The Madoff of Crypto Or How $Luna is structured in an Egyptian fashion

By Diogenes Casares 04/27/2022

Terraform Labs, the company behind the Terra Blockchain, $Luna, $UST, Anchor Protocol / $Anchor, has seen a lot of attention recently. As crypto prices decrease, investors have been lured by 20% fixed APY on the Anchor protocol in dollar terms using Terra’s stable coin UST. Collectively these tokens have a MC of $85.37 billion, which would place Terra as the third-largest crypto project by MC after BTC and ETH. Terra has managed to accomplish this by having a siloed incentive structure to promote further deposits into Anchor, driving demand for $UST which pushes the price of $Luna higher at the expense of the $Anchor token and now the Anchor Treasury. The 20%

Diagram of the incentive structure of the Terra Ecosystem

APY in $UST is an incredibly high return rate even for DeFi where double-digit yields are not unheard of (see Ribbon Finance, Dai, Abra, etc.) although most protocols that offer such returns also run the risk of impermanent loss or other potential negatives (options expiring ITM in the case of Ribbon vaults, capital depreciation risk, etc). Thus Anchor’s fixed return is incredibly lucrative from the perspective of investors, especially as it is pitched as a stable investment, with the Anchor website equating it to a savings account. The high return of the $Anchor protocol means (intuitively) that borrow rates for $UST/$LUNA in Anchor must be higher than the already insane 20% APY. The borrowing rate stands at approximately 24%, which is, quite simply, absurd. It is higher than the average interest rate on credit card debt, which is infamously high. It does not make economic sense to borrow $UST at such a high rate when better loans can be provided with other collateral and stablecoins. While Anchor’s 20% fixed APY is high, it is not Olympus DAO’s 10,000%+ yield. This is because Anchor and Terra are targeting sophisticated investors and purposefully building a long runway (IE they want assets to be deposited for a long period of time and for the protocol to last longer). Olympus DAO was the Nigerian Prince scam of crypto. Terra is a potential Ponzi that will impact institutional investors lured by high yet not “insane” returns the same way some of the smartest institutional investors fell for Madoff’s 20% returns. The returns are just enough to make normally diligent investors not ask any questions and not too much to make them wonder whether it is sustainable. This report is asking the questions investors are failing to ask.

Accounting that Would Make Enron Proud

In order to pay for the 20% returns, Terra has established an elaborate system to shift costs onto other investors in order to pay the returns (IE dodgy accounting). Initially, borrowers who deposited staked $Luna, wEth or wAvax would receive liquidity mining rewards paid out in the $Anchor token. TThese rewards would actually outpace the borrowing rates in dollar terms, meaning that taking out a loan on Anchor would mean a borrower would earn money from the amount of money they received in $Anchor token. Effectively, this meant that purchasers of the $Anchor token,

Chart of Deposits in UST (Green) and Total Borrow measured in UST (Black). Ratios are all Borrow$:Deposit$

who are betting that the protocol’s token would increase in a similar way to $UNI or $COMP tokens on Ethereum, were effectively subsidizing borrowing rates.

Additionally, the Anchor Protocol has an ongoing buyback program that, as the name suggests, emulates traditional buybacks where the Anchor Protocol will purchase some of its own tokens in hopes of driving the price up. Anchor has spent to date $18 million-plus on this program. The buybacks effectively pushed $Anchor token prices higher. This meant that new borrowers, when they entered the app, would have the calculations done with this inflated price and make financial decisions believing that the $Anchor token would remain stable and thus their borrowing costs would remain low. This worked for a while the $Anchor token price remained high, but in May of last year, the price of the $Anchor token crashed. This is to be expected given that borrowers were selling the $Anchor token en masse in order to buy UST or otherwise cash out. This price collapse made borrowing on $Anchor not as lucrative, as it began to actually cost money to take out a loan (you know, like how loans are supposed to work). The impact of the $Anchor token price decrease and the resulting increase in real borrowing costs was that the gap between the Collateral/Borrowing value and Deposit value started to deviate. Whereas previously the ratio had been roughly 1:1, as the $Anchor token price decreased and total deposits in Anchor increased, the ratio shifted. After the initial massive price decrease in May which was in line with other crypto price decreases, the ratio turned to 1:2. As $Anchor continued to decrease in value or remain stagnant and TVL increased by multiples of ten, the ratio continued to lengthen as there was no major incentive to borrow from the $Anchor protocol, especially when compared to simply depositing assets in the protocol or borrowing from another protocol in order to deposit in Anchor, effectively arbitraging lower borrow costs on Ethereum lending protocols to take advantage of high returns on Anchor. This increase in deposits compared to collateral meant that instead of having Anchor having a net profit (as Anchor had when it was funding much of its yield via airdropping its token, allowing it to keep any

