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Analysis
31 May 2022

How Terra created the perfect exit liquidity

If the Terra Ecosystem was a sinking cruise ship, the captain and distinguished guests fled in superyachts, leaving most passengers behind without lifeboats.
Dumping on retail
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In a standard 'pump-and-dump' scheme, the ‘dumpers’ hype up demand before aggressively selling their bags into the built-up demand. During the dump, often called a rug pull, usual supply-demand dynamics apply. Eventually, the supply offered by the dumpers seeking to squeeze out every penny dominates demand, and the price crashes – pump-and-dump completed.The nature of the pump-and-dump scheme is such that profits are created while killing the token in the rug pull. The success of the pump-and-dump is determined by how much exit liquidity you are able to make.Whether intentional or not, the Terra dollar (UST) worked as the perfect exit liquidity in what can be described as a prolonged pump and dump scheme. A combination of LUNA supply control, the psychology of the dollar, and guaranteeing high yields secured with their own pre-mined tokens created sustained exit liquidity.The Terra protocol featured no built-in inflation mechanism to spread the wealth and no meaningful airdrops of LUNA. By definition, the early holders must profit by one of two mechanisms:
  1. If others were to enter the ecosystem, the early holders must profit by selling tokens to new entrants.
  2. Or if they simply hold, they will have theoretical paper value when the tokens appreciate in value.
No block reward and a highly concentrated LUNA supply gave all power to the early holders
The early distribution of the later valuable tokens was very concentrated, as witnessed by the early distribution of LUNA tokens.Distribution of Luna tokens on October 3rd, 2020.
Luna Distribution
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Exchanges are excluded. Source: Arcane Research. Blockchain data from FlipsideCrypto.
Thinking of how popular the Terra tokens became, a lot of profit must have been taken by the early holders virtually by definition. But as witnessed by the spectacular crash, real value was first gained when converting to other cryptocurrencies outside the Terra ecosystem. And the possibilities for transporting value out of the Terra Ecosystem were either through exchanges or the few existing bridges.
Terra blockchain data shows that wallets connected to Terraform Labs and the large early LUNA holders have made tremendous profits
I have analyzed the value flows in the Terra Ecosystem with a particular emphasis on the use of the exit gates via bridges or centralized exchanges. To avoid obscuring the picture, I have only accounted for transactions up to May 5th, some days before the downfall.The analysis reveals that sets of John Doe wallets interacting closely in clusters have massive net outflows from the Terra ecosystem to bridges and centralized exchanges. The common denominator among the clusters is that one or more wallets in the cluster received significant transfers from Terraform Labs wallets or the largest John Doe wallets as of October 3rd, 2020 (referred to as early John Doe wallets hereon).The set of John Doe wallets in the clusters obviously put great trust in one another, sending straight-up transactions of millions of dollars frequently between themselves. In total, there are close to 3,000 wallets in the clusters. And many of the clusters have received funding from more than one of the Terraform Labs wallets and the early John Doe wallets.
Net outflows of $6 billion
From October 2020 to May 5th, 2022, the clusters have net outflows of $6 billion to exchanges and through bridges (flow value calculated by using market prices at the time of transfer). In contrast, all the other hundreds of thousands of wallets have a net inflow of $6.5 billion.Net flows in the Terra ecosystem, evaluated at market prices at the time of transfers.
Net flows all
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Source: Arcane Research. Blockchain data from FlipsideCrypto.
The net outflows/inflows are evaluated at market prices at the time of transfer. This muddies the picture somewhat. The clusters deposited large amounts of LUNA tokens to exchanges when prices were still ‘low.’ Outflows of LUNA are therefore undervalued relative to inflows of LUNA. The following figure illustrates the point. Early John Doe wallets have a net outflow of 53 million LUNA to exchanges valued at $700 million at the time of transfer. Later, 13 million LUNA valued at $3 billion were likely returned to wallets in the clusters and used to mint UST. The net outflow of LUNA calculates to 40 million, but the dollar value evaluated at the time of the transfers gives a net inflow of $2.3 billion. Therefore, we have reason to believe that the potential for creating outside profits was larger than the $6 billion net flow that's calculated based on the assumption that portions of the early deposits of LUNAto exchanges were not sold.Net flows to/from exchanges.
Net flows exchanges
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Source: Arcane Research. Blockchain data from FlipsideCrypto
UST created the perfect exit liquidity
Showing that a select group of founders and early investors likely have become enormously rich might be kicking in open doors. But how this was enabled through the burn/mint mechanisms is worth dwelling somewhat on. And whether intentional or not, it was the perfect way to create sustained exit liquidity for their initial endowment of LUNA tokens.The burn/mint mechanism in the Terra ecosystem was simple. With certain limitations, you could at any time convert 1 dollar’s worth of LUNA to 1 UST by burning the LUNA, and vice versa. In theory, if I owned all LUNA tokens, I could drive up prices on the exchanges by buying my own tokens, then mint a great amount of UST while at the same time reducing the LUNA supply through the burn/mint mechanism.The meteoric price rise of the LUNA token in the fall of 2021 enabled the large LUNA holders to convert LUNA into great amounts of UST. Simultaneously, the Anchor protocol, guaranteeing a 20% yield on UST with reserve backing provided by, among others, Terraform Labs, created significant demand for the UST. In this way, large LUNA holders could cash out their LUNA by minting UST and selling into the Anchor induced demand for UST on exchanges. And the greatest part, LUNA profits could be realized without creating sell pressure on the LUNA token.By pumping the LUNA token, the burn/mint mechanism, and creating a sustained demand for the UST token through Anchor, the perfect exit liquidity for large LUNA bags was created. And the UST exit gates were used at scale for a set of very early LUNA holders. At best, the profits can be described as collateral winnings in a failed bootstrapping attempt.
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