Why Terra Luna Collapsed with Jonathan Wu

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https://www.whatbitcoindid.com/podcast/why-terra-luna-collapsed

Jonathan Wu is head of growth at Aztec network. In this interview, we pick over what happened when the stablecoin UST crashed, how it linked to the Terra blockchain and Luna governance token, the issues with recursive lending, and the need for financial disclosure in the industry.

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TIMESTAMPS:
00:00:00 Introduction
00:05:56 Explaining Terra/Luna; what triggered the crash
00:20:46 Liquidation contagion; the need for disclosure
00:32:46 Protection of investors; nothing being fully trustless
00:39:31 Role of Bitcoin in the Terra/Luna crash
00:48:03 Impact of failure; limited success stories in DeFi
00:55:41 Impact of Terra/Luna crash on other stable coins, Bitcoin and Ether
00:59:41 Play to earn; PoS; Ethereum merge

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“The larger these stable coins are, the more adoption there is, and the more stable they’re likely to be. But then the worse and more contagious the effect is if it fails. It’s almost like you have to be really big, in order for it to be stable. But once you get that big, the cost of failure is immense.”
— Jonathan Wu

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Stablecoins have provided financial sovereignty for millions who have been failed by their financial institutions and want predictable value in a currency. So, the failure of a stablecoin that had been financially backed by some of the biggest investors in DeFi has been particularly traumatic for many investors.

Unlike some stablecoins, UST, native stablecoin of the Terra Blockchain, was under collateralized i.e. it wasn’t backed by another asset. Maintaining its peg to the dollar was (theoretically) stabilized algorithmically: linkage of UST to a governance token, Luna, and a complex dance of creation and burning of both of these coins. In theory, this enabled UST to remain decentralized.

In practice, there were some inherent weaknesses in the process. Not only was the stablecoin designed to be a payments rail, but the governance token, Luna, could be staked to derive yield. It was accepted by lending protocols that allowed for recursive lending (rehypothecation), an activity raised as a significant risk to DeFi by many critics of yield farming (e.g. Allen Farrington).

Then the house of cards started to crumble. Or, as Jonathan describes it: the death spiral began. The result was a quick unravelling of an asset, which had had a market cap of over $18 billion. An asset that many investors believed, wrongly, was devoid of the risks associated with altcoins. An asset now with an effective value of zero.

The story involves large profits being made by major investors, a CEO who overplayed his hand and got some major calls wrong, some shady characters in the DeFi lending ecosystem, complex strategies not many understand, and a lot of people who could ill afford to lose their investments getting seriously burned.

The critical issue is this again places Bitcoin in a bind. Its price was directly affected, but its reputation suffers: retail investors are warier to adopt, and regulators are more empowered to pounce. There is a lot for the industry to learn, and learn quickly. The stakes are currently stacked unfairly, and it’s the same people who end up losing.