Dear Square 1 readers,

What you’re witnessing in the crypto market the past 72 hours has been one of the largest liquidation events in history. I’m writing this to briefly reflect and provide a very high level overview of what’s happening.

Terra Luna is an algorithmic stable coin protocol. If you remember the concept of a collateralized debt position (CDP) implemented by Maker DAO protocol on Ethereum, this is similar. The difference is that while Maker is overcollateralized (ie. more value locked than debt out) Terra relies on their ecosystem to leverage an arbitration opportunity of minting and burning UST based on the $LUNA price.

Users of the Terra protocol create “stable” UST coin by burning Luna. UST is also backed by some amount of diversification into Bitcoin made by their founder Do Kwon, but the primary asset backing UST is the $LUNA token. Further, it was made to be “highly efficient” meaning the value of UST on the open market matched closely to the value of collateral supporting it. While this can work in theory (and did work for a year and a half since Oct. 2020) the $UST price recently broke the $1 peg in a massive way.

Other stable coins might fluctuate some, but this systemically challenges the algorithmic system supporting UST.

Some people believe that the peg will return within a few days, others say a few weeks. I personally do not know what will happen, but there are many cascading effects from this event.

Lightly collateralized algorithmic stable coins prove to be the biggest threat to crypto at the moment. These types of systems rely on sophisticated minting, burning, and yield to balance themselves, and as we see today, are easily manipulated by large players looking to extort a profit.

Mark Slapinski - Technology @SlapinskiMark

Nevin Freeman warned about the dangers of algorithmic stablecoins like Terra and Celo years ago, but nobody listened. #terraluna #cryptocurrency

2:53 AM ∙ May 12, 2022

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There’s a rumor that Blackstone and Citadel made this occur via a 100K BTC loan and OTC deal with Do Kwon himself. I’ve yet to see a credible new source confirm this, but it isn’t outside the realm of possibility…

Onchain Wizard @OnChainWizard

How to make a >800 million dollars in crypto attacking the once 3rd largest stablecoin, Soros style: Everyone is talking about the $UST attack right now, including Janet Yellen. But no one is talking about how much money the attacker made (or how brilliant it was). Lets dig in🧵

8:27 PM ∙ May 10, 2022

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And it isn’t that the Terra ecosystem wasn’t warned, nor aware… this next post made in 2021 describes how Terra can be attacked the same way Soros broke the bank of England in 1992.

FreddieRaynolds @FreddieRaynolds

A few weeks ago I responded to @tbr90’s tweet with a brief outline of how a wealthy attacker could not only break @terra_money but profit heavily doing it with a Soros style Black Wednesday attack. Below I provide a detailed breadown...~$1B capital needed. https://t.co/MIbSH3Lwpq

7:59 PM ∙ Nov 25, 2021

2,348Likes772Retweets

Unfortunately, programatic economic systems hold flaws that can’t be reduced to pure math/science.

Lunatics (Terra’s community) speculate the price of UST to repeg in the coming days or weeks.

This is a terrible day for the ecosystem at large, and deeply unfortunate for retail investors and consumers who were convinced to use Terra and related products for their benefit.

Regardless of whether UST comes back to peg, the ecosystem just suffered a massive multibillion dollar hit that will take weeks or months to settle. I would anticipate an actual bear market to form for some months if not longer.

Definitely not the end, but a new opportunity for people to learn and become aware of protocols with systemic risk.

I hope you all are left unscathed by the situation. Money is certainly not everything, and the technology being built in the crypto space will prove to be continually important despite this setback.

All the best,

JD