In this series of articles I seek to take a balanced and reasonable perspective on everything that has transpired since the UST-depeg catastrophe. I expect the majority of readers to be upset with at least some of the points made because I will attempt to de-construct most of the prevailing narratives which have been the loudest among the various stakeholder groups. I will also attempt to answer some of the frequently asked questions which I have received.
This was originally designed to be a single article but as I bottomed out each of the points mentally, I realized that covering everything I wanted to cover would likely result in an article three times in length. I have also unfortunately fallen ill at the time of publication and faced with the difficulty of half-assing a substantial portion of the analysis - I have decided to split the article up into multiple pieces.
The Terra Ecosystem
I find it sensible to first begin with a basic explanation of the Terra ecosystem and the algorithmic relationship between the ‘stablecoin’ US Terra (UST) and the ‘governance token’ Terra Luna (Luna) which fuels the engine of the Terra ecosystem. This will help us understand why the Terra ecosystem collapsed as spectacularly as it did.
Many readers will be familiar with how the algorithm works. But for those that do not - here is what I hope is a plain English explanation.
UST is the product which delivers on the Terra promise of ‘decentralized money’ - a token which seeks to always be pegged to the US Dollar. This is achieved by creating a swap mechanism between UST and Luna. The blockchain allows any person at any time to immediately swap $1 of UST for $1 of Luna. This means that if anyone were to purchase a single $UST at 0.97, he could swap that for $1 worth of Luna and pocket the difference. If UST were trading at say $1.03, it would make sense for anyone to swap $1 of Luna for that UST, again pocketing the difference.
What this achieves is that the supply of Luna contracts and expands depending on the demand of UST. If the demand for UST goes up, more Luna is burned to create UST and the supply is constricted. This consequently also means that the value of Luna will increase. But if the demand for UST were to go down, then Luna has to be created in order to burn UST. This inflationary mechanism would thus lead to a decrease in the price of Luna.
Luna absorbs the volatility of UST. In layman’s terms, if you purchase Luna, you are betting on an increase in the demand of UST and agreeing to bear downside risk if there is a decrease in demand of UST.
Onlookers pointed out the obvious risk. The mechanism for restoring UST to the peg hinges on there being a demand for Luna. If demand for Luna dries up and the price of Luna plummets, more Luna must be minted for every UST to be burned. This further reduces the price of Luna as the newly minted Luna is sold into ever-weakening demand necessitating the minting of even more Luna for subsequent UST to be burned. This is the ‘death spiral’ which critics repeatedly drew attention to and which finally played out in the days following the first de-peg event.
Central to the ecosystem is also Anchor Protocol (Anchor). Anchor is a protocol on Terra that provides users with what was initially up to 19.5% APY. It was fairly transparent that 19.5% APY was not sustainable and the yield reserves out of which these yields were paid had to be topped up. It was likely seen as a method of increasing demand for UST until Anchor itself could generate sustainable yields.
Before we cover the collapse, it is important to quickly cover two other ‘relevant’ entities within this ecosystem.
Firstly, Terraform Labs (TFL), the company founded by the charismatic and controversial Do Kwon was the main team behind Terra. TFL functionally ‘managed’ the Terra ecosystem due to its large share of the Luna supply alongside its relationship with the validators (persons with whom Luna is staked) who participate in governance. Though purportedly decentralized, it is incredibly apparent to any layperson that TFL is (and to this day remains) the centralized force behind the Terra ecosystem. We will consider this in far more detail later on.
Secondly, the Luna Foundation Guard (LFG), a non-profit founded in January 2022. The formation of the LFG perhaps shows that Do Kwon (despite his public bravado) or at least his investors were in fact cognizant of this risk. There evidently was some understanding that a massive bank run would send the algorithm into a death spiral and the LFG was set up to guard against that eventuality. As of 7 May, LFG held reserves amounting to between 2.5bn to 3bn in a basket of crypto assets including most notably, 80,394 BTC. We will also discuss the role of the LFG in more detail later on.
The Collapse
On 8 May 2022, UST lost its peg slightly. This coincided with significant outflows from Anchor but the peg was largely regained by the end of the day. Do Kwon, in his usual manner, publicly mocked naysayers on Twitter.