additional rewards) Anchor now faces a major shortfall. The current amount of interest in $UST the protocol must generate over the next year is $2.7 billion. The protocol itself is only projected to make a bit under half of this, meaning that roughly $2 billion will be needed to be injected into the protocol in order to match current yield, not to mention future yield, as the TVL of the protocol is continuing to expand dramatically. Currently, TerraLabs has $1.6 billion in Bitcoin reserves and 800 million in other assets. This is still $400 million short of the amount needed for current obligations not to mention future obligations as demand for deposits has continued to grow. If the number of deposits continues to grow at the current rate (calculated linearly, exponential and polynomial gives out amounts higher than the total amount of stable coin in circulation). The longer users deposit without selling, the longer TerraForm can pay out investors using its own UST instead of backed stablecoins like USDC or other assets. Essentially, as long as money is in the protocol Terra can pay with big old IOUs that nobody realizes are IOUs backed only by Terra and hope nobody pulls all their money at the same time the protocol could have as much as $50 billion in UST. This would mean obligations of $9 billion at the new rate of 18%, which the Anchor Protocol has just changed to its new standard return rate, a sign that cracks are beginning to show as this is a major move from Anchor’s previously consistent 20%. Even with this nominally lower return rate, deposits are still coming into the protocol as it remains more competitive than other lending platforms due to its lack of foundation in any economic reason and its subsidization by TerraForm Labs.

In order to maintain the set APY, Terraform Labs will have to either inject cash which will cost the protocol dearly and is unsustainable or it can lower the APY. In order to lower the APY to a point where the treasury will operate net neutral, the rate would have to be cut in half to at least 10%. This would make $UST yields uncompetitive and likely lead to a route for $Luna and circulating $UST, effectively cutting down liquidity dramatically and threatening the beginning of a death spiral as

arbitrageurs are unsure if the price of $UST will remain steady as there is no utility for $UST without the Anchor Protocol.

TerraForm’s Warchest

TerraForm’s war chest has been built off of UST’s fee structure (which has allowed TerraForm to build such a large treasury). This makes UST significantly uncompetitive compared to other low slippage stable coins with better yields and fiat bridges provided by exchanges (IE USDC, GUSD, BUSD, etc.). The only reason people have UST is to put it into the Anchor Protocol. If there is no Anchor Protocol there is no use for $UST and thus there is no value in having $Luna which is intrinsically tied to the amount of circulating UST. The entire ecosystem collapses in on itself as UST fails to remain tied to the dollar or at the very least suffers a colossal decrease in circulating supply and Terra’s war chest is diluted as without volume, the protocol cannot gain fees which it can use to subsidize Anchor Protocol or other projects which are meant in turn

To avoid this kind of scenario, Terraform Labs claims to be in talks to buy $10 billion in BTC and that it has “funds ready”. However, it is unclear how much liquid non-Terra ecosystem tokens Terraform labs has between itself, Anchor Protocol and the Luna Foundation Guard, which is tasked with maintaining the UST peg (IE in the event of a death spiral). While collectively it is known Terraform Labs has at least $2 billion, it has not been entirely upfront about what other positions it has. It has been injecting UST already into Anchor (it injected $450 million into the protocol in February) but this massive spending has hardly put a dent in the assets and has only served to increase demand for the Anchor deposits as they are now seen to be backed by Terraform’s pocketbook. Injecting UST is also inefficient, as effectively these injections cut into the liquidity of $Luna. As a result, Terraform has shifted towards acquiring large amounts of BTC and recently Avax.

The basic idea is that these assets can appreciate and hold their value over time, allowing the protocol to pocket the difference. However, no longer having a direct USD peg is incredibly risky. If

UST Market Cap and Terra Price

BTC’s price increases dramatically, Anchor will be able to succeed for at least another year and pay off the interest. If BTC decreases in value, TerraForm’s reserves backing Anchor APY will effectively be cut down even more, potentially decreasing their runway to less than a year. Given the closed nature of TerraForm Labs and Luna Foundation Guard (LFG), it is not even known at what price TerraForm acquired the BTC, but it can be presumed due to current conditions that the protocol has lost anywhere from 5–10%. It is my personal belief that Do Kwon, the man behind TerraForm, believed that his announcements of buying BTC would push more purchases as is what happened with Microstrategy and Tesla BTC buying announcements in the past. While there was a slightly noticeable increase around the time of the announcement, this price did not hold and after a minor rally continued to fall. The announcement of BTC purchases also “happened” to coincide with an aggressive crash in the price of $Luna. At the nadir of this crisis, the announcement of BTC purchases was made and buoyed by evidence of Terra backing UST’s reserves and having cash on

