The rise and fall of the Terra ecosystem, Delphi Digital's "Terra Gamble" reflection

Original Title: 《Learnings From Last Week》

Written by: Delphi

Compiled by: Yang Shu, ForesightNews

Last week, Terra's UST fell victim to the death spiral of algorithmic stablecoins, with the market capitalization of UST and LUNA evaporating by nearly $40 billion. It remains unclear whether this was a coordinated attack by large participants or a typical bank run, but either way, it is arguably the most catastrophic event in the cryptocurrency industry since Mt. Gox.

At Delphi, our core mission has always been to make cryptocurrency happen better and faster, which is why last week's events had such a frustrating impact on all of us. Ironically, what we believed in led to the opposite outcome, tearing apart the perception of who we are and what we represent.

We have always known that such things were possible and have tried to emphasize such systemic risks in our research and public commentary, but the fact is we miscalculated the true likelihood and risk of a "death spiral" event. We have made some efforts in the past week to address this, which we should do, and criticism is fair; we accept it.

In this article, we will transparently disclose the involvement of various departments at Delphi in the Terra ecosystem, explain what our positions are, where we believe the positions went wrong, and what lessons we have learned.

Delphi's Involvement with Terra

Before we begin, it is important to provide some background information about Delphi and our organizational structure.

"Delphi Digital" is a cooperative association composed of independently owned and operated entities that share the "Delphi" brand and certain shareholders, resources, personnel, and values.

The "Delphi Ventures," "Delphi Research," and "Delphi Labs" entities collaborate under the "Delphi Digital" brand, and understanding this distinction is crucial, as each department's level of involvement in the Terra ecosystem is very different.

Below, we will outline each entity's involvement in the Terra ecosystem.

Delphi Ventures

Delphi Ventures Master Fund purchased a small amount of LUNA tokens (approximately 0.5% of our net asset value) in the secondary market in Q1 2021, and we only increased our exposure after the initial purchase, currently sitting on unrealized significant losses.

Even at LUNA's highest price this year, LUNA and other Terra assets account for only about 13% of Delphi Ventures' net asset value.

Based on the number of trades, less than 5% of Ventures' total trades are related to companies or protocols within the Terra ecosystem, which includes Delphi Ventures' participation in the recent LFG funding (February 2022) — a $10 million investment that has been completely lost based on the current LUNA price, and Delphi Ventures did not sell any LUNA during this event.

Delphi Research

First, a disclaimer: the core goal of the reports published by Delphi Research is to help open-source our team's learning outcomes, allowing people to gain insights into how these protocols work and the roles they play in cryptocurrency, as stated at the top of each article, these reports are for reference only.

Delphi Research first reported on Terra in February 2021, and since then, we have published six reports focused on Terra, which is just a small part of our research outcomes during the relevant time period.

In April 2022 alone, Delphi published 30 posts (excluding our free daily newsletter, which includes a section at the top of each report disclosing Ventures' positions and Delphi Labs' involvement in the Terra ecosystem).

Additionally, many reports have sections focusing on potential UST decoupling risks, and we will not delete or edit any of our Terra reports but will make them publicly available so that anyone can go back and read our analysis and make their own judgments. We share the links below in the order they were published:

Reports focusing on Terra or its ecosystem in 2021:

• Mirror vs Synthetix? How About Terra (02/03/2021)
• Stablecoin Growth Propels LUNA Forward (03/04/2021)
• Anchoring The Market to a New Reference Rate (3/16/2021)
• Anchor Runs A Surplus After Adding bETH (08/24/2021)
• Mapping The Moon: An Overview of Terra's Ecosystem (12/22/2021)

Reports focusing on Terra or its ecosystem in 2022:

• Valuing Layer 1s -- Memes, Money, or More? (04/26/2022)

It is important to note that Delphi Research has not and will never accept payment for publishing research reports; from a financial perspective, the research entity's balance sheet is unaffected by this event, except for the approximately $20,000 UST payment we received through Suberra, we have not sold any UST.

Delphi Labs

Unsurprisingly, our software development company, Delphi Labs, has the most exposure to Terra, and we are also building products on the Terra ecosystem through Delphi Labs because we believe that if decentralized currency is integrated on Layer 1, focusing on real-world adoption and built on relatively scalable and interoperable blockchains, then Terra is most likely to succeed.

When we first began researching the Terra ecosystem (Q1 2021), it was rapidly evolving and seemed to occupy a unique position within the Cosmos ecosystem, but it lacked key foundational primitives, and the number of builders attracted was far fewer than emerging competitors like Solana, at that time the UST supply was below $1 billion.

Delphi Labs spent over a year of R&D contributing to the joint ventures of building Astroport (Foresight News note: Terra ecosystem AMM protocol) and Mars Protocol (Foresight News note: Terra ecosystem lending protocol), Delphi Labs has never sold any of the tokens it holds nor made money through token sales.

The primary funding for Delphi Labs comes from internal funds provided by individual shareholders of Delphi Labs, aside from an unconditional grant of 30,000 LUNA (approximately $250,000 at the time) and 466,666 UST provided by TFL for work on Mars Protocol.