The next day, outflows continued and Do Kwon, TFL and LFG started taking things far more seriously. The peg fell to a day low of 0.793 where it closed the day and it was on this day that the LFG voted to deploy funds to defend the peg. The LFG announced that, 1.5bn - half in UST and half in BTC - would be made available as a ‘1.5bn [liquidity pool]’, in Do Kwon’s own words. The price of Luna halved from the previous day’s close as the algorithm went to work.
As a reminder - the built-in solution without intervention from the LFG is that new Luna would be minted by the protocol until all the UST debt that wanted to exit had left the system. Luna was built to absorb the volatility of UST and this is exactly what it did.
May 10 would be another pivotal day. Another 3bn or so of UST was withdrawn from Anchor, probably as Anchor depositors started to panic about the situation. The peg would oscillate on this day up to a high of 0.948 before closing at 0.684.
Two major events occurred on this day. Firstly, Do Kwon apologized for his silence on Twitter commenting he needed ‘razor-focus to deliver’ and then later publicly teased a ‘recovery plan’ for UST, encouraging the public to ‘hang tight’. Rumors circulated that a billion dollar bailout package was forthcoming with the deal involving rescue funds being allocated Luna at a 50% discount that would be locked for a certain period.
If there was such a plan - it certainly fell apart as Luna would have given these investors a 50% discount within the day. What we do know after the fact was that TFL exercised some sort of right in a ‘Master Services Agreement dated January 10, 2022’ to execute trades on behalf of LFG, deploying 33,206 BTC which was a sizable majority of what was left of the LFG reserves. We will consider this in more detail later.
Despite TFL and Do Kwon’s efforts, UST closed the day at 0.684 although it did hit a 0.948 high. Luna opened at about $32 and closed at $17.5.
11 May 2022 was when the death spiral began playing out drastically. As billions of dollars of UST presumably sat on exchanges waiting for an announcement of a recovery plan, Do Kwon dropped the bombshell that there was no recovery plan involving external funding at all. The plan was to let the algorithm play out, massively inflating the supply of Luna and depressing its price until the ‘bad debt’ (in Do Kwon’s own words) could be flushed from the ecosystem. Do Kwon also endorsed a proposal to increase Luna minting capacity so that UST could be removed from the ecosystem at a quicker rate.
The market, as one would imagine, did not react well. After a short period of confusion where both Luna and UST experienced a quick price spike from any communication from TFL or Do Kwon at all, the market quickly priced in the fact that there was no rescue package forthcoming. UST hit a low of 0.299 but did manage a recovery to 0.801 to close the day. As it turned out - this would be the last chance for retail UST holders to exit at a reasonable haircut. Perhaps more would have, if not for the fact that Do Kwon had assured the public that UST will become ‘fully collateralized’ going forward, that UST was being prioritized (‘the only way forward’) and the public was still under the impression that LFG had reasonable reserves (the 1.1bn). It is perhaps difficult to blame him for not being fully transparent - Do Kwon and TFL were trying their best to prevent a bank run after all.
As for Luna? It opened the day at $17.45 and closed at $1.07. Demand was clearly drying up all while supply continued to expand. We were now at the point where a single Luna needed to be minted to burn a single UST.
12 May 2022 was where there was no return for the current Terra chain. If Do Kwon, TFL or the validators had stopped the blockchain at this point (or at any point prior), perhaps there would have been a chance of saving the Terra chain. Do Kwon was strangely silent, despite his inspired (but vaporous) declarations of the previous day. TFL’s official twitter account tweeted a thread largely mirroring Do Kwon’s assertions of the previous day and supporting a proposal to burn the community UST pool. The focus at this point was clearly still to support UST at the expense of Luna - exactly the way the Terra ecosystem was designed.
This news destroyed the market’s demand for Luna. Luna plummeted from $1.07 to close at 0.003559 - devaluing by about 300 times over the course of 24 hours. Ever-lowering Luna prices led to an ever-increasing amount of Luna that had to be minted to burn a single UST, feeding the death loop in an incredibly spectacular fashion.
As for UST? It started the day at 0.801 and closed the day at 0.40. We had now reached the point where Terra had completely lost the public’s confidence. UST holders no longer believed in a re-peg within a reasonable time frame and were itching to exit at any ‘reasonable’ price. On 12 May 2022, only about 2.6bn remained in Anchor. In just 6 days, almost 12bn dollars had left the protocol. This is a bank run on a scale which most banks would not survive. For reference, the Basel III capital adequacy ratio is 8%. From the price fluctuations of UST - clearly there was still some liquidity. There was a portion of the market that clearly believed that UST would re-peg in the middle-long term and was willing to purchase a ‘stablecoin’ at a discount in the hopes that the mechanism would work as planned or that a deal would be struck to achieve the re-peg.
