By Benjamin Dean
This week has seen a series of rapid contractions in the digital asset ecosystem. In a space that is well known for volatility, even this week marked the observers. To navigate effectively, investors need to understand the broader investment context in which these events occurred, the trigger for the sharp sell-off, and how this is part of the evolutionary process that could propel the digital asset ecosystem forward. , but also backwards sometimes.
Since January 2022, the general market sentiment has been “risk free”. After an unprecedented rise to all-time highs for the digital asset ecosystem, which reached over $3 trillion in market capitalization in November 20211, a series of external factors set in. The first was the abandonment of a tighter monetary policy in the major economies, especially the United States, during the year 2022. The second was the outbreak of the conflict between Ukraine and the Russian Federation Russia, which caused volatility in commodity markets and further fueled already-high inflation. Finally, portfolio managers face a 60/40 stock and bond portfolio that has found its limits as broader equity markets have contracted at the same time bond market yields have fallen. The NASDAQ, in general, and non-profit tech stocks, in particular, have seen strong selling in 2022. It is against this backdrop that a series of events have unfolded over the past week.
The most recent sell-off impetus in the digital asset space has been the “detachment” of the ironically called “stablecoin” associated with the Terra blockchain, referred to as UST, and the associated LUNA cryptocurrency.
Not All Stablecoins Are Created Equal – Or Equally Stable
Not all stablecoins are the same – the term is usually applied too broadly. Some stablecoins are backed and managed by a regulated, centralized company (e.g. Circle’s USDC). Some are over-collateralized but algorithmically managed (eg Maker’s DAI). Then there’s Tether, which is centrally managed and mostly backed by as-yet-undisclosed commercial paper.
Figure 1: Stablecoin market share from May 2021 to May 2022 in USD
The UST stablecoin is designed to maintain a peg of US$1. It does this using an algorithm tied to Terra’s native cryptocurrency called LUNA, which fluctuates based on the value of UST. Say succinctly:
If the market value of Luna is 100 USD, you can exchange 100 UST for 1 LUNA. This is the stability mechanism. If the UST has lost its peg and is trading at $0.95, you can still trade 100 UST for 1 LUNA and sell the LUNA for $100, making a profit of $5. This way, Luna’s market liquidity is used to support the value of the UST, and as long as there is demand for Luna, arbitrageurs should keep the system online.2
Over the past few weeks, the entity that runs LUNA, the so-called Luna Foundation Guard (LFG), has started acquiring bitcoins to build up a reserve with which to defend the UST peg if needed. As of May 5, 2022, the LFG has acquired US$1.5 billion in bitcoins.3
There are a number of well-known ways an undefended algorithmic stablecoin design can fail. One of them is the “coupon curse”,4 which is a situation where there is not enough demand to absorb the demand for the LUNA cryptocurrency in the face of UST liquidations, which sets off a chain reaction in which more UST holders seek to liquidate their holdings, which makes the already stripped UST fall even further. This cascading chain of events has been seen before.5
On May 8, 2022, significant liquidations of UST took place on the decentralized exchange Curve. These large liquidations have put pressure on the stowage of the UST. As part of the peg defense, the LFG began trading bitcoin for other US dollar tokens, to allow them to intervene in the market and support the ecosystem. This put downward pressure on the spot price of bitcoin and spawned a new “theater rush” for UST holders.6
What is unique about this incident is the size and scale of the Terra/LUNA ecosystem. At its peak in early April 2022, the LUNA cryptocurrency was valued at the equivalent of approximately US$41 billion. On Friday, May 6, he was worth US$27 billion. Today7 he is worth less than 300 million US dollars8. The maximum amount of USTs in circulation was over US$18 billion on May 7, 2022.9 The Terra Network was taken offline on May 12, 2022.ten
The rapid liquidation of LUNA and the de-anchoring of UST sent shockwaves throughout the digital asset ecosystem. In addition to the effects on the bitcoin spot price, due to bitcoin being sold off rapidly to defend the peg, the LUNA price crash has resulted in margin calls and liquidation for leveraged LUNA holders. The ripple effects could also be seen in disruptions to other pegged stablecoins, with slight declines in the collateralized USDT “Tether” token11 and collateralized USDC “Circle” token premiums.12.
An ecosystem characterized by a lot of trial and error will sometimes have… errors
Taking a step back from this week’s events, to put them into perspective, consider that there has been a rush of investment in new protocols and decentralized applications in 2020-2021. More venture capital has flowed into the space in 2021 than in the previous six years combined.13 These newly developed technologies and ventures have not been fully battle tested in an extremely adversarial software environment – their potential returns, uncertainty, and investment cases are vastly different from more established networks like Bitcoin and Ethereum.
There have been countless technical and economic failures throughout the 13-year history of the digital asset ecosystem. Before the Terra/LUNA event, perhaps the best known was the DAO hack14 for US$150 million at the time, which led to the hard-forking of Ethereum and the collapse of Bitconnect by US$2.4 billion15. Both cases were far from the magnitude of the Terra/LUNA collapse this week. This is partly because the digital asset ecosystem has never been bigger. In terms of scale, incidents like this can have the impact they have, because the ecosystem is very different from that which prevailed just three years ago.
Going forward, expect two major trends to emerge. A trend will see the failure of a variety of experiments for technical, economic, organizational, regulatory or other reasons. This is how the venture capital business model works: a small proportion of portfolio companies carve out the lion’s share of outsized returns, while most break even or fail. The other trend will see a handful of survivors finding scalable, sustainable business models and a new crop of experiences to compete against. This is where the opportunities lie over the next two years.
1 https://www.coingecko.com/en/global_charts2 Inspired by: https://0xfoobar.substack.com/p/partially-collateralized-algostables?s=w 3 https://www.cnbc.com/2022/05/05/luna-foundation-guard-bolsters-stablecoin-reserve-by-raising-1point5-billion-in-bitcoin.html4 https://mirror.xyz/damsondao.eth/OVeBrmrfcWm7uKLlA2Q4W1XTVkFU3cMKfNWhgf7mQuM 5 https://0xfoobar.substack.com/p/partially-collateralized-algostables?s=w 6 https://twitter.com/onchainwizard/status/1524123935570382851?s=21&t=roAPYhzJEb3SI2gisN0gKQ 7 At time of writing 5/12/22.8 https://www.coingecko.com/en/coins/terra-luna 9 https://www.coingecko.com/en/coins/terra-usd ten https://twitter.com/terra_money/status/1524785058296778752?cxt=HHwWgMDS6dH7j6kqAAAA 11 https://www.ft.com/content/5887ef43-d43a-4608-a1ac-aacc99f076b9 12 From 6:49 p.m. GMT on 05/12/22: https://www.coingecko.com/en/coins/usd-coin 13 https://www.wisdomtree.eu/-/media/eu-media-files/other-documents/research/market-insights/WisdomTree-Market-Outlook-Model-Portfolios.pdf#page=26 14 https://www.gemini.com/cryptopedia/the-dao-hack-makerdao 15 SEC Sues 5 Over $2 Billion Bitconnect Ponzi
Benjamin Dean, Director of Digital Assets at WisdomTree in Europe
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.