We are very proud of the quality of the protocols that the Delphi Labs team has helped build and how the team has handled itself throughout. Over the past year, the Labs team has contributed to many innovations in the field, including:

• Lockdrop & LBA: An innovative token launch mechanism that has since been adopted by many protocols across multiple chains;
• C2C lending: Creating a transparent, quantifiable risk framework around smart contract to smart contract lending, resulting in the first third-party protocol utilizing Mars credit lines;
• Open-source branding: Both Astroport and Mars brands are open-sourced under knowledge-sharing licenses, allowing anyone to use, edit, or fork the brands;
• Transparency: Astroport and Mars adopted an extremely transparent approach, with the initial builders' token allocations publicly disclosed, including amounts, terms, and voting rights. All legal documents (including token grant agreements and multi-signature agreements) are open-sourced on the respective project's GitHub. This includes unique clauses regarding the obligations to participate in the DAO and independent voting, resulting in numerous disclaimers and disclosures outlining all potential risks faced by users, including the risk of UST decoupling;
• Many other open-source research contributions, such as Dynamic Interest Rate Model Based on Control Theory, Attack Cost and Profit from Manipulating Constant Product Market Maker TWAP Oracles in DeFi Protocols, Framework for Setting AMP Parameters on Stable Swap Pools, etc.;

Overall, we are proud of how these protocols performed under extreme conditions. For example, the Astroport smart contract system and the front end operated by Delphi Labs endured incredible loads, and as the trading volume of Terraswap (another AMM on Terra) declined, it became the only way for people to exit their positions on Terra.

As for the future, after placing a big bet on Terra and failing, we want to ensure that we learn lessons and make the right choices moving forward. We have formed a cross-departmental team composed of some of the smartest minds from Delphi Research and Delphi Labs, and we will take the time to ensure we evaluate all possible options and make the right long-term decisions.

We will publicly document this to share our journey and experiences with the community, and in the same spirit, we also want to take some time to publish some retrospective analyses, in which we review our historical involvement with Terra, our positions, and thought processes, as well as why we placed big bets and where we think we went wrong.

Discovering Terra

We began researching Terra in early 2021, which is the report linked above regarding the Mirror Protocol. While we found the Mirror Protocol interesting, what truly piqued our curiosity was its underlying network, Terra—a set of algorithmic stablecoins natively integrated into Layer 1 economics, focusing on real-world adoption and built on a relatively scalable and interoperable blockchain.

Terra began to establish demand for its stablecoin through CHAI, a payment network in South Korea, which had a trading volume of $1.5 billion at the time and over 2.5 million users. By the end of 2021, Terra added support for CosmWasm smart contracts, allowing third parties to build applications centered around these stablecoins.

Its first application, Mirror, gained significant traction by allowing users to access synthetic real-world assets, and we also fulfilled the promise of "an ecosystem built around real-world use cases for creating decentralized stablecoins."

The Terra ecosystem rapidly evolved, and the power of the community was undeniable. The community element is a tremendous strength that we particularly recognized, as it cannot simply be created through incentives. Despite these tailwinds, the Terra ecosystem lacked builders and key foundational primitives, such as trading protocols and lending protocols. We took the time to study, invest in, and build on Terra to gain a deeper understanding of these foundational primitives and decided to help build them through Delphi Labs.

These key foundational primitives would enable builders to create new products, providing additional utility for UST, with the goal of expanding the UST supply as utility increases.

The Failure of Anchor

Anchor Protocol launched in March 2021, and initially, it aligned very well with our thesis. The idea was to use proof-of-stake (PoS) assets as collateral to provide stable yields to depositors. This allowed individuals to help secure PoS networks while giving them the option to forgo staking rewards in exchange for higher borrowing rates.

When Anchor Protocol started, three-digit APYs were common, so a 20% APY was considered an attractive yet reasonable starting point. Anchor's reserves were used to cover the difference between the yields paid to UST depositors and the yields earned from the staked assets of borrowers.

When Anchor Protocol was in deficit, the protocol would allocate its governance token, ANC, to incentivize additional staked asset deposits.

The era of high APYs has passed, and APYs in the market have significantly shrunk, but Anchor Protocol's deposit rates remained at 20%, leading to a continuous increase in UST deposited in Anchor, which only accelerated the reserve deficit. In response, the initial rebalancing mechanism was abandoned, replaced by Do Kwon directly allocating funds to the reserves.

Ultimately, this led to the classic algorithmic stablecoin error—using unsustainable incentives to guide supply, which was clearly effective during economic booms but often underestimated during economic downturns, the scale of redeemable UST liabilities tends to be underestimated, primarily due to the domino effect of bank runs, which can even destroy the confidence of some of the strongest holders.

This is why we view the LFG and BTC reserves as a significant step in mitigating this issue, effectively converting some excess UST demand into exogenous reserves that can be used to defend the peg when necessary.

While lowering Anchor's APY yields, creating some exogenous collateral would significantly reduce systemic risk in the network. We believe that high levels of external collateral are necessary in the long run, as this is the way to achieve the goal. Unfortunately, its growth rate is not fast enough compared to the supply of UST, and coupled with the decline in the value of BTC reserves, the excess liabilities are too large to hedge.

Looking Ahead

We chose to believe in the Terra ecosystem, investing a significant amount of money and time, placing a big bet, but the outcome did not meet our expectations. Fortunately, Delphi is fully self-funded, and when we make such high-confidence bets, our own capital is at risk. We understood the risks of the algorithmic stablecoin model in advance and sought to maintain transparency throughout the process; however, it is clear that we miscalculated the risks. To the outspoken critics of Terra's algorithmic stablecoin design—you were right, we were wrong.

Anyone who knows us (whether as a business or individuals) understands how heartbreaking it is for us to see the ecosystem we have worked so hard to advance be thwarted by such events. We are committed to making a positive impact on cryptocurrency and the world as much as we can.

We always say that actions speak louder than words, so Delphi will let our work and efforts speak for what comes next.