Little did they know what would happen the next day.
On the 13 May 2022, Do Kwon released a Twitter thread which showed a sharp U-turn in his narrative. Though he had previously reiterated the importance of restoring confidence in UST, Do Kwon accepted that the UST experiment had failed and now supported an alternate proposal which no longer spoke of making UST holders in USD terms - instead it would allocate the pre-depeg holders 40% of the governance tokens in the new chain and post-depeg holders 10% of the governance tokens in the new chain. We will dive into the structure of this proposal (which forms the basis for the current prevailing proposal) later on.
This completely destroyed any demand for UST. On 12 May 2022, UST traders bought based on the promise of a re-pegged UST, one that would be ‘fully collateralized’ in Do Kwon’s own words. On 13 May 2022, UST was being offered simply tokens in a new chain - a fork of the very chain that had ‘defaulted’ on UST the first time. Worse - it was the pre-depeg holders that would receive the lion’s share (40% of supply). UST holders today would have a far smaller share (10% of supply), reducing the price at which people were willing to pay for what were effectively tokens in the new Terra ecosystem (Terra 2.0).
UST understandably nuked from 0.40 to 0.154. It is barely worth speaking of Luna at this point - it opened the day at 0.003549 and closed at 0.000102. Another 3000% decrease in a single day.
It also certainly didn’t help that the chain was halted on this day before being restarted a few hours later. For all intents and purposes, we could probably call 13 May 2022 the day Terra died.
Fast forwarding to the day on which this article is published, UST is trading at about 0.08 and Luna is trading at 0.0014. A few events have since transpired.
The LFG has published its reserves and it claims that substantially all of its reserves have been deployed.
Do Kwon and TFL have been looking to spearhead a revival of Terra via the launch of a Terra 2.0 which does not have a UST component at this time.
The community, including notable figures such as CZ from Binance and Vitalik Buterin have rallied around the proposal to make whole smaller holders of UST as much as possible (the Small Holders Plan).
We will now look into all of this in more detail.
The Luna Foundation Guard
Many questions have been raised about the actions of the Luna Foundation Guard. The fact that approximately 2.5bn in funds have been deployed to unsuccessful ‘defend the peg’ in a way that is far from transparent has attracted a lot of scrutiny. Let me lay out what we do know - based on what Do Kwon, TFL and the LFG has told us.
On 8 May 2022, the LFG’s reserves stood at about USD 3.05bn - we know this from their publicly disclosed document at: https://datastudio.google.com/u/0/reporting/b31cc9e5-c54c-4418-a6ce-b332c57e82e9/page/4YBqC?s=or-T7NeGLew
On 9 May 2022, the LFG Council voted to loan 750m of BTC to OTC market makers to protect the peg; and loan 750m UST to accumulate BTC when market conditions returned to normal. This was announced on the LFG Twitter account and retweeted by Do Kwon.
About 13 hours later on 9 May 2022, Do Kwon tweeted ‘Deploying more capital - steady lads’. The public did not hear further about any capital being deployed from Do Kwon, TFL or the LFG until the LFG post-mortem on 16 May (the LFG Report).
Now what did we learn from the LFG Report?
LFG deployed 52189 BTC between 8 - 9 May 2022 and sent this to a counterparty OTC. The counterparty returned a bit over 1.5bn UST and 5313 BTC to the LFG. Worth noting that this does not align with Do Kwon’s announcement - the LFG deployed a lot more BTC (1.5bn worth) than he said they voted to deploy (750m).
On 10 May 2022, TFL “on behalf of the Foundation”, sold 33,206 BTC for 1,164,018,521 UST in a last ditch effort to defend the peg.
No further non-Terra-ecosystem based reserves were deployed by the LFG - only a swap of UST to Luna in order to guard against a potential attack.
The key assets left in the LFG as of 16 May 2022 are about 10m worth of BTC and 60+mil worth of AVAX.
Now it is clear that there is a lot of controversy over the deployment of these reserve funds. The general view is that the LFG, TFL and Do Kwon were reckless at how they deployed the reserve, attempting to overwhelm the UST sellers early on to restore confidence in the peg.
