Points: 10
Format: Individual or pairs
Related Lesson: L07: Smart Contracts & Game Theory
Submission: Written analysis + 5-minute presentation
Overview
Cryptoeconomic systems fail when mechanism design breaks down, incentives misalign, or trust assumptions are violated. In this assignment, you will dissect a real-world crypto failure event using the game theory and mechanism design concepts from Lesson 7. By reconstructing what happened, identifying root causes, and proposing improvements, you will develop the analytical skills needed to evaluate the resilience of cryptoeconomic protocols.
Learning Objectives
- Reconstruct a timeline of key events in a major crypto failure
- Identify mechanism design flaws using game theory concepts (Nash equilibrium, incentive compatibility, death spirals)
- Analyze how rational actor behavior contributed to systemic collapse
- Propose concrete mechanism improvements that could have prevented or mitigated the failure
- Communicate technical findings clearly in a short presentation
Choose Your Event
Select one of the following three events to analyze. Each involves a different type of cryptoeconomic failure.
Option A: Terra/Luna Collapse (May 2022)
Algorithmic Stablecoin DeFi Death SpiralThe UST algorithmic stablecoin lost its dollar peg, triggering a hyperinflationary death spiral in the LUNA token. Over $40 billion in value was destroyed in under a week. The collapse exposed fundamental flaws in reflexive token economics and the fragility of algorithmic pegging mechanisms.
Key Dates
- May 7, 2022: Large UST withdrawals from Anchor Protocol (~$2B) begin destabilizing the peg
- May 8, 2022: UST depegs to $0.98; Luna Foundation Guard (LFG) deploys $1.5B in BTC reserves to defend peg
- May 9, 2022: UST falls to $0.35; LUNA supply begins hyperinflating as arbitrage mechanism mints new LUNA
- May 10, 2022: Do Kwon proposes emergency measures; LUNA drops 96% in 24 hours
- May 12, 2022: Terra blockchain halted; UST at $0.10, LUNA effectively at $0
- May 13, 2022: Full collapse confirmed; ~$40B market cap destroyed
Option B: FTX Collapse (November 2022)
Centralized Exchange Fraud & MismanagementFTX, the world's third-largest crypto exchange, collapsed after revelations that customer deposits had been secretly transferred to its sister trading firm Alameda Research. The failure destroyed $32 billion in valuation and demonstrated how centralization and lack of transparency undermine the trust assumptions of the crypto ecosystem.
Key Dates
- Nov 2, 2022: CoinDesk publishes leaked Alameda Research balance sheet showing heavy FTT token concentration
- Nov 6, 2022: Binance CEO Changpeng Zhao announces Binance will liquidate its FTT holdings (~$580M)
- Nov 7, 2022: FTX halts withdrawals as users rush to withdraw; classic bank run begins
- Nov 8, 2022: Binance signs non-binding letter of intent to acquire FTX, then withdraws within 24 hours
- Nov 11, 2022: FTX, FTX.US, and Alameda Research file for Chapter 11 bankruptcy
- Nov 12, 2022: ~$477M in suspicious outflows (possible hack); SBF resigns as CEO
Option C: The DAO Hack (June 2016)
Smart Contract Exploit Governance CrisisThe DAO was the first major decentralized autonomous organization, raising $150M in ETH. A reentrancy vulnerability allowed an attacker to drain 3.6 million ETH ($60M). The community's response -- a controversial hard fork -- split Ethereum into ETH and ETC, raising fundamental questions about immutability, governance, and "code is law."
Key Dates
- Apr 30, 2016: The DAO launches; crowdfunding raises 12.7M ETH (~$150M) from 11,000+ investors
- May 26, 2016: Security researchers publish warnings about reentrancy vulnerability in splitDAO function
- Jun 17, 2016: Attacker exploits reentrancy bug, draining 3.6M ETH (~$60M) into a child DAO
- Jun 17-Jul 15, 2016: 28-day withdrawal delay (built into DAO code) prevents attacker from moving funds
- Jul 15, 2016: Ethereum community votes on hard fork proposal; ~85% support the fork
- Jul 20, 2016: Hard fork executes at block 1,920,000; funds returned to investors. Ethereum Classic (ETC) continues on the original chain
Activity Structure
1 Phase 1: Timeline Reconstruction (15 minutes)
Using the key dates provided above, reconstruct the event timeline. For each date:
- Summarize what happened in your own words
- Identify the key actors and their incentives at that moment
- Note any game-theoretic dynamics (e.g., coordination failure, bank run, prisoner's dilemma)
- Mark the point of no return -- when did the failure become irreversible?
2 Phase 2: Root Cause Analysis (15 minutes)
Apply game theory and mechanism design concepts from L07 to identify why the system failed. Address:
- Incentive misalignment: Where did individual rational behavior lead to collective harm?
- Mechanism design flaw: What specific design choice made the system fragile?
- Trust assumption violation: What assumptions about actor behavior proved wrong?
- Nash equilibrium analysis: Was the "collapse" outcome a Nash equilibrium? Why did no rational actor have incentive to prevent it?
3 Phase 3: Mechanism Improvements (10 minutes)
Propose exactly 2 specific mechanism improvements that could have prevented or mitigated the failure:
- Each proposal must be concrete and implementable (not just "be more careful")
- Explain how each proposal changes the incentive structure or payoff matrix
- Identify potential trade-offs or new risks your proposal introduces
- Reference a relevant concept from L07 (e.g., incentive compatibility, commitment devices, Schelling points)
4 Phase 4: Presentation (5 minutes)
Present your findings to the class. Structure your presentation as:
- Event summary: What happened? (30 seconds)
- Timeline highlight: The critical turning point (1 minute)
- Root cause: The game-theoretic explanation for failure (1.5 minutes)
- Mechanism improvements: Your 2 proposals (1.5 minutes)
- Q&A: Answer peer questions (30 seconds)
Deliverables
| Item | Points | Description |
|---|---|---|
| Timeline Reconstruction | 2 | Accurate timeline with key actors, incentives, and game-theoretic dynamics identified |
| Root Cause Analysis | 3 | Clear identification of mechanism design flaws using L07 concepts |
| Mechanism Improvements | 3 | Two concrete, well-reasoned proposals with trade-off analysis |
| Presentation | 2 | Clear communication, time management, ability to answer questions |
| Total | 10 |
Tips for Success
- Think in payoff matrices: For each key actor, what were their options and expected payoffs?
- Use L07 vocabulary: Nash equilibrium, dominant strategy, mechanism design, incentive compatibility, moral hazard, adverse selection
- Be specific: "The mint-burn arbitrage loop was not incentive-compatible under stress" is better than "the mechanism failed"
- Consider counterfactuals: How would different mechanism designs have changed actor behavior?
- Acknowledge complexity: Real failures have multiple contributing factors -- identify the primary mechanism design flaw
Related Resources
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