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May 16, 2022

Ember Nuggets Issue #32 -The Terra Meltdown and Why Ember Fund Avoided It

Let's talk about Terra's collapse... 


Hey Ember Crew,

I’m sure you’ve already read in the news about the recent Terra collapse, but I wanted to shed some light on the finer details of the situation. In short, macroeconomics led to a weakness in Terra (UST/LUNA), creating an opportunity for exploitation that an attacker (or attackers) took advantage of.

Rest assured, Ember Fund had no exposure to Terra and our investors are safe. During our due diligence on Terra earlier this year, we were uncomfortable with the lack of collateralization on the Anchor Protocol offering 19.5% APY.

Before we dig in, as always, don’t forget to keep stackin’ those sats:


The Terra Collapse: What is it and What Happened?

Terra, founded by Do Kwon and Daniel Shin in 2018, is a blockchain built in the Cosmos ecosystem. The network went live in April 2019 with the purpose to create an algorithmically-pegged stable coin tied to the US dollar and a network to support global payments. There are two key aspects to Terra; LUNA is the crypto and TerraUSD, also known as UST, is the stable coin.


Now, the peg maintenance mechanism between LUNA and UST:

There is a “promise” to people that you can always redeem one UST for $1 worth of LUNA. Say that LUNA is worth $0.10, which means you can burn 10 LUNA to create 1 UST. If LUNA is $10, you would burn 0.1 LUNA to get 1 UST. UST is always meant to trade at $1 with a market-making mechanism for arbitrageurs. In theory, this all sounds good but let’s remember that both LUNA and UST were created out of thin air with no material backing from governments, fiat, or other real-world assets (excluding capital raised).


On to what happened…

Do Kwon has had very publicized feuds with folks on air and in the news that challenged the UST/LUNA. He openly challenged parties to try and bring down Terra. Do Kwon seems to have put a target on his back with his behavior and was challenging parties that were showing him the weakness in LUNA/UST.

Since markets have been extremely volatile over the past few weeks, a downtrend in price and tightened liquidity of crypto assets was created, forming the vulnerabiltity that brought Terra down.


Here's the abridged play-by-play (thanks to Route 2 FI on Twitter):

  • Supposedly, Terra Labs had pulled $150M of UST liquidity from 3-Pool on Curve to migrate over to 4-Pool - to help maintain balance and diversify across another asset.

    • There was now limited liquidity in the active 3-Pool, and the attacker exploited it

  • The attacker swapped $85M of UST to USDC creating an imbalance in the pool

  • While all of this is happening, the attackers borrowed 100,000 BTC to short (i.e. betting that the price of Bitcoin will fall)

  • The attackers then buy $1B UST in an OTC trade (peer to peer, over the counter)

  • Rumors and fear start spreading like wildfire and deposits on Anchor, the protocol on Terra that offered users a 19.5% yield on UST, start falling ~$10M every minute

  • The US markets begin to open in the red, further exacerbating fear and weakness in the macroeconomic environment, fueling the selloff in crypto

  • To help fight the depeg, LFG starts to sell LUNA and Bitcoin to restore it -> this leads to downward price pressure on both LUNA and Bitcoin (remember the attackers shorted Bitcoin)

  • This leads to the death spiral and the crazy unwind we saw over the past few days

  • Attackers keep dumping UST sending LUNA supply to 6.5 trillion

  • Bitcoin starts selling off due to massive sell pressure

  • LUNA price continues to fall, because of the re-peg mechanism that continues to issue more LUNA

  • With all the events happening rapidly there was massive chaos in the markets and the fear was beginning to reach unsustainable levels

Now that the dust has settled...

Today, LUNA is halted on most exchanges from trading and effectively $0 and the Terra blockchain has shut down from processing any new transactions.

In my opinion, the trust has been shaken and it seems unlikely Terra will be able to recover. Terra has massive backers and partners that could help breathe new life into the project and help them “fix” the stablecoin mechanism, but with tightness in the market and massive write-offs that many would have likely endured this week, it is doubtful.

The events over this past week are very nuanced. One thing is clear, billions of dollars were wiped out for companies in the ecosystem, consumers that had their savings in UST, and many others.

Luckily, Ember Fund has not included UST in any of our portfolios due to some inherent risks we saw with the asset. So rest assured when investing with us:

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