In another world if this had worked, they would have been celebrated as heroes. Unfortunately, it is clear that LFG, TFL and Do Kwon miscalculated what size is (sorry - can’t resist!). After they burned through their two slugs of BTC within a 72 hour span, the only things backing UST apart from fairy dust and pixie dreams was the hope that they had not yet fired their shot.
One of the most interesting points to note from LFG’s disclosure is that TFL traded “on behalf of the Foundation” pursuant to a “Master Services Agreement dated January 10, 2022” (Master Services Agreement). It was in fact this statement that most piqued my curiosity. It means that TFL likely exercised an overriding right to perform the trades on 10 May 2022 without going through the usual LFG processes. It shows us that a legal relationship existed between TFL and LFG via the Master Services Agreement. I would be very keen to see what is in this agreement. Furthermore (and I am speculating here), one wonders whether the LFG specifically stating the fact that TFL took the wheel is indicative of the LFG board members distancing themselves from the decision to deploy 1.1bn of capital on 10 May 2022.
Now let me address some common questions about the LFG
Is the LFG legally obliged to defend the peg?
In classic lawyer-y speak, it depends. The LFG is a non-profit organization incorporated in Singapore - likely a company limited by guarantee. We do not know what their constitutional documents or charter say so we cannot confirm whether their purpose is actually to defend the peg.
Even if it is - this is unlikely to be an obligation directly owed to UST holders (and certainly not Luna holders) that can be enforced against the LFG.
It is worth flagging that retail should stop looking at the LFG as a fund designed to bail retail out. It is clear to me that LFG was set up in order to defend the cross-holdings of the institutional investors who had Luna and UST exposures. The LFG makes sense for these investors as long as their interests continue to align with retail.
Do UST holders have a debt claim against the LFG by nature of their holding UST?
The answer is probably not. I will cover this in more detail in the TFL section and the same analysis regarding the characterization of UST as debt applies.
Is LFG going to refund me? I held my UST in Mirrors, Anchor, Binance and FTX.
I don’t know. I don’t work for LFG, TFL or Do Kwon and have no insider info.
Is LFG going to refund me if I sold my UST?
I don’t know. I don’t work for LFG, TFL or Do Kwon and have no insider info.
Proposals: Do Kwon, TFL and the Small Holders Plan
This bit is going to be incredibly chunky because before we even start thinking about the proposals - we need to actually understand what UST and Luna is. It is clear that there is a lot of confusion around this which prevents meaningful conversations around managing this crisis.
UST and Luna - what are they, really?
As outlined above, UST is a token which is pegged to the value of $1 by way of an algorithm. If UST is above $1, an arbitrage opportunity arises where one can burn UST for $1 of Luna. If UST is below $1, an arbitrage opportunity arises where one can burn $1 of Luna for 1 UST.
It is easy to conceive of UST as debt and Luna as equity given the nature of each of these instruments. UST has a ‘fixed’ value of $1 with ‘coupon payments in Anchor’ and no upside whereas the supply of Luna is meant to decrease (and the price likely increase as a result) if the demand of UST increases and decrease if the amount of UST decreases (with the price likely increasing as a result). Luna is also a governance token that provides decision-making power, further supporting the parallels to equity.
But it is merely that - a parallel. Why?
UST is not issued by any entity but the Terra blockchain and it maintains this through the arbitrage mechanism. It is not a promise that UST will always be worth $1, it is more of a ‘promise’ that if the Terra ecosystem works, UST will be worth $1 by way of the arbitrage mechanism. It is not a token that says ‘the Terra ecosystem will unequivocally at all times give you 1 USD for 1 UST’. UST most importantly is not at this time considered debt issued by TFL or Do Kwon himself. Given TFL’s centralized role in the Terra blockchain, it would be interesting to see if any legal arguments materialize to impose Terra ‘debt’ onto TFL. I believe this answers many questions regarding a proposal that has characterized UST as a distressed debt claim.
I suspect I would have upset a lot of UST holders at this point - so let us move on to upsetting the Luna holders.
Luna holders have largely no case against the protocol, TFL and Do Kwon at all. I know it would upset anyone who holds Luna but the fact is, you are invested in an instrument that is designed to absorb volatility. Your investment prints multiples (and I am sure many benefited from this) when the demand for UST increases but you are also running the risk of your asset being devalued when the demand for UST decreases.
