often determined by what we collectively believe it to be worth. $1 can buy you a slice of pizza because we collectively believe that the same $1 can also get you a pack of candy from the dollar store. The US Dollar will continue to be perceived as a currency of value as long as its economy continues to produce, create value and grow.

The bold mechanism design of the Terra-Luna project was an innovative demonstration of the concept of money, something that its counterparts mostly lack. It did not hurt that Terra-Luna’s frictionless and collateral-less mechanism, along with the attractive 15–20% rates that Anchor protocol provided UST stakers, allowed for the rapid and decentralised growth of UST. It was so easy for anyone to mint UST, unlike other stablecoins like DAI or USDC which are issued by centralised entities. The applications that were built on it were top-notch as well, a testament to the quality of its developer community. If there was a model of what a scalable and decentralised currency of the future would look like, UST was the closest to being that currency. This is why I was so optimistic about the future of LUNA and UST.

2. Understand the risks. Take them seriously. Monitor them.

I have seen many comments that LUNA and UST collapsed as the 20% rate that Anchor offered was unsustainable. This is a gross oversimplification and misrepresentation of everything that happened. While the 20% rate is indeed unsustainable, this was an intended feature of Anchor Protocol. The 19.5% rate that Anchor offered was partly funded by loans on Anchor, but majorly funded by LFG and Luna’s backers. The Terra-Luna project was basically paying people money for holding UST as a way to incentivise adoption of UST, and it worked brilliantly for many months. While Anchor would later go on to feature as part of how and why LUNA and UST collapsed, the collapse really wasn’t all that simple.

The investment case for LUNA and UST had one key risk — the death spiral. In this worst-case scenario, massive selling pressure on UST would lead to a drop in UST’s price to less than $1, resulting in a depegging of the UST. Arbitrage traders would step in to purchase more UST to convert to LUNA, and sell LUNA on the open market to profit off the arbitrage trade. This, however, leads to an equally massive selling pressure on LUNA and a severe dilution of the token supply, resulting in a sharp fall in its price. Fear takes over and UST holders are worried about the inability of the mechanism to keep the peg, rushing to exit and liquidate their UST. More LUNA is minted and sold in the meantime, resulting in the rapid fall in the value of LUNA, as well as a sustained decrease in UST’s value. The demand for LUNA eventually dries up and UST loses its value.

See this thread for a more detailed explanation of what happened: https://twitter.com/route2fi/status/1524775762074783746?s=21

I had known of this threat. Yet, I did not take it seriously enough. A 40% drop in the value of LUNA in 2–3 days and the first signs of UST struggling to hold its peg should have sounded alarm bells in my head. I did not think to monitor the 3-pool which saw a huge and consequential injection of UST, leading to the huge UST sell-off and the start of the death spiral. I did not take this risk seriously enough, and had blind faith that the team at LFG was going to be able to get out of this as they did for previous depegging events.

I held on to my liquid UST in Anchor Protocol for a 20% APY upside, with a very real and immediate 100% downside risk. The least I could have done was to withdraw it from Anchor and convert it into USDC for the time-being, and get back into Anchor if and when the tide passes. But I didn’t take the risks seriously enough. Neither did I actively monitor them or make active decisions when it mattered. And I got burnt badly for it.

3. You earn or you learn

The collapse of LUNA and UST felt horrible. I felt dejected and disappointed in myself. I had lost a sizeable portion of my capital, and many what-ifs filled my thoughts. I didn’t want to think or take action to cut any losses. I just sat and watched everything burn.

But after a few days, I’ve realised that there were many things that I could have done better, and that this loss would be in vain if I did not let this mould me to become a better investor.

Moving forward, these are things that I will do:

  1. Write down the most important reasons why you are invested in a project. If any of them disappear, it is time to reconsider the investment.
  2. Write down the most pertinent risks or deal-breakers for every investment. You may be an optimist at heart, but it is important to take them very seriously.
  3. Actively monitor the risks — they may be more important than monitoring the bull case.
  4. When shit hits the fan, look at what you’ve written down, and follow it. You’ve already prepared for this moment.

Sometimes in life you earn. When you don’t, you learn.