hand, the price increased dramatically. The only way $Luna, $Anchor and $UST will likely survive is if the price of BTC is able to keep up with the massive increase in obligations the Anchor Protocol has. If this is the case and cryptos rally, it is also likely that TVL will actually decrease as investors return to riskier investments and staking rather than staying in the supposed “safety” of USD-pegged $UST deposits on Anchor. This would be incredibly good for the Terra ecosystem as the value of its assets increase while its obligations owed decrease, leaving Anchor if not with a profit then at least with some more assets to back future deposits.

However, if the situation is reversed or the situation stays the same, the Terra ecosystem is in serious danger. Should the price of bitcoin decrease alongside other assets, investors used to high returns will enter Anchor Protocol as a way to gain UST in order to buy more crypto in the future. Thus, as the value of Terra’s balance sheet decreases, its obligations will decrease. This will spell disaster and the potential destruction of the ecosystem and if not necessarily a de-pegging of UST at the very least a dramatic negative price impact on $Luna.

The Connection Between $Luna and $UST in Depth

$Luna in general has had its price highly tied to the supply of UST. This is because at any point, $Luna can be turned into its equivalent value in $UST. There are an unlimited amount of $UST tokens that can be minted, but a limited amount of $Luna. That means that as the amount of $UST increases, there is effectively more liquidity for $Luna, as both assets can be converted into each other similar to traditional liquidity pools but using miners that verify prices in order to avoid a potential point of failure including an oracle (although this system is still vulnerable to failure if the price moves faster than miners realize). Essentially, the more $UST Terra gets into the Terra ecosystem, the more liquidity there effectively is for $Luna and thus the higher the price of the token.

Counter Arguments

Point: Reserve has staked assets that earn a higher percentage that will accommodate changes.

While interest is earned, it is nowhere near enough to cover the 20%. Even if the reserve were to make the 20%, since it is only $1.7 billion in comparison to the $13 billion TVL or $1.6 in obligations, the money made ($340,ØØ) is nowhere near the total required to cover the protocol’s shortfall ($800,ØØ). This is simply not a valid argument. 10% from staked Luna is dependent upon more people wanting to buy Luna.

Point: Collateral is in staked assets which earn 10%, which means the yield only has to be an additional 10%!

Collateral on Anchor only accounts for 1/4th of TVL on Anchor. APY is also closer to 7% than 10% and the “additional 10%” is a gap that there is no magic way of filling. This APY is also in non-stable assets. The argument of “oh but it will be fine as long as the chart go up” is much more worryingly countered with “But what if it doesn’t?”. The low collateral rate is in spite of the fact that borrowers are effectively being subsidized due to payments in Anchor tokens.

Point: If the Terra ecosystem expands especially due to payment processing, upwards buying pressure will increase dramatically.

Terra faces major hurdles to becoming accepted. It is not partnered with major exchanges the same way BUSD is with Binance, GUSD is with Gemini and USDC is with Coinbase. This makes fiat-UST bridges more costly. Slippage is relatively high compared to USDC and other cryptos and it is not as proven. Terra founders were chased out of their home country of Korea for regulatory reasons and merchants have to work with regulators. A supposed new payment processor like Terra having issues with regulators would be a major red flag for merchants, not to mention fees in comparison to other stablecoins and a lack of major fiat ramps

Conclusion

I do not believe Terra and the Terra ecosystem were made in bad faith. I do believe however from my experience seeing Iron Finance and other algorithmic stable coins as well as treasury-backed tokens with high yields such as Olympus DAO and its myriad of forks, that Terra and its tokens have a very real risk of collapsing and being worth near zero if the blockchain does not find a real use-case that can eclipse its current use for “savings” which in reality has been an attempt to use siloed liquidity to use the Anchor Protocol and it’s token to boost circulating $UST and thus the value of $Luna at the expense of investors in the $Anchor token for enough time at least for other use cases to materialize. The yield farming has now dried up and with it most of the inflows of capital that came into Terra. Terra is facing rising obligations and no way to pay them unless there is a dramatic rise in use cases, in the price of cryptos in general, or if they torpedo their main protocol and effectively their own project. None of these options are permanent besides real, viable, and sustainable use cases which have yet to materialize, and for this reason, it will likely reach a point of critical failure in the near future, potentially sweeping with it the $90 billion in value it has created in its ecosystem and leaving investors who thought they were investing in a safe and secure savings protocol penniless.