I have repeatedly made the point that within the Terra ecosystem, assuming that the Terra ecosystem is healthy, UST is the safe asset and Luna is the volatile asset. It would require incredible mental gymnastics (which can only be performed by persons holding incredible Luna bags) for anyone to claim otherwise.
The Proposals - drawing an important line
Before we actually go into the proposals - it is here that I must draw an important line. If we accept, as I outline above, that the ‘claims’ of UST and Luna are are against the Terra protocol, then it is incorrect to claim that Terra 2.0 should be responsible for the value lost by UST and Luna holders in the old chain (Old Terra).
UST and Terra holders need to face up to the unfortunate reality. If Terra 2.0 does not materialize and developers cease to support Old Terra, the residual claim of your UST and Luna is actually close to zero. Old Terra with no demand for Luna cannot possibly burn off all the outstanding UST and without burning off all the outstanding UST, Luna can never recover in price. It sucks but this is the reality. The ‘fundamental’ value of any UST or Luna now is literally (a) price of airdrop for Terra 2.0 plus (b) potential reimbursement from TFL/LFG plus (c) potential gains from suing TFL/LFG.
This is why when I discuss any of the proposals for Terra 2.0, the language I use is not one of rights and entitlement but equitability. Terra 2.0 is not entitled to give anything to bagholders from Old Terra at all (unless certain interesting and novel legal arguments succeed) but to the extent they choose to do so, is it equitable to split the pot in any certain manner?
The Proposals
Now that we have that out of the way - let us look at the proposals. The key focus is on the Do Kwon / TFL-supported proposals (we can discuss their behavior in more detail later) because these are the proposals most likely to pass. The Do Kwon / TFL-supported proposals tend to have the same frameworks. Let us call this the Do Kwon Framework.
The Do Kwon Framework
The Do Kwon Framework consists of splitting the stakeholders up into multiple classes. Broadly - these are:
the pre-depeg LUNA holders;
the pre-depeg UST holders;
the end-of-chain LUNA holders;
the end-of-chain UST holders; and
the developers (Builders) / community pool
Multiple proposals have been put out and revised but they follow broadly the same framework with only tweaks to the % allocation to each class. Initial proposals provided 40% each to the pre-depeg LUNA holders and 40% to the pre-depeg UST holders but later drafts have revised this with the pre-depeg UST allocation being reduced significantly and the pre-depeg LUNA holders decreased to 35%. We can broadly categorize these classes into two larger categories: (a) Builders and (b) community / users, both of which bring value to Terra 2.0.
For Terra 2.0 to succeed, it needs a talented and motivated group of Builders and a community of users. There is no value in Terra 2.0 without users and there is no value in Terra 2.0 without dApps. This is a balance that must be struck.
I mentioned above that Terra 2.0 technically has no obligation at all to provide any airdrops to bagholders from Old Terra. But they almost certainly must do so as a matter of practicality in order to win back the goodwill and trust of the community of users. The best way to do that is to recapture the stakeholder groups that had already been in Old Terra.
I reiterate that we must accept at this point that we are entirely at the whim of the Builders and it is absolutely up to them what sort of proposal or allocation they support. They will nonetheless make the decision which they think is best for capturing the goodwill of the community of users and we can only provide feedback. This decision does not have to be made based on fairness, it could well be that this decision is made practically. For example, it may be perceivably unfair that pre-depeg Luna holders have in most iterations of the Do Kwon Framework been given a very sizable allocation vis-à-vis other stakeholders despite investing in a high-risk asset but it may be that for practical reasons, perhaps these are considered more valuable to Terra 2.0.
I have suggested at multiple times that perhaps the most equitable solution would be for the Builders to fork the chain, reserve the % allocation they are happy with for themselves / the community pool and let the other stakeholders negotiate amongst themselves instead of choosing winners and losers so that people walk away without feeling like they had a ‘deal’ forced upon them by TFL / Do Kwon / the Builders. I maintain that this is a viable solution for maximizing goodwill but you see here that I am very close to falling into the trap of thinking that the allocation is compensatory in nature.
In any case - let me in this article consider the equity and practicality of the distributions as between the various parties.
Pre-depeg Luna v. Post-depeg Luna
This is an easy one to address from both an equity and practicality perspective. Luna holders, to the extent that Terra 2.0 wants to allocate them an airdrop, must draw a distinction between pre-depeg and post-depeg Luna.
