Crypto just had a Lehman moment
Thoughts on UST / LUNA
Crypto became too big to ignore.
The global cryptocurrency market capitalisation reached $2.9T last November currently down more than 50% at $1.4T. For reference, Saudi Aramco and Apple are worth around $2.3T at the time of writing, with global gold around $12T .
At that size, we doubt the theory that crypto is just one big bag of hot air. There is unarguably some value and opportunity for value creation within that market but we will argue about that another day.
What we do not doubt right now is the risk it carries for the broader market. A significant number of publicly traded companies hold crypto on their balance sheets. An even bigger number lies within private companies.
Recently, we realised the range of individuals with exposure to crypto was wider than we previously thought. Successful business people from my circles, not the usual target group for “get-rich-quick” schemes at all, do own more than just Bitcoin or Ether.
Timing may not be perfect to start writing, but as a banker friend of mine reminded me: everybody’s smart in a bull market. Opportunities emerge during harder times. So, bear with us for the meat of it.
This week, crypto had a “Lehman” moment. Luna, a top 10 project by market cap went from $22B to $0.2B in 3 days, and will likely hit 0 soon enough. Remember Lehman Brothers was a $60B company in 2007. We want to seize the opportunity to share more information about this situation and what could have been easily anticipated by people paying attention.
I believe “crypto” suffers a lot from semantics: reading crypto literature feels like Tolstoy to me. If you did not read “War and Peace”, one given situation is made of so many characters with relatively similar sounding names, patronymics, diminutives, titles etc… It’s quite challenging to simply keep track of who is who on any page.
In the case of Luna, the main protagonists are two Korean nationals named Do Kwon and Daniel Shin who created and lead Anchor protocol, Terraform Labs and Luna Foundation Guard (LFG) to initiate TerraUSD (symbol UST 🤨 ), Terra (symbol LUNA 🙄 ), Anchor (symbol ANC, this one is the easiest).
Yes, they definitely have a naming problem.
Anyway, their goal was to create and maintain a stablecoin, UST. What is a stablecoin you ask? It’s a crypto asset designed to maintain a 1:1 value to a fiat currency, in that case the US Dollar. In theory, you could redeem 1 UST for 1 USD anytime.
The need for stablecoins comes from several directions :
even the largest cryptocurrencies are still very volatile (they’re still young, small in market cap and illiquid): if/when working as intended, stablecoins achieve very close to 0 volatility. Hey, at least that’s the intent!
volatility is a cost businesses do not want to carry when accepting crypto payments. Stablecoins thus support wider adoption for crypto payments in business settings
an investor willing to exit their volatile crypto assets at a profit by going cash would trigger taxable events in most jurisdictions. Sell crypto for USD, get taxed. Sell crypto for stablecoins, postpone the tax
exiting to fiat incurs expensive fees
stablecoins enable many new on-chain financial instruments: leverage, short, stocks, ETFs, lending… Demand for such on-chain instruments fits the larger demand for more transparency in the financial markets, with these instruments being openly auditable (preventing shady situations like the Gamestop blowup of hedge funds last year after they had shorted more than 100% of existing shares)
Although there exists other stablecoins we’ll talk about another day, Terraform Labs argued they would create a superior solution with UST being a decentralised, algorithmic solution. Why not just have an entity hold as much USD or Gold or anything valuable and stable enough to be able to emit stablecoins and supply USD to anyone willing to redeem them? Terraform Labs sought more decentralisation, without any single point of failure. So what’s the algo then you might ask?
Basically, they created another coin, LUNA, that would be burnt (destroyed) in order to mint (create) 1 UST. This mechanism is executed on the blockchain by a smart contract out of the hand of any centralised entity. Deflation in LUNA incentivises LUNA buying, thus providing backing for UST.
In order for that scheme to work, they built Anchor protocol, a lending platform to incentivise holders by paying high interests to lenders and charging low interests to borrowers. The risk this created is quite easy to grasp. The rate offered to lenders was as high as 20% (with negative real rates, who could resist), while borrowers would pay around 8%. Although they openly announced these rates could be considered “promotional” and limited in time, the 12% spread should be born somehow.
Enter the “yield reserve”, a treasury implemented to pay for said spread 😐 . If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck. The word you are looking for is “Ponzi”. Paying early funds with fresher ones. Including professional VCs…
One can argue transparency mitigated the unsustainable nature of the scheme. The yield reserve (the reserve built to cover that spread) was openly accessible and known, sloping distinctively toward 0 with a runway of weeks/months. While the source of those funds was not explicit, likely VC funding, the risk from total depletion of that reserve was certain. At least smart investors could gauge that risk in real time and enjoy the 20% return on their capital while it lasted.
“Don’t worry, we won’t operate as a Ponzi forever, just long enough for us to grow big.”
This issue was only dampened by the promise the large unsustainable spread would be promotional only. The problem thus emerged that the whole scheme relied on the doubtful belief that holders would hold after that “promotional period”, and not enter in a spiralling escape. That risk was largely downplayed by the founders and backers and we believe the peg and high interest paid to lenders anaesthetised stakeholders.
The last nail in the coffin came from foolish announcements from founder Do Kwon to buy large sums of Bitcoin (for a total of $10b) to strengthen the protocol. We say foolish, because someone announcing their buying beforehand, and their willingness to sell as an emergency measure whatever the price down the road sounds very naive, to not say dumb. Was he asking to be run over?
That stance is the perfect shorting setup for someone with firepower: upon the announcement, borrow and sell Bitcoin into their buying (announced in time and size), then tank the protocol to provoke the need for them to liquidate their Bitcoin at any price (as announced), forcing Bitcoin price down. Buy back lower and return the Bitcoin you borrowed. Just add some options and extra steps to build a safety net and you have a bulletproof trade, highly profitable trade.
This playbook has been warned against and ignored ostensibly by Do Kwon’s camp. In the end, this is most probably what happened, whipping a lot of investors and probably netting the “attacker” around $900M.. Someone with size was able to trigger the vicious spiral of a run on the bank: everyone rushing for the exit at once. Investors keeping funds in UST, thinking they were equivalent in value to USD, woke up to UST bottoming at 4 cents.
Truth is, we expected that to happen when the yield reserve could not be bailed out again, the way it has been in Jan 2022 already. Reasons we anticipated ranged from macro environment to private / vc market contraction. While the cause did not check our card, the result did not disappoint.
The lesson taught here is old: if it’s too good to be true, there is a catch.
We expect regulators will likely use this event as a public argument for tremendous increase in regulation of the field, especially stablecoins. Janet Yellen already mentioned before the House Financial Services Committee.
Remember the information needed to anticipate this situation was all public, contrary to Lehman Brothers or the Madoff scandal and many independant experts did foresee what just happened. They had to endure screaming into the void for many months, being ridiculed and belittled, especially by founders of that particular scheme.
In the end, this event is the perfect reminder that understanding the fundamentals is paramount to gauging risk in any investment. While it is true for a 60/40 portfolio at any time (bond holders just endured highly unusual losses YTD), it is obviously necessary with digital assets.
Always make sure you have the right eyes in the right place.
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Entrepreneur and independent consultant in technology, innovation, alternative investments and fine arts.
Entrepreneur & software developer, Youtuber, crypto enthusiast since 2017. Warned investors about the high risk of UST since early 2021.
None of the information provided in this newsletter constitutes financial advice. This is intended for entertainment, education and general information only.