#### Need to know

• Algorithmic stablecoin terraUSD collapsed this month, losing its peg to the US dollar and plunging to less than 15 cents in a matter of days.
• The failure is widely believed to be the result of a co-ordinated attack by speculators, with some estimating that up to $1 billion was deployed to destabilise the cryptocurrency. • Crypto experts say terraUSD’s demise was inevitable – a flaw in the stablecoin’s design led to hyperinflation in a related token, killing any hope of arbitragers steadying the ship in the way its creators intended. • “The collapse came as no surprise,” says one crypto hedge fund manager. “It was only a matter of time.” • Critics say the project naively relied on frictionless, instantaneous markets and defence mechanisms such as a reserve fund that were woefully inadequate. Perhaps the most shocking thing about the collapse of terraUSD this month was how many people saw it coming. Most crypto investors blame the stablecoin’s failure on a targeted attack by speculators, akin to how George Soros ‘broke’ the pound in 1992. While the assault was a surprise, to many in the industry the collapse was inevitable. TerraUSD, commonly referred to as UST, and its sister token luna were linked by an arbitrage mechanism designed to ensure UST would hold a steady price of one dollar. Between May 9 and May 13, though, UST plunged to less than 15 cents and luna to around a hundredth of a cent. “It was probably the most successful speculative attack on a cryptocurrency ever,” says Yin Luo, vice-chairman of quantitative research, economics and portfolio strategy at Wolfe Research. Crypto insiders estimate as much as$1 billion was deployed to destablise UST. Social media buzzed with rumours that Citadel and BlackRock were behind the attack, though both deny any involvement.

According to Igor Igamberdiev, a researcher at crypto industry publication The Block, proprietary trading firm Jump Trading spent nearly $700 million trying to defend UST, to no avail. Luna Foundation Guard, a not-for-profit entity set up to support the decentralised ecosystem, blew through its$3 billion reserve fund in a desperate attempt to check the fall.

Yet multiple experts say UST’s collapse could have — indeed that it would have — happened anyway due to the construction of the terra ecosystem, which ensured that inflation in luna would at some point inevitably become overwhelming.

“It was a flawed design,” says Alexander Lipton, a global head of quantitative research and development at the Abu Dhabi Investment Authority and co-author of a well-regarded textbook on blockchain and distributed ledgers. “Algorithmic stabilisation is an impossibility and an oxymoron and people pursuing it need to improve their understanding of finance.”

Lipton, who says his views are his own, predicted in lectures back in 2018 that stablecoins such as UST would run into trouble.

###### If it was not a concerted attack that brought terra down, eventually something would have derailed the project
Anatoly Crachilov, Nickel Digital Asset Management

Terra’s stabilisation mechanism relied on perfect arbitrage. If UST fell below a dollar, traders were incentivised to buy the coins and swap them automatically on terra’s blockchain for a dollar’s worth of luna. They would then sell luna for dollars and buy more UST until the peg was restored. If UST’s price rose above a dollar, the process would work in reverse, with arbitragers buying a dollar’s worth of luna and swapping it for one UST, and so on.

But when UST ran into trouble, a flaw in the mechanics unleashed a feedback loop of colossal inflation. To fund the UST-luna swaps, the system automatically minted new luna and “burnt” UST. This caused luna’s price to fall so fast as to panic holders and shatter the arbitrage logic that was supposed to stand the system up.

This defect in UST’s design was well understood by more sophisticated players. “The collapse came as no surprise,” says Anatoly Crachilov, co-founder and CEO of Nickel Digital Asset Management, a $300 million hedge fund running arbitrage and multimanager strategies in cryptocurrencies. “It was only a matter of time until market conditions were unfavourable enough for luna to slip into a death spiral caused by hyperinflation,” he says. “If it was not a concerted attack that brought terra down, eventually something would have derailed the project.” Nickel sold out of its UST positions on January 27, more than two months before the crash. There were other problems with the terra project. UST’s creators assumed markets were instantaneous, quants say, when in reality the arbitrage trade on which the system depended took hours to execute during the height of the panic. As it turned out, the holders of UST were overwhelmingly yield-chasing speculators who would quit the currency at the first sign of trouble. Ultimately, UST and luna’s self-referencing mechanism was like a fantastical perpetual motion machine, Lipton says, dryly noting the French Academie des Sciences banned submissions from scientists laying claim to such machines back in the eighteenth century. The fact that UST was able to draw in$18 billion of capital at its peak, he says, is “mind boggling”.