Let me address the counter-argument here; which has been repeated ad infinitum by anyone who has bought post-depeg Luna.
“Why should someone who bought Luna before the de-peg be given a larger allocation than me when we bought the same asset? They knew that the protocol would death spiral into hyperinflation and took that risk!”
I have obviously made the question above far more intelligent than the majority the persons posing the question.
The answer goes back to the point that this isn’t about compensation. If Old Terra were to continue on and some sort of bailout sum were allocated to Old Terra Luna holders within the Old Terra ecosystem or if the Old Terra ecosystem were to generate value - I absolutely agree that the Luna holders should be treated the same, regardless of when they bought in.
However we aren’t talking about compensation here. We are talking about equity, about fairness in allocation to participants within the Terra ecosystem. And when we are talking about fairness, it would be unfair for pre-peg Luna holders to receive close to nothing while Luna buyers who entered when Old Terra was in its death knolls attracted the lion’s share.
In the practical sense, when we think of the airdrop as a method of generating goodwill, then the motivations of recipients absolutely matter. Now believe me when I say I do not believe pre-peg Luna holders to be saints (based on personal experience, this class perhaps has the largest percentage of obnoxious individuals) but it is probably fair to say that pre-peg Luna holders are as a class probably more likely to engage in Terra 2.0 meaningfully as opposed to post-peg Luna holders who were clearly a bit more speculative. It would be silly from a practical perspective to prioritize the latter over the former.
Cynically, we can also speculate that perhaps prioritizing pre-peg Luna holders is a matter of insider pressure. There is obviously no source for this but one might reason that TFL investors, employees, validators, Builders and other key players with influence over Terra 2.0 probably were massive pre-peg Luna holders. These persons would also have interacted more with and heard the stories of pre-peg Luna holders (given pre-peg Luna holders were likely the most energetic crowd since they were the ones making astronomical returns) resulting in the decision-makers value them more as Terra 2.0 participants.
Pre-depeg UST v. End-of-chain UST
This is where I have difficulty figuring out the equitable and practical justifications behind separating the two classes. It is my view that it is in every party (including the Builders and Luna holders)’s interest that pre-depeg UST should not be in a separate class as post-depeg UST.
From an equity perspective, it forces us to deal with the moral quandary that UST holders who dumped and exited immediately at the first sign of a de-peg (thus exacerbating the bank run) actually become net winners because they exited at say 0.98 and benefitted from an airdrop whereas those who held fast throughout believing in a re-peg (the ones who didn’t contribute to the Old Terra collapse) lose out in comparison. This certainly does not feel equitable.
But sir - why can’t we do something where we ‘reward’ the people who didn’t sell and penalize those that did?
My answer to that from an equity perspective is because choosing to hold or sell is a choice which UST holders were faced with. Your choosing to hold should not result in your receiving an unknown windfall at the expense of those who chose to sell and vice versa. I will admit though - there is actually an incredible practical argument for weighting airdrops in favor of those that didn’t sell (which we will cover later).
Now let us look at the practical considerations.
If Terra 2.0’s intent with the airdrops is to reach the community members with the most conviction, surely it must be the UST holders who held fast even though they were watching their UST savings get wiped out? This is perhaps the practical justification for favoring the pre-depeg UST holders who held all the way down to sub 0.10. Aren’t these the guys you would want in Terra 2.0?
In any case, I support not distinguishing between pre-depeg UST holders and end-of-chain UST holders because of the practical benefits.
Before I explain why, it is important to note that any UST holder now essentially has a token which is a proxy for tokens in Terra 2.0. If 10% of the Terra 2.0 allocation goes to UST holders now, US Terra will likely trade on the open market at half the price of what it would trade at if Terra 2.0 allocation is at 20%, and 1/3 of what it would trade at if the allocation to UST holders is 30%.
This provides UST holders with choice, whether they bought in pre-depeg or post-depeg. They can either choose to stay with Terra 2.0 or exit into USD on the open market at a far better price than if there were a percentage of allocations locked into pre-depeg UST holders.
This also allows Terra 2.0 to be efficient with its allocations. By not distinguishing between class and therefore not locking in a class of holders that fundamentally intended to hold a stablecoin into a speculative governance token, it ensures that anyone who actually enters into Terra 2.0 via the airdrop to UST token holders made the cost-benefit analysis between selling UST on the open market or holding UST for the airdrop and weighted it in favor of participating in the new Terra 2.0 ecosystem as opposed to exiting UST at the offered price point.
