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The rise and fall of Terra/Luna

By Mueller-Frank, Manuel / Anders, Romina / Vilaplana, Roser
Economics Finance

This case study examines the rapid rise and collapse of the Terra/Luna ecosystem, one of the most significant failures in cryptocurrency history. Founded by Do Kwon in 2018, Terraform Labs created the algorithmic stablecoin TerraUSD (UST) and its companion token Luna. Despite early success, Terra’s model—relying on minting and burning to stabilize UST’s peg to the U.S. dollar—collapsed in May 2022, wiping out billions of dollars in market value. The case explores the mechanics of the Terra ecosystem, the role of the Anchor protocol offering high yields on UST deposits, and the failure of the Luna Foundation Guard’s reserves to stabilize UST during the crisis.

The collapse highlighted the risks of algorithmic stable coins and the unsustainable nature of Terra's dual-token model. Key figures, especially Do Kwon, contributed to the downfall through overconfidence and ignoring warnings. This case serves as a cautionary tale about the fragility of decentralized finance (DeFi) systems, raising questions about governance, developer responsibility, and the need for regulatory oversight in the cryptocurrency space.

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Collection: IESE (España)
Ref: ECON-434-E
Format: PDF
Number of pages: 29
Publication Date: Mar 21, 2025
Language: English

Description

This case study examines the rapid rise and collapse of the Terra/Luna ecosystem, one of the most significant failures in cryptocurrency history. Founded by Do Kwon in 2018, Terraform Labs created the algorithmic stablecoin TerraUSD (UST) and its companion token Luna. Despite early success, Terra’s model—relying on minting and burning to stabilize UST’s peg to the U.S. dollar—collapsed in May 2022, wiping out billions of dollars in market value. The case explores the mechanics of the Terra ecosystem, the role of the Anchor protocol offering high yields on UST deposits, and the failure of the Luna Foundation Guard’s reserves to stabilize UST during the crisis.

The collapse highlighted the risks of algorithmic stable coins and the unsustainable nature of Terra's dual-token model. Key figures, especially Do Kwon, contributed to the downfall through overconfidence and ignoring warnings. This case serves as a cautionary tale about the fragility of decentralized finance (DeFi) systems, raising questions about governance, developer responsibility, and the need for regulatory oversight in the cryptocurrency space.

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Year: 2022
Geographic Setting: United States
Industry Setting: Financial

Learning Objective

The teaching purpose of this case is to provide students with a deep understanding of the role and risks associated with stablecoins in the cryptocurrency ecosystem. Through the Terra/Luna collapse, students will learn key concepts related to the structure and functionality of stablecoins, particularly the differences between algorithmic and collateralized stablecoins, which are central to understanding Terra’s failure. The case discussion has five main segments.

  1. Role of Stablecoins in Crypto: The case will highlight the main function of stablecoins in the world of blockchain and cryptocurrencies.

  2. Difference Between Algorithmic and Collateralized Stablecoins: A core part of the discussion will be the difference between algorithmic stablecoins, like UST, which rely on a self-regulating system of minting and burning tokens, and collateralized stablecoins, such as Tether, which are backed by assets like fiat currency or high-quality liquid assets. This comparison will help students grasp the technical and financial distinctions, including the risks and rewards associated with each model.

  3. Design of the Mint/Burn Algorithm and its Fatal Flaw: Students will explore the mint/burn mechanism that was central to Terra’s design. This algorithm aimed to maintain the peg of UST by increasing or decreasing the supply of UST and Luna based on market conditions. However, the case will show the fatal flaw of this system. This will provide a valuable lesson in the limitations of algorithmic stablecoin models.

  4. Factors Contributing to Early Success: The case will examine factors that led to Terra’s early success, including its own high-throughput blockchain, which allowed for fast and low-cost transactions, making it appealing for e-commerce and attractive for developers.

  5. Timing of the Unravelling and Ultimate Failure: Finally, the case will address the timing of the unraveling.

By studying these aspects, students will gain a comprehensive understanding of the complexities of stablecoins, their potential for success, and the critical design and operational flaws that can lead to catastrophic failure.

The rise and fall of Terra/Luna

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€8.53

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"The rise and fall of Terra/Luna"