### War on terra

When it came, terra’s unravelling played out in less than a week. The first signs of trouble appeared over the weekend of May 7. UST dropped around 2% before recovering to $0.995 and luna fell from$80 to $60. In the following days, UST fluctuated wildly. It fell to 40 cents on May 10 before recovering to 90 cents, then collapsed again to 20 cents on May 11 before bouncing back, briefly, to 80 cents on the morning of May 12. By the afternoon of May 13, UST’s value had plunged to about 14 cents. The terra blockchain was halted on May 12, then again on May 13, after which no on-chain swaps could be carried out. ###### The attackers doubled the pressure by selling additional UST on Binance Carlos Betancourt, BKCoin Capital Several market participants point to an$85 million UST to USD Coin swap on the decentralised crypto exchange Curve on May 7 as the shove that first tipped the system off its footing.

USD Coin is a collateralised stablecoin backed by cash and government debt.

The trade triggered talk of trouble on social media, says Carlos Betancourt, founding principal at crypto hedge fund BKCoin Capital. The rumours in turn propelled $2 billion in withdrawals of UST from the Anchor protocol, an on-chain borrowing and lending platform where much of the UST in circulation was parked. Betancourt calls this “the initial sign of a possible de-pegging event”. That prompted Luna Foundation Guard to activate its defence mechanism, buying Bitcoin with UST to reduce supply in the market and lift the price. In what is widely seen as a misstep, LFG had already committed to removing$150 million of UST from the main stablecoin liquidity pool on Curve on May 7 to supply a new pool. The move was meant to improve liquidity going forward but did the opposite in the immediate term.

That allowed an “unidentified attacker” to use about $350 million of UST to drain the main Curve pool, Betancourt says. “At this point… users of Anchor started hitting the exits.” On the evening of May 9, UST dropped to 97 cents. “The attackers doubled the pressure by selling additional UST on Binance,” Betencourt says. Some estimate as much as$700 million UST was dumped over a three-day period. Whether this was part of a co-ordinated effort, how many attackers were at work and who they were remains unknown.

### Death spiral

This was precisely the sequence of events in which terra’s founders (see box: Founding principles) had proposed arbitragers would step in. In practice, as investors began heading for the exits, the luna mint went into overdrive.

As UST’s value fell, the arbitrage mechanism necessitated the creation of ballooning quantities of its sister token. That meant luna holders were getting diluted, causing its value to crater. Selling pressure led to a one-sided market, further weighing on the price.

This is a well-known phenomenon in traditional finance, dubbed a ‘death spiral’, that is commonly seen in companies that issue convertible bonds. Bondholders convert to stock when a company runs into trouble, which dilutes the stock and causes more bondholders to convert, leading to further dilution and more conversions.

He estimates that over $10 billion of UST deposited into the high-yielding Anchor protocol could be termed “mercenary” money from investors that would “de-risk at the first sight of worsening conditions”. More sophisticated investors had been tracking metrics such as redemptions from Anchor, how much UST was being minted and burnt, and activity in the biggest UST wallets. Most of all, though, they were watching the capitalisation ratio of UST to luna for signs of impending freefall. ###### If you could reverse the trend, you’d make a killing Nikita Fadeev, Fasanara Capital When that ratio approached one, confidence snapped. “The point had been that the market cap of luna should be a lot bigger than UST’s and that gives more confidence in the system,” Fadeev says. During the year to May, luna’s capitalisation had been about two to three times that of UST. As investors crowded into the latter to harvest interest on Anchor deposits, its capitalisation climbed from$10 billion to $18 billion, pushing the ratio to less than two. By May 8 the ratio was close to one. That meant any further fall in the price of luna would make it impossible to convert all outstanding UST into a dollar’s worth of luna. “At that point it was clear the system that should keep UST stable could not work anymore,” Barbon says. The fund Fadeev runs at Fasanara pulled its money once the system’s “health metrics worsened”, he says, “and it became apparent that luna and UST were at the point of no return”. Even at this stage, theory says the collapse could have been reversed. The Block reported plans for a possible$1 billion bailout whereby investors would buy luna at a deep discount and be locked in for two years.

But such a plan is unlikely to have worked, crypto specialists say. “Most likely it would serve as exit liquidity to those looking to get out,” Fadeev explains. “If you could reverse the trend, you’d make a killing. But to do that with a high likelihood of success would require much more capital than was available at that time.”

### ‘Impossible trinity’

Terra’s founders had not ignored the possibility of hyperinflation completely.

In a 2019 white paper setting out their idea, terra’s founders noted that dilution from “unmitigated” minting of luna would “present a problem” for those holding the token. But the white paper says nothing of the likely inflation rate of luna in a panic, or the risks of such a collapse in value overwhelming the arbitrage incentives.