This also solves the moral quandary. If pre-depeg UST holders sold as UST spiraled down, they made a conscious decision based on their own risk profile to get rid of the distressed asset at the price they sold at. If someone bought UST on the way down believing that it would re-peg, they likewise made a conscious decision based on their own risk profile. It seems inequitable to choose winners and losers based on their respective risk profiles and price points.
For anyone asking why the same analysis does not apply to pre-depeg Luna holders and post-depeg Luna holders - the answer is because there was no hyperinflationary mechanism to account for.
To round this off - a cynical and practical take on distinguishing between pre-depeg UST holders and end-of-chain UST holders. Who were the lucky ones that would benefit off having exited their UST at close to par value while Do Kwon publicly attempted to allay fears of a bank run? The insiders, investors or whales. Perhaps even the counterparties and market makers LFG deployed their reserves to!
Again - I am not hating on any of these insiders or key investors that would disproportionately benefit. If their involvement is what it takes to make the pie bigger for everybody, then it is something that retail will have to accept.
Pre-depeg Luna v. Pre-depeg UST
And finally - we deal with two groups whose interests were perhaps fundamentally built to be opposing within the Terra blockchain and it was this relationship that made Old Terra one of the largest blockchains by market-cap - the pre-depeg Luna holders and the pre-depeg UST holders. Perhaps one could even think of it broadly as the Luna holders and UST holders generally, for this held true until it was publicly announced that the seigniorage mechanism would be halted.
It is perhaps here where we see Do Kwon and the Builders, the key architects of the Do Kwon Framework, seemingly overwhelmingly favor Luna holders for practical reasons despite it being equitably unsound to do so. Let me explain why.
We should bear in mind, and I am typing this almost for myself as much as for the reader, that the new chain is not about compensation. This article seeks to consider, as far as there is an airdrop to affected stakeholders, what an equitable split between affected stakeholders might look like.
The reason I have reminded readers (and myself) of the above is that because of my trad-fi background and the easy-to-make mistake of thinking of UST and Luna as debt and equity instruments (based on Do Kwon’s tweets - he does the same!), conventional wisdom is that equity should receive nothing until debt is paid out in full. But since we are not in that trad-fi world and we are not considering strict legal rights, we have to accept that it is equitable to allocate at least some value to Luna holders.
It is the quantum of value allocated to the pre-depeg Luna class in particular which has made me uneasy when considering equitability of distribution. Pre-depeg Luna, on every iteration, takes home the lion’s share of the airdrop vis-à-vis the pre-depeg UST holders (or UST holders generally) except in Do Kwon’s very first iteration of it (which has them taking home an equal 50-50 share) and it appears that on every further iteration of the draft, whenever there has been a need to reallocate value to the other stakeholder classes, the ‘losers’ has been whoever held UST.
The reason this is difficult to justify? It is inequitable to greatly favor one class of participant in Old Terra (especially pre-depeg) over another class of participant especially when that favored class of participant has actually signed up to the instrument in Old Terra which is meant to absorb the losses of the other class. Luna was by design meant to trend towards zero while UST trended towards 1 due to market forces for as long as UST remains under 1. To then provide a large airdrop to those who knowingly took the risk and a smaller airdrop to those who chose to forego the upside in exchange for insulation against the downside seems like a misalignment of incentives.
It is at this point where I must address this rather ludicrous narrative which I have commented on several times. Shockingly, it has been repeated (in generally less crass forms) by persons who seem to be builders and key community members. It goes like this.
Luna holders are the true believers of Terra. UST holders are just VCs and opportunistic money coming in to make the 19% Anchor yield. We need the true believers in Terra 2.0.
(Before I am accused of creating strawman arguments, I would beseech the reader to please consider that the way I have framed the comment above is far more concise and reasonable than pretty much all versions of this argument.)
Though often wrapped in some sort of false morality, it actually sounds more like a bit of a practical argument too. My view is that we can break this argument down into two statements:
Pre-peg Luna holders morally deserve more because they were true believers in Old Terra
Pre-peg Luna holders as a demographic are more likely to participate meaningfully in Terra 2.0 and therefore should be given more to incentivize such participation to maximize the value of Terra 2.0
I would say the first statement merits no response but I have learned that one must spell out the fallacies in a statement for there to even be an almost infinitesimally small chance for an entrenched participant to consider changing his or her mind. So let us pick apart the true believer narrative.
