The Plan for Terra’s ‘Return to Form’ After Big Collapse, According to Do Kwon

Last updated: May 12, 2022
4 Min Read
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Following what may go down as the most dramatic crypto catastrophe of all time, Terra Labs founder Do Kwon has laid out the beginnings of a plan for the Terra ecosystem to recover.

Earlier this week, TerraUSD (UST) began to un-peg from the US dollar as sell pressure exceeded what the system’s mint and burning mechanism could keep up with. Since investors can redeem 1 UST for $1 worth of LUNA, problems arise when UST is well under its dollar peg, mainly that traders can buy UST for say $0.70, then redeem for $1 worth of LUNA, and then sell their new LUNA coins for the difference. The arbitrage and sell pressure from panicked investors effectively pushed the price of LUNA to zero on Wednesday, shaving off tens of billions of dollars of market cap within hours.

LUNA went as low as $0.70 before a wild 1000% rebound, likely stemming from short covering, then collapsed again, currently sitting at $1.69 while UST is currently 32 cents off its dollar peg at $0.68.

Writing in a lengthy Twitter thread, Do Kwon said that he fully intends on the Terra community doing a complete rebuild back to where it was.

“Before anything else, the only path forward will be to absorb the stablecoin supply that wants to exit before $UST can start to repeg. There is no way around it,” he said.

Kwon said he endorses Terra community proposal 1164, which suggests increasing the basepool from 50M to 100M SDR, or in other words, raising the system’s minting capacity from $293 million to $1.2 billion. Some have referred to this as “Kwontitative easing.”

This change would effectively allow UST to be absorbed quicker, according to Kwon. Even though more sell pressure on LUNA is to be expected in the near term, the proposal assumes that eventually, LUNA and the mint and burn mechanism would stabilize.

“With the current on-chain spread, peg pressure, and UST burn rate, the supply overhang of UST (i.e., bad debt) should continue to decrease until parity is reached and spreads begin healing,” he said. “Naturally, this is at a high cost to UST and LUNA holders, but we will continue to explore various options to bring in more exogenous capital to the ecosystem & reduce supply overhang on UST.”

Image via Shutterstock

While no official explanation of what caused the events have been given, a consensus is forming that it was a coordinated attack, rather than an unfortunate bug in the system.

Pseudonymous DeFi expert Onchain Wizard suggested in a viral thread that an entity orchestrated the entire thing by borrowing 100,000 BTC, selling it to the Luna Foundation Guard (LFG) to effectively create a short position, and then simultaneously dump large amounts of UST. The overwhelming sell pressure on UST would in turn force LFG to sell off its BTC reserves in order to defend the peg, putting downward pressure on BTC before yet another massive UST dump.

“So you have a ~$4.2bn short position built. Over the same time, the attacker builds a $1bn OTC position in $UST. The stage is now set to create a run on the bank and get paid on your BTC short. In anticipation of the 4pool, LFG initially removes $150mm from 3pool liquidity.

But this only starts the de-pegging. LFG begins selling $BTC to defend the peg, causing downward pressure on BTC while the run on $UST was just getting started.”

As Onchain Wizard says, LFG may have been desperately selling off BTC to restore the peg while the attacker would have been selling all its UST on Binance, causing the exchanges to suspend withdrawals of UST and fueling more bank run panic.

Different variations of this scenario have gone around and there may never be an exact explanation, but regulators are already using the episode to discredit decentralized stablecoins and call for government-backed central bank digital currencies (CBDCs).

Yesterday when the Terra situation kicked off, Treasury Secretary Janet Yellen mentioned it in a hearing, saying:

“A stablecoin known as TerraUSD experienced a run and decline in value. I think that this simply illustrates that this is a rapidly growing product and there are rapidly growing risks.”

Yellen added that she thinks it would be” ​​very appropriate” to pass regulation, preferably by the end of this year.

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