Parsing Terraform Labs (in liquidation) vs Jane Streeeeeeeet

Per WSJ:

The administrator winding down Do Kwon’s Terraform Labs has sued Jane Street, alleging that the high-speed trading giant engaged in insider trading to profit unlawfully from and ultimately hasten the crypto empire’s collapse.

Todd Snyder, the plan administrator appointed by a bankruptcy court, is seeking damages from Jane Street, its co-founder Robert Granieri, and employees Bryce Pratt and Michael Huang.

Here’s the complaint. It’s so heavily redacted that piecing together the story is tricky beyond the allegation that Jane Street new starter Bryce Pratt kept gossip lines open from his time interning at Terraform. This is from page two:

Jane Street’s traders created a secret message chain involving current and former employees of Terraform. The message chain was even named “Bryce’s Secret,” after former Terraform intern and then-current Jane Street systems developer Bryce Pratt. Jane Street used Bryce’s Secret chat group and other backchannel sources of non-public information to front-run trading that hastened the collapse of Terraform. Its abuse of material non-public information from insider █████████ allowed Jane Street to unwind hundreds of millions of dollars in potential exposure at precisely the right time, mere hours before the Terraform ecosystem collapsed.

In an emailed statement, Jane Street called the suit “desperate” and “a transparent attempt to extract money”.

Here’s a quick recap of what we’re talking about, starting with the basics.

Terraform issued stablecoins on its Terra blockchain whose values were notionally pegged to various currencies. A Luna token was intended to act as a arbitrage counterweight as one Luna token could always be redeemed for one Terra token’s face value, regardless of their market prices.

It was nonsense, of course, but the machine might’ve kept running for a bit longer had Terra tokens been used as a medium of exchange. They weren’t. About three-quarters of Terra’s USD-pegged stablecoin was locked up in the system’s Anchor protocol, which offered 20 per cent APY to depositors.

This Ponzi scheme entered a death spiral during six days of May 2022, when Terra’s USD token broke the buck. Terraform tried to defend the peg first with reserves held by Luna’s Foundation Guard, a ringfenced independent entity that was neither ringfenced nor independent, but confidence was shot. Approximately $40bn in magic internet money disappeared. Kwon was last year sentenced to 15 years in prison on two counts of fraud.

Speculation of a co-ordinated attack on Terra surfaced almost immediately, the ground for conspiracy having been softened by Iron Finance, a similar algorithmic stablecoin that blamed its collapse in 2021 on market manipulation by whale traders it didn’t identify.

The most popular theory around Terra’s failure was that some group was short-selling bitcoin to cause panic, having loaded up on enough TerraUSD tokens to drain the Luna liquidity pool. Citadel Securities and BlackRock both denied social media chatter claiming they were involved, before Jane Street’s name was attached in March 2023 on news that US prosecutors were looking at group chats between trading firms.

There’s nothing as interesting as bitcoin shorting in the visible bits of the complaint, whose focus is on withdrawals from Terra’s Anchor protocol around when the run began. The big transactions were on May 7 through two crypto wallets: Wallet A, which is said to have belonged to Jane Street, as previously reported, and Wallet B, which was owned by Ponzi scheme operator Celsius.

It’s enough for our purposes to know that the trigger to panic was a withdrawal late on May 7 of 85mn TerraUSD via Wallet A. If you really want to go through all the trade sizes and timings, “Anatomy of a Run: The Terra Luna Crash” by Jiageng Liu et al offers a readable version while Nansen’s on-chain analysis includes all the technicalities.

Snyder’s complaint cites media reports to conclude that Jane Street is probably behind Wallet A. It notes that the firm never publicly confirmed or denied ownership, however, and there’s also nothing to suggest collusion between Celsius and Wallet A’s owner.

The group chat offers a clearer thread of evidence. Set up in February, “Bryce’s Secret” was between Pratt, a Terraform software engineer, and Terraform’s head of business development. The initial talk was about Pratt setting up an introduction with “a big company that wants to get involved” with a fundraising. The complaint continues:

While Terraform’s software engineer and Pratt initially remained coy about the “big company” seeking to invest in Terraform, they did not maintain the mystery for long. Later in the chat, Terraform’s software developer said to Pratt, “bro we all know who the buyer is. its where u work,” then revealed the company Pratt represented: “Jane Streeeeeeeet.”

Pratt introduced Terraform’s head of business development by email to Jane Street’s DeFi team. But while Terraform tried to broker an investment of “at least 9 figures in size” in exchange for discounted Luna tokens, Jane Street “turned those communications into a back-channel source for material non-public information about Terraform”, the complaint alleges.

Copious redactions mean the non-public information remains that way. Perhaps the most interesting of what’s left is a paragraph about Terraform’s plans to launch a new “curve pool”, through which traders could swap between various tokens that were all nominally pegged at a dollar.

The Terra Curve 3pool allowed swaps between TerraUSD and stablecoins issued by Tether and Dai. Curve 4pool was to add a hybrid stablecoin called Frax to the mix. It was Terraform’s plan for 4pool to become the preferred liquidity reservoir.

Terraform had given a go-live date for 4pool but had not announced plans to move tokens from 3pool to 4pool in preparation, including a trade of 150mn TerraUSD processed late on May 7. Thirteen minutes after that trade, Wallet A’s owner withdrew a further 85mn TerraUSD and liquidity in 3pool available to arbitragers became stretched. TerraUSD fell to 2.5 cents below par, and a rush for the exits began.

The Complaint alleges that Jane Street acted having known in advance about the vulnerability, though any Economics 101 class would have provided the same insight. Inside knowledge of when Terraform’s reorganisation trade was happening might have given Jane Street an edge — though the 85mn trade was towards the end of a period of heavy withdrawals and, for a high-frequency trader, 13 minutes is an eternity.

It’s not known why Terraform would continue with the pool transfer plan when available liquidity was already so thin. Maybe the promise of nine figures in new investment had a bearing? We’ll find out if the documents are unsealed.

The complaint also notes that Jane Street might have gained some kind of edge by being told about Jump Trading’s reported bailout of Terraform when it broke the buck in 2021. Snyder sued Jump Trading for $4bn in December.

The complaint’s other unredacted paragraph of note gives a definition of “maximal extractable value”, which is essentially a method to front-run transactions by jiggling around orders while they’re waiting to be validated onto the blockchain. A New York federal court classified TerraUSD, Luna and various derivatives as unregistered securities in January 2024 so maybe that fits the definition of securities fraud; we don’t know.

Snyder seems confident. “Jane Street abused market relationships to rig the market in its favour during one of the most consequential events in crypto history,” he says in an emailed statement.

On behalf of injured parties, we will pursue all avenues supported by the facts and the law against those who exploited their position and reaped substantial profits at the expense of Terraform Labs’ creditors. The Wind Down Trust is committed to holding accountable any party whose misconduct deepened the harm caused by Terraform’s collapse.

How much caveat emptor applies for injured parties expecting 20 per cent yield on an algorithmic stablecoin deposit, and whether or not it’s securities fraud to shout fire in a crowded theatre that’s on fire, are questions we’ll let others answer.