Terra: A failure of the ecosystem?

There has been a general crash across the cryptocurrency market in recent days. However, the most egregious scenario isthe Terra ecosystem, which seems to be failing in many ways.

What happened to the wholeTerra ecosystem?

Until a few days ago, Terra was seen as one of the most promising projects that Blockchain 3.0 has been fighting against Ethereum.

In addition to its own native tokenLUNA, one of its main strengths is UST, an algorithmic stablecoin that powers DeFi protocols.

What might have been an advantage over the main competing blockchains turned into a disaster.

The sharp drop in LUNA is the first anomaly as the cryptocurrency industry enters an ongoing bear market phase, losing around 40% of its value in 24 hours.

There is no specific reason, but what triggered this "black swan" event was a chain of events. The avalanche of negative news from many sources exacerbated the general panic among market investors.

LUNA starts to crash

The most notable price drop occurred onMay 9th. LUNA fell more than 30% by industry volatility standards as the broader market braced for a sustained decline. Unfortunately, the torrent has no will to stop. The market continues to record heavy sell-offs, and on this day, LUNA hit a low of $0.83, well below the top 10bymarket capitalization of $90.

As can be seen in the chart below, the hope of recovery seems increasingly remote.

The price trend of LUNA in the past 3 months ended with a sharp drop

The sharp depreciation of the price undoubtedly led to a massive sell-off of the cryptocurrency by early investors. This was definitely one of the first factors that led to the start of a strong decline.

The record volume recorded by Tether immediately confirms the first part of the puzzle. Yesterday, the third most traded currency pair on Binance was LUNA/USDT. Strictly speaking, the top two are BTC/USDT and ETH/USDT, which remain strong due to their established market dominance.

UST, Terra's algorithmic stablecoin

UnlikeDAI, the only collateral backing UST is actually LUNA. From a certain point of view, this may be an advantage for cryptocurrency prices. To issue a loan on UST, the only collateral that can be deposited into a smart contract is LUNA. This was certainly an important factor supporting demand growth, at least a few days ago.

The flip side of the token is the scarcity of sustainability and robustness of this model. Reliance on a single asset can destabilize the entire ecosystem, as the collapse of the same asset can lead to a catastrophic event response. Ironically, that's exactly what's happened in recent days.

The moment the price of LUNA started to crash, the collateral ratio was no longer sufficient to maintain the stablecoin's peg.

The ratio of collateral to assets issued as loans is considered stable in the system at around150%. This means that for every unit of UST allocated by a smart contract in a DeFi protocol, there must be enough LUNA locked up for a consideration of at least $1.5.

AfterLUNA fell sharply, UST reacted by losing its entire peg to the dollar, hitting a low of $0.29 .

Investorsreact to DeFi protocols

According to DeFi Lama, the TVL locked in smart contracts in DeFi protocols developed on the Terra blockchain has dropped by 54% in the past 24 hours alone.

In less than a week, TVL fell 86% from $30 billion to now stabilizing below $4 billion.

Downside peaks in Terra's DeFi TVL, which tends to follow LUNA's price action

One of the biggest reasons isthe incentive policy operated by Anchor, the largest lending protocol in the Terra ecosystem. In fact, they offer APY levels as high as around 20%, which many consider to be inflated and not believable .

Some people think that their model is just a publicity to attract investors. It has never been able to sustain itself on its own profits. DeFi is committed to innovating the tools that traditional finance has already provided, using mechanisms that have been proven to work for centuries. Most of the returns that savers deserve come from their own funds , not from good management that allows them to generate sufficient profits.

For all this, users responded with flights from major agreements. In less than a week, Anchor lost more than75% of its TVL, followed by staking platformLido, which lost more than90% of its value.

Expert comments on this particular case

Leading the charge is Terra founder Do Kwon, who is trying to calm the mood with a series of tweets. The most recent of these, and possibly the most important, is a desperate attempt to encourage users not to abandon the ecosystem.

The tweet reads:

"Announcement on recovery plan for $UST coming soon. Hold tight".

In retrospect,it seems ironic that he called himself a “stablecoin guru” on his Twitter profile. He has to work hard to regain his credibility in the community.

Words from ARK36 COO

Then there are two standout comments. The first one comes from ARK36 COOAnto Paroian, he said:

“Without a doubt, the loss of UST’s peg will be seen as one of the defining moments of the current crypto market cycle. Unfortunately, the consequences of this situation go beyond the material losses suffered by Luna investors.

Decoupling could lead to significant regulatory risk — if not for the entire crypto space, then certainly for the stablecoin market. Minister Janet Yellenhas already highlightedLuna’s case at a Senate Banking Committee meeting, calling for full regulation of stablecoins by the end of the year.

Of course, regulation is good for the crypto space in the long run, but if stablecoin issuers are regulated as strictly as banks, it could kill the most innovative, prosperous and important industry in the crypto market one.

More generally, the crash will reignite discussions about whether truly decentralized, algorithmic stablecoins are possible or indeed desirable. So far, the UST situation has shown us that the potential advantages may not outweigh the risks of the entire crypto space. DeFi users should also take note – 18-19% yields on DeFi savings protocols utilizing decentralized stablecoins are not without a significant degree of risk”.

After all, as one of the basic laws of financial countries, higher returns always mean higher risks.

Comments from LikvidiCEO

Finally, the CEO of Likvidi,Ransu Salovaara, commented as follows:

“First of all, this sounds a little too good to start with Anchor, a DeFi platform that primarily uses UST, offering 19.5% APR for depositing and staking UST on their platform. That’s more than what other platforms like Celsius and AavecanofferMore than 100% higher. So naturally, Anchor gets a lot of users and promises such a high annual rate of return. That's why Anchor, UST and related token Luna have become so big, but the high interest is from their Paid out of pocket, so it's marketing, not real finance.

Now some people have chosen UST’s algorithmic peg as the target of market manipulation, and borrowed a large amount of bitcoins to execute it. Some people call it the “Soros-style” attack on UST. Bitcoin fell to $32,000, UST and Luna fell 75-90%.

The case will be of keen interest to cryptocurrency, financial and regulatory personnel.Yellenalready called for stablecoin regulation yesterday , thanks to UST. It is estimated that the “short seller attackers” made approximately $800 million in this campaign”.

HopefullyTerra, LUNA and UST will be a lesson for everyone. We will just have to wait for the reaction of the market and those involved in the crypto and DeFi ecosystem and hope for a more sustainable future.