News: Terra Collapse

A summary of the events of 11th May 2022

At the time of writing markets are in a panic. Wider economic conditions, including rampant inflation, subsequent rate hikes, war in Ukraine and economic slowdowns have set the stage for a 2022 market correction. Cryptocurrencies were already on a downward trajectory, in line with the wider stock market. Then on May 10th, the stablecoin project Terra Luna, which we discussed in our Scallop learn page here - came under attack and lost its dollar peg. What does that mean, and why has it rocked the whole crypto space?

Losing the peg

Stable coins are a cornerstone of the Defi world, we discussed this in full here..

The stablecoin is the most important product in crypto, uniquely serving the currency function of cryptocurrencies. — Do Kwon founder of Terra Luna

Investors and traders were able to use stablecoins to trade on exchanges that don't support fiat, to use as a safehaven in volatile markets, as well as locking up money in the Defi ecosystem to get returns from yield as opposed to speculative trading. TerraUSD, a stable coin trading as UST, was a top 10 marketcap stablecoin that was at the heart of the terra ecosystem. As a recap:

  • Founded in 2018, Terra is a blockchain protocol supported by a number of algorithmic stablecoins. The most popular is called TerraUSD, or UST.

  • The stablecoins maintain their peg's through a coin called LUNA.

  • LUNA is a speculative cryptocurrency. Terra keeps the prices of its stablecoins in check by changing the supply of Luna.

  • This supports a Defi ecosystem, which hosts apps like CHAI which is used by 25 million Koreans as a payment system.

All of this depends on UST remaining at $1, however over the last few days we saw the price drop and the stablecoin lose its 'dollar peg'

The event

So what happened? Well there is speculation of a coordinated attack on the project... Charles Hoskinson, founder of Cardano, retweeted the following:

So lets break that down, essentially an entity with a lot of buying power borrowed 100,000 BTC to sell into the market. [Note - since writing, Gemini have denied the claim that they lent 100,000 BTC to Citadel]

"borrowing BTC" allows this party to sell BTC without owning them and buying them back at a later date in an effort to make profit, it is also known as 'going short'.

This party then waited for a time that the liquidity was low in the UST ecosystem (there was a migration of one of the liquidity pools at the time). There are reports that they even sold BTC at a discount price to the Terra project who took the bait. They sold hundreds of millions of UST for BTC which further reduced their liquidity.

Remember: you need liquidity to absorb the selling pressure of the stablecoin without the price moving

On May 9th at 15:00, without the liquidity to absorb the sell pressure, the price starts falling .. this then causes Luna to have to sell BTC in the market to free up money in order to buy more UST to prop up the price. This puts pressure on the BTC price because there is so much selling.. this causes prices of all crypto to drop even more! It's a cascade that is about to cause a panic.

Terra Luna had left themselves vulnerable by allowing their liquidity to drop too dramatically, at a time when they were migrating liquidity. The market also knew about their bitcoin position here...

Loss of faith

As soon as the price starts to fall, investors lose faith and flee to other, safer coins. This causes a run on the bank. The date is May 10th and there is total panic in the market.

Luna, which is the coin that is minted and sold to support the fluctuations in Terra USD and keep it pegged to a dollar see's total capitulation. Currently trading at $0.05 from its peak of $85 on 5th May.

This panic caused a drop in the whole market, Ethereuem, the #2 coin by marketcap also saw a major decline. There is no safe haven, and money is leaving the market, fast. So that brings us to today, the market is down 30% this week, with BTC trading at a modest 28k.

What is next? What does this mean?

Well it's a huge blow for Cryptocurrencies, Defi and Algorithmic Stablecoins. There is major fear in the market, but everything is holding steady. All eyes are on USDT (tether) which is the largest marketcap stablecoin. This project has come under scrutiny for not disclosing its holdings and therefore leaving the market in doubt of what the coin is backed by. For now, it is holding steady. There have been many instances in the past where cryptocurrencies have come under fire, this is not the first and it will not be the last. Seeing as this appears to be a coordinated attack on a major project, we should see things return once the panic subsides.

For projects like Scallop, it really is business as usual. The tech team continues to work on the launch of the app, and there is no disturbance to our workflow. As a project we are focussed on a goal of providing seamless and easy access to digital money for all users, and that is not affected by these market moves. Whilst we worry for the health of the wider ecosystem, there is an understanding that this is a new frontier, and there are bridges to cross along the way. There was speculation that Terra was unsustainable, and that turned out to be well founded worry. As an industry, we continue to learn, to grow and to build.

A few words from Scallop

We at scallop are so passionate about this technology, and so excited about its potential, it is heartbreaking for us to see these events unfold. We understand that there are many of you reading this that are feeling the same, and are suffering heartbreaking losses in your portfolios. We sympathise fully, and want to reassure you all that we are working tirelessly to deliver a product that will take us into a new era of banking. We really believe that. The market has always been a volatile entity, and we have had many crashes along the way. They are nothing new, and they are never nice. This is part of the crypto space, we are a small and vulnerable industry when compared to the behemoths of the business world. That is also why this is an exciting space. The projects will return, stronger and more resilient. The technology is sound, and there is a huge amount of talent working within the ecosystem. We are excited about the future, and we hope you are too. For now, let's all hang in there together.

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