We go back to thinking about what roles UST and Luna play in the ecosystem. Perhaps most readers are tired of it by now but let me present it from another angle at this point.
Luna: increases in value as long as there is demand for UST and Old Terra is healthy
UST maintains a value of 1 USD as long as Old Terra is healthy
Both stakeholder groups inherently must believe that the Old Terra ecosystem is healthy or they would not commit funds into it. To draw a parallel, if Andy puts money into a savings account in the United States and Bob puts money into the S&P 500, it cannot be said that Bob believes in the United States economy but Andy does not, and vice versa!
The difference here is that Andy believed in the stability of the United States economy whereas Bob believed in the growth of it. Both inherently require belief in the United States economy continuing to function. The same applies for UST holders and Luna holders in respect of Old Terra.
In fact, as I have stated in a tweet, one would expect a reasonable ‘citizen’ of Terra to have monies in both UST and Luna. In the Old Terra economy, UST functions as a savings account and Luna functions as a bet on the growth of the ecosystem and economy. A sensible citizen of the Old Terra economy with reasonable risk management would very likely have his net worth tied up in both.
I would thus heavily caution against thinking that only high risk appetite participants are ‘believers’ in Old Terra, particularly when the product Old Terra actually purported to provide is not growth but stability. Luna holders believed in the appeal of a stablecoin and invested in its potential for fueling growth and UST holders believed in the stablecoin itself. Terra 2.0 will not succeed without confidence in both growth and stability.
Now moving on to the practical point.
The practical justification for allocating pre-depeg Luna holders more than pre-depeg UST holders is based on the assumption that pre-depeg Luna holders as a demographic are more valuable to the success of Terra 2.0. It is unknown if this assumption is accurate. It is certainly fair to say that Luna holders would be more excitable than UST holders - after all what is there for UST holders to be excited about? Luna holders on the other hand were up probably 1000% (if not more) on their initial investments and would certainly be louder as a group. UST holders have no reason to be loud given the fact their upside on the instrument itself is capped. Is the ‘lunacy of the Lunatics’ worth enough to Terra 2.0 to heavily weight the airdrop in their favor? I do not know the answer to this question but my instinct (which I do not claim to be able to back up with data) is that a more equal distribution would result in more goodwill accruing to Terra 2.0.
As always - we have to cover the cynical point which I am sure any reader up to this point can make a guess at. Significant Luna holders were likely insiders, investors and Builder groups. After all, it would be sensible if one were building on Old Terra, an insider or someone with a voice in the direction of Old Terra to have held the proxy equity instead of the proxy debt where there is no upside (beyond Anchor) since this is how you harvest the fruits of your labor. Combine that with the fact that Luna retail holders were likely to be the loudest and closest to these Builders, insiders and key persons and it would not be a stretch to say that the brains behind the Do Kwon Framework-based proposals were perhaps more exposed economically and socially to Luna. My response to this remains the same - if this is what is necessary to make the pie bigger for everyone, then so be it.
I have unfortunately fallen ill and will end Part 1 here. In Part 2 (hopefully there isn’t a Part 3 or 4), I will look at the Small Holders Proposal and address other proposals which involve forks etc. I will also speculate on the potential claims that might arise against Do Kwon, TFL and LFG.
It is my hope that sharing the thinking around value allocation between stakeholders will allow people to understand the different perspectives even if they do not agree with them. Twitter (or even Discord) as a medium for discussion is terrible when there are deep issues to be considered and I would encourage anyone, particularly those active in the decision-making process for Terra 2.0 to take a step back and consider all arguments (even those they do not agree with). This is why I have decided to publish this article in its unfinished form at a time when modifications are still being made.
It is probably helpful to have a disclaimer here. I am writing this article completely free of charge and have not received any value from any person to represent any views whatsoever. In fact I have not received any value from any person at all (just in case people think the previous disclaimer is being too specific!) All views published are absolutely my own and do not represent legal or financial advice. I have no inside information whatsoever. I am writing this article on my own time in my personal capacity out of academic interest in what looks like the highest profile protocol insolvency (fueled by Asperger’s and obsessive compulsive personality disorder) and these views are not a professional opinion from me, my employer or any other groups or institutions.