Galaxy Digital — an investment management firm — alongside other “all-star roster” of venture capital (VC) firms such as Pantera Capital, Arrington Capital, and Lightspeed Ventures, to name a few, had backed Terraform Labs (TFL) to the tune of US$ 150 million back in July 2021.
Novogratz had such a strong belief in the project that he had a LUNA tattoo done some weeks before the implosion. The billionaire now says the tattoo is a constant reminder that VCs should undertake thorough due diligence before investing in a crypto-based project. As the crypto community continues to lament over the Terra fiasco — and understandably so — here are three important lessons that we can learn from it:
Algorithmic Stablecoins Are Inherently Fragile
Unlike other typical cryptocurrencies like Bitcoin (BTC) or Ether (ETH) that have high volatility rates, stablecoins are pegged to more sturdy assets such as the U.S. dollar, gold, or commodities. They are designed to allow users to derive the benefits of paying with cryptocurrencies without the typical wild price swings that are associated with volatile virtual currencies.
The problem arises when the price drastically deviates from the peg. Under such circumstances, investors panic and there is essentially a run on the bank which sets the coin’s price on a downward spiral. This is what happened with Terra USD (UST). Unlike other stablecoins such as USD Coin (USDC) or Tether (USDT) that are pegged to cash and less risky assets, UST relied on a fragile algorithm and LUNA — a sister cryptocurrency — to maintain its price.
For every UST that the network minted, an equivalent of US$ 1 worth of LUNA was burned and vice versa. Whenever the UST price fell below US$ 1, users could burn it, essentially decreasing UST supply and theoretically pushing up the price to equilibrium. And whenever UST price surged past US$ 1, users could take advantage of it and mint more UST while burning LUNA. This would increase the UST supply and pull the price back to US$ 1.
An architectural design that UST/LUNA leveraged can only work when the cryptocurrency market is mostly up and investor confidence is high. In a bear market, this model cannot work. Once the stablecoin loses its peg to the US dollar, it sets in a vicious cycle with traders rushing to redeem their stablecoin for cash. This results in an increased supply of the stablecoin leading to a drop in price. This is what happened to UST which lost nearly 100% of its value in about 24 hours.
The problems that plagued UST are unique to algorithmic stablecoins, which differ from fiat-backed stablecoins such as USDC and USDT that have mostly worked so far. These coins are pegged to non-crypto assets which equate to the value of all the outstanding tokens. In the case of USDC, Grant Thornton — an accounting firm — reviews the USDC’s holdings every month to ensure that the peg is held while USDT’s reserves are reviewed by independent accountants.
Proof of Stake Has Weak Decentralization and Security Assumptions
The Terra network was essentially a proof-of-stake (PoS) blockchain that ran atop the Cosmos ecosystem and utilized Tendermint Byzantine fault tolerance (BFT) for consensus. In a PoS-based network, consensus occurs in a two-round process where one validator proposes a block while other validators vote on it.
If the block receives a supermajority of votes, it is committed to the ledger and the validators are incentivized for their efforts with the validator that proposed the block earning more. However, to become a validator, you must stake more tokens in the network, and the more coins you lock in the system, the greater the chances of being chosen to propose and confirm blocks.
In the case of Terra, the consensus method used is called delegated proof-of-stake (DPoS) where a few validators’ large concentration of staked LUNA tokens raises serious issues about decentralization and security. If a malicious actor were to enforce its rules over the network, it would only need to coerce a few validators.
Perhaps, this was one of Terra’s biggest architectural flaws, as Terraform Labs — the organization that created the network — held more than 50% of staked LUNA, with its founder holding a significant amount. Before the implosion, the network allowed only 130 validators — stakeholders with the most significant staked LUNA — to participate in the consensus process.
Under such an environment, a “51%” attack would be easy to launch since it only requires two-thirds of the staked LUNA. And if more than one-third of validators misbehave, it causes instability problems on the network. While DPoS is scalable, it has high barriers to entry which inhibits decentralization.
It is due to the inherent weaknesses with DPoS that pundits have been wondering whether Do Kwon — CEO and founder of Terra — had been forthright about his involvement in the fiasco. For example, were the DPoS validators the same ones that controlled the Bitcoin collateral? What happened to the US$ 3.5 billion in BTC that the company bought to steady the ship?
It has also emerged that Do Kwon closed Terraform Labs and liquidated two South Korean offices just a few days before the collapse of the network, further raising transparency issues about the network’s governance model.
Hub and Spoke Model Is the Best Blockchain Interoperation Strategy
The knock-on effect of the downfall of the Terra network was felt across the entire blockchain space because most protocols had integrated the protocol into their ecosystems. At the time, the projects that took the greatest hit were those hosted on the Blockchain, including Anchor Protocol (ANC), Mars Protocol (MARS), and Astroport (ASTRO).
All these protocols were decentralized finance (DeFi)-focused. As such, they had integrated heavily with UST as the primary stablecoin and LUNA as the major source of total value locked (TVL) on their smart contracts.
Being a Cosmos-based network, virtually all the assets in the entire Cosmos ecosystem were also hard hit by the collapse of UST. For example, Cosmos (ATOM), Osmosis (OSMO), and Kava (KAVA) rely on the inter-blockchain communication (IBC) protocol, and Tendermint BFT were affected due to their integration with Terra.
However, because of the Cosmos’s hub and spoke model, the cumulative effect of Terra’s collapse was not as dire as it could have been with point-to-point connections. In a hub and spoke model, message transfer and inter-blockchain communication occur via a hub. The hub allows the network to be cognizant of every transaction since it translates virtually everything into a canonical language. In case a particular blockchain fails, it can quickly be unplugged from the interoperable network.
What Analog Envisions for Web3 Ecosystem
The downfall of Terra is an epiphany moment in every sense of the word. While we empathize with investors that lost their investments, it also serves as a reminder that blockchains — and any other technology out there — that are not built on sound principles are bound to break at some time.
It is now time to pick up valuable life lessons from the Terra fiasco and build solid foundations for blockchain ecosystems. After all, learning is a continuous process and what does not kill you only makes you stronger! At Analog, we believe that blockchain provides a tremendous promise to unlocking opportunities in a digital era.
However, despite the promise, there are still significant challenges that we have to tackle such as a lack of interoperability framework, weak consensus protocols, and absence of privacy-preserving mechanisms. It is these challenges that have made the sector vulnerable to issues that have befallen the Terra network.
That is why we have a strong research and development (RD) team that undertakes research activities on omnichain interoperability to help developers build a solid network, one that delivers cross-chain capabilities. The network we are building at Analog leverages a proof-of-time (PoT) consensus protocol — built from the ground up — to allow decentralized applications (dApps) to communicate seamlessly through validated event data.
By allowing current and new dApps to communicate frictionlessly across heterogenous blockchains, Analog unlocks a range of real-world use cases in decentralized finance (DeFi) and the metaverse. Click here to learn more about Analog and let us know your thoughts.
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