An $85b crypto collapse reveals a new kind of bank run

Terra’s coins were supposed to be the future of money. But they relied on confidence, which can vanish in an instant.

Zeke Faux and Muyao Shen

May 25, 2022 – 8.00am

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Late last year, on the advice of a friend, Odosa Iyamuosa invested his life savings of $US4000 ($5700) in a cryptocurrency called Luna. The 28-year-old, who lives in Abuja, Nigeria, researched the coin himself online, and what he found seemed promising. Luna’s price was soaring, thanks to the success of another coin with which it was deeply intertwined, TerraUSD.

Some of the crypto industry’s biggest names had already invested, including Galaxy Digital Holdings, the high-frequency-trading firm Jump Trading, and venture investment arms of the exchanges Coinbase Global and Binance.

Do Kwon, the 30-year-old founder of Terraform Labs, insists he has a plan to revive his financial system. Bloomberg

For Iyamuosa, it seemed like his best hope to get out of Abuja, where he says many jobs pay just $US2 a day, or less. He’d scraped together a little money selling knock-off Nike and Adidas sneakers to local buyers he found on Instagram.

He wanted to increase his savings to $US16,000 and enroll in a data-analytics program at a college in Toronto, so he could get a job at a big US company, like Netflix or Google. And for a few months, it looked like his plan was working. The value of his Luna coins doubled. “I sent money to my mom and my siblings,” he says. “I was able to eat properly.”

Then this month Luna and TerraUSD collapsed. TerraUSD was a so-called stablecoin, which means it was supposed to keep a constant value of $US1. But it dropped below $US1 and kept falling, and Luna tokens, once worth more than $US100, crashed to below US1¢, all but erasing a combined market value that had topped $US60 billion. Iyamuosa says his coins are now worth a total of just US3¢. “I didn’t even know what to do – I felt like just dying,” he says. Iyamuosa says he decided against suicide because it would devastate his mother.

For the past two years, soaring prices for Bitcoin, Dogecoin, and other cryptocurrencies have been stoking a powerful fear of missing out on a chance to make an overnight fortune. And promoters of what’s called DeFi, or decentralised finance, where users can deposit, borrow, and lend coins, were promising super-high yields without super-high risks, as if the traditional rules of finance no longer applied.

One reason for TerraUSD’s popularity was that holders were offered yields of 20 per cent. The crypto industry more broadly encouraged the sense of FOMO with its marketing, painting investing in crypto as a way to seize control of your future.

“If you want to make history, you gotta call your own shots,” LeBron James said in one of several Super Bowl ads for crypto exchanges.

Now social media is filled with stories from investors like Iyamuosa, who say they’ve lost their life savings on Luna. A list of suicide hotlines is pinned at the top of the Reddit forum devoted to the tokens.

The two coins’ collapse fed a digital-asset rout, helping wipe out more than $US300 billion from the combined value of all cryptocurrencies in the week ended May 13. Bitcoin, which traded for more than $US60,000 as recently as October, now goes for half that. For the moment, at least, the entire crypto edifice looks shakier.

The holy grail

Not long ago, Luna and TerraUSD’s backers were talking as if they had reinvented finance. The tokens’ creator, Do Kwon, a 30-year-old South Korean who studied computer science at Stanford, said he wasn’t making just another form of digital cash – it was going to be a new financial system, one outside government control that was cheaper and faster to use and paid higher interest rates to savers.

“Creating a decentralised form of money on which you can build an entirely new type of permissionless financial ecosystem is the holy grail of cryptocurrency, and that’s exactly what Terra does,” Kwon said in a promotional web video.

The system around the coins was complex. Start with the stablecoin. These coins have become an important part of the crypto world as a stand-in for traditional cash.

Since they’re designed to have a constant value, they’re easier to use to pay for things in the real world. (Bitcoin and other coins like it jump and plunge in price so much that the seller of a BMW might only end up with a Honda’s worth of tokens by the time the deal gets done).

Kwon envisioned Terra stablecoins being used for instant payments and transfers around the globe, undercutting Visa, Mastercard, and Western Union.

The concept wasn’t new. But unlike other stablecoins, TerraUSD didn’t even claim to be backed by dollars or other assets held in a bank account. Instead, it was supposed to be worth $US1 because it could be redeemed for $US1 worth of Kwon’s other token, Luna.

If Luna was worth $US10, you could redeem one TerraUSD stablecoin for 1/10th of a new Luna, which you could sell on an exchange for $US1. If Luna was worth 10¢, you’d get 10 Lunas.

Luna itself was supposed to climb in value as the network grew more popular because its holders accrued usage fees. It was essentially a mullet network: in the front, a boring, businesslike stablecoin, and in the back, the Luna get-rich-quick party.

TerraUSD launched in 2020, but it gained little traction until March 2021 when Kwon introduced a third part of the network: Anchor, a quasi-bank for crypto where users could deposit their Terra stablecoins and earn 20 per cent interest. (As is typical in crypto, Kwon says his company, Singapore-based Terraform Labs, wrote the software, but all three legs of the system are “decentralised,” controlled by their users.)

