Terra is a base-layer (L1) blockchain with native asset, LUNA, used primarily to collateralize the Terra ecosystem’s stablecoin, UST.

This week, the UST stablecoin lost its peg to the dollar, causing a “death spiral” that brought LUNA down from $90 to $0.

It was an unprecedented event whose implications are still being worked out in the crypto space.

Takes on the fundamental reason LUNA crashed range from “it was an inside job” to “20% yields are unsustainable,” with “LUNA itself was undercollateralized” and “LFG, the Terra treasury mismanaged funds” falling in between.

Shady dealings not withstanding, it was Terra’s tokenomics that caused its demise.

Examining LUNA’s fundamental value

All currencies get their value from use as a medium of exchange.

Cryptocurrencies are no exception.

In LUNA’s case, this value comes from use as collateral.

LUNA collateralizes UST, and LUNA holders make decisions about the protocol – governance.

Like all pure-governance tokens, LUNA doesn’t derive much value from its ability to make these changes.

TAM for pure governance tokens is the value of controlling a protocol.

This is a huge problem.

Neutral or profit-oriented parties have no reason to bid the price up. Users are unlikely to be deeply invested.

This leaves malicious actors in charge of governance for cheap.

— Nate (@EatSleepCrypto) May 3, 2022

Most of LUNA’s value came from the belief that it would be used as collateral for borrowing UST.

Terra: a short summary

Over the past two years, Terra ascended to the top of CoinMarketCap, fueled by “guaranteed” returns on Anchor Protocol.

In March, founder Do Kwon announced Terra would buy $10 billion in reserves, to fortify LUNA.

By May, ~$2.5 billion in BTC had been accumulated by LFG, the Terra treasury, but there were $14 billion UST outstanding, making Terra an easy target since the foundation couldn’t cover deposits.

Taking profits in stablecoins like USDT, DAI, and UST is popular way for traders keep money the ecosystem, and avoid centralized exchanges.

UST holders were attracted for this reason, but the fundamental driver of Terra’s growth was 20% yields on stablecoins deposited into Terra’s Anchor protocol.

On May 12, series of shorts on UST caused it to fall below $1.00.

Over the next few days, a bank run followed.

UST fluctuated wildly, causing Terra to mint new LUNA by design, and prompting LFG to sell its BTC reserves for LUNA, hoping to bring the UST peg back to $1.00.

It didn’t work; the crypto community had lost faith in UST, recognizing Anchor as a pyramid scheme.

After several days, facing a hopeless situation, Terra network validators paused the blockchain to prevent further attacks.

Lessons from Terra (LUNA)

LUNA’s use was rather limited. It was primarily used to create UST.

Irrespective of LUNA’s sizeable Total Addressable Market – a multiplier of demand for stablecoins – LUNA’s TAM is fickle.

Anchor’s 20% yield ultimately depended on LUNA’s continued growth.

A few takeaways:

1. Cryptocurrencies get their value from use as a medium of exchange.
   1. The resilience of a cryptocurrency depends on the diversity of its economy. LUNA was used for a single purpose; when Anchor failed, LUNA failed.
2. All value is belief.
   • Once the belief that LUNA could create UST was shaken, the price spiraled.
   • To Terra’s credit, it (still) has lots of supporters, and a vibrant community, but even this isn’t enough to fix bad tokenomics.
3. Tokenomics must be sustainable. Without sustainable tokenomics, projects risk stagnation or collapse.

The bulk of the implications from Terra’s collapse are likely to play out over the coming weeks and years. In such an interconnected system, these effects are not immediately obvious – tokenomic design can be complex.

If you are creating a token and would like some help with tokenomics, feel free to reach out for a free consult.