‘Beautiful and decentralised’

Perhaps this raises an eyebrow? Indeed, some people in the crypto world argued it was unsustainable. After all, 20 per cent is higher than Bernie Madoff’s made-up returns at his hedge fund. But Kwon pitched it as a safe alternative to banks such as Wells Fargo, even saying that one day other fintech companies like Venmo might deposit user funds there.

“What’s beautiful and decentralised about this system is that it requires no central intervention,” Kwon said in January on a podcast. “It’s just sort of beautifully combined together using a set of game theoretic incentives.”

You can’t just create more money out of thin air.
— Steven McClurg, chief investment officer at Valkyrie Investments

In 2021, Luna’s price increased hundredfold, and nearly $US10 billion worth of TerraUSD stablecoins were created.

On Twitter, Kwon, whose avatar was an Iron Man-ish armoured hero, said Terra was unstoppable and trolled anyone who questioned his ideas. “This community bought Luna, so they definitely are not poor as your broke ass,” Kwon tweeted at one critic in March.

Galaxy Digital founder Mike Novogratz described himself as an “official Lunatic” in January. Twitter

Fans took to calling themselves Lunatics. “I’m officially a Lunatic!!!” Galaxy Digital founder Mike Novogratz tweeted in January, after tattooing his left shoulder with the word “Luna” next to a wolf howling at the moon.

“My tattoo will be a constant reminder that venture investing requires humility,” the billionaire said in a letter posted online on May 18. (Company filings indicate that selling Luna tokens contributed to $US1 billion in realised gains last year for Galaxy.)

But TerraUSD had a flaw, one it shared with money-market funds or banks before the invention of deposit insurance. If users lost confidence in the system, they could rush to sell or redeem their coins, and others might follow, fearing they wouldn’t get their $US1 per token back if they waited too long.

In theory, the network could always issue more Luna tokens to those who wanted out. But that was a risk, too. The more tokens issued, the further the price of Luna would drop, which in turn would mean the network would have to issue even more, exacerbating the decline. On Wall Street, that’s called a “death spiral.”

“The idea was: ‘We’ll just print more Luna out of thin air to back the price of the stablecoin,’ and that doesn’t really work,” says Steven McClurg, chief investment officer at Brentwood, Tennessee-based Valkyrie Investments. “You can’t just create more money out of thin air.”

‘Watching my own house burn’

The crisis started on May 7. Luna had already been drifting down as part of a general slump in asset prices. After a trader made a large swap of TerraUSD for rival stablecoins, its price dropped to US99¢, prompting speculation the dollar peg was at risk. Kwon had amassed a few billion dollars’ worth of Bitcoin as a reserve to back TerraUSD in case of emergency, and on Twitter he projected confidence about its stability.

“Those of you waiting for the earth to become unstable — I’m afraid you will be waiting until the age of men expires,” Kwon wrote on – May 8. But the next day, the Terra redemptions continued, forcing Luna to issue more tokens.

Luna fell by more than half, to less than $US30, then lost another two-thirds in value the next day.

Kwon exhorted followers to hold on. “Getting close ... stay strong, lunatics,” he tweeted. But there was no stopping the death spiral. By the morning of May 13, 6.5 trillion Lunas were in circulation, and the price had dropped to $US0.00001834. TerraUSD’s price dropped below US20¢ because even if it could be redeemed for an immense pile of Luna tokens hypothetically worth $US1, there was no one to buy them.

Iyamuosa, the Nigerian investor, says he’s spent the days since the crash in disbelief. Down to his last $US20, he’s still on Twitter and the chat app Discord, hunting for a crypto project that will make his money back.

His dream of moving to Canada to study seems out of reach. “There’s literally nothing else for me again,” he says. “I don’t know, man. Honestly, there’s no job, there’s no nothing.”

Other investors also say they were prepared for ups and downs, but never imagined such a rapid collapse. Senior Bernier, 24, a flooring contractor in Montreal, says he lost about $US250,000. “Do Kwon is a guy I’ve always believed in,” he says.

“It felt to me like I was watching my own house burn down or something,” one investor said on an audio support group on Twitter Spaces. “You’re not an idiot, you’re not unlovable,” the host said. “Please don’t make any rash decisions guys.”

Kwon didn’t respond to messages seeking comment. “I am heartbroken about the pain my invention has brought on all of you,” he tweeted on May 13. He said he has a plan for reviving his financial system, this time without a stablecoin.

The crypto market appears to have stabilised. Tether, the most popular stablecoin, which says it’s fully backed by sound investments, dropped below $US1 before recovering.

But Terra’s collapse has amplified calls for rules for stablecoins in the US, UK, and South Korea. Authorities in South Korea revived a financial-fraud investigation unit to look into the Terra collapse, news reports said.

Regulators say a collapse like this could pose risks to the broader financial system if crypto and the complex DeFi ecosystem continue to grow.

“A lot of people thought that a stablecoin was just going to be as good as a dollar,” Rohit Chopra, director of the US Consumer Financial Protection Bureau said last week. “But they’re learning that it’s not.”

Bloomberg Businessweek