May 15, 2022

Insights, news and analysis for the professional investor

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Welcome to Crypto Long & Short

First, I want to highlight that a lot of regular, hardworking people lost money because of the crypto market crash over the last week or so. Some people lost all of their money. While money isn't everything, losing a lot of it sure does feel like it. If you or someone you know lost money in the LUNA/UST crash, know that life is always worth living.

If you somehow don't already know, terraUSD (UST), a cryptocurrency that is supposed to stay at $1 (aka a stablecoin), is no longer $1. When something is supposed to be $1 and it's not, that's usually not good. What's more, the crypto token that backs UST, LUNA, also lost virtually all of its value. These losses have been widely reported on, and so in all likelihood, this is the umpteen-millionth piece about UST you've seen.

But it has to be done because readers will remember me gushing over the Luna Foundation Guard (LFG) – the nonprofit aimed at promoting and stabilizing the Terra ecosystem (which issues UST and LUNA) – announcing it would buy $10 billion of bitcoin to back UST. In fairness to me, I was mostly excited that I was able to write about something that Hal Finney published to the famed Bitcoin Talk forum. But in fairness to … the truth, I was not not excited about the possibility of a bitcoin-backed stablecoin.

All said, I'm going to pack as much as I can into this column about Terra without being overwhelming or unoriginal.

Here goes …

– George Kaloudis

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The Briefing

There are these things in crypto called stablecoins. Stablecoins are supposed to be $1. Usually. Sometimes they are 1 euro or 1 won, but usually not. Blame U.S. dollar hegemony. Stablecoins exist so that crypto-natives can get in and out of the dollar easily without needing a bank to approve deposits and withdrawals. Stablecoins facilitate most crypto trading volume and power the never-ending crypto carousel that is "DeFi" (decentralized finance). More importantly, stablecoins are used by citizens subject to totalitarian governments spurring on hyperinflation.

There are a few flavors of stablecoins out there, notably tether (USDT), USD coin (USDC), binance USD (BUSD) and dai (DAI). Also quite notably, we had terraUSD (UST). These are the five largest stablecoins and they represent roughly $160 billion of value. Three of these stablecoins (USDT, USDC, BUSD) are collateralized stablecoins issued by centralized entities. These entities own a treasury of dollars that back each coin so that each coin can be redeemed for $1 by the holder from the issuer.

DAI is different in that it is collateralized and backed by a diversified portfolio of crypto assets. Instead of being issued by a centralized entity, a decentralized autonomous organization (or "DAO") called MakerDAO manages DAI. DAI is collateralized with crypto rather than dollars, but it is, and this is critical, overcollateralized.

UST is even more different. It's not collateralized at all. It is an algorithmic stablecoin powered by the Terra protocol. Instead, it is backed by a crypto token called LUNA. I covered how this works in a previous newsletter writing:

When UST's price is too high (>$1), the protocol incentivizes users to burn (destroy) LUNA and mint (make) UST. When UST's price is too low (<$1), the protocol incentivizes users to burn (destroy) UST and mint (make) LUNA.

This is pretty clever on the surface. It's simple. If the demand for UST is high enough to increase its price to $1.01, the protocol prints some UST in exchange for getting rid of some LUNA. The problem is that it works perfectly until it doesn't. And boy did it stop working last Monday …

That's supposed to be $1, not 11 cents. The LUNA chart somehow looks worse.

OK, naturally, you're thinking that the mechanism broke or something. It didn't break. It worked as designed and you can see that if you look at the amount of LUNA that has been issued as the protocol tried to algorithmically bring UST back to $1 while LUNA's price was also tanking.

That's right. The total supply of LUNA went from about 725 million tokens on May 5 to about 7 trillion on May 13. Meanwhile, LUNA lost 99.9% of its value. This is what hyperinflation looks like.

As mentioned above, Terraform Labs (the company behind Terra) laid out a plan to buy $10 billion of bitcoin and other crypto assets through the LFG in order to act as a backstop in case something like this happened. The problem remained, though. UST wasn't fully collateralized like the other stablecoins in the top 5. Before the collapse, UST's market capitalization was $18 billion, way more than the nearly $4 billion the foundation had in reserve.

Whatever happened, we got lucky.

Our friends at crypto data provider Kaiko did a great job breaking down what exactly happened. The short of it is this: UST dipped below $1, and all attempts, both by the Terra protocol algorithm and by the lending out of LFG reserves to trading firms, couldn't bring UST back to $1. Between UST and LUNA, over $40 billion of value was lost.

What exactly happened doesn't really matter. What really matters is that when something bad happened, Terra couldn't handle it. What really matters is that an undercollateralized, algorithmic stablecoin will fail no matter how long it succeeds.

The system failed. But if we're honest, UST was a wild success up until the moment it wasn't. History should serve as a lesson here, when we inevitably will see a successful UST copycat crop up in 2027 or whatever.

We also are incredibly lucky that UST and LUNA aren't big or intertwined enough to cause mass hysteria across all markets. I honestly believe we were lucky this happened in 2022 and not in 2030. Bloomberg's Matt Levine put it well:

Five years from now, if every cryptocurrency goes to zero … well, I don't know what the next five years will be like, but a plausible story (as of last week anyway!) is that there will be continuing integration of crypto into the real economy. More crypto companies will be big and important and intertwined with other companies; their stock will be in the indexes and they will borrow money from banks and use their own money to finance real businesses. ... Crypto platforms will be used for real economic activity; ordinary people will invest their savings in those platforms, and those investments will be used to finance real, non-crypto business activity.

Spot on. Even if you're like me, a bitcoin maximalist praying for the day where we go back to just one cryptocurrency, you have to admit that we are going to see more crypto in more industries in the short to medium term. Except next time an undercollateralized, algorithmic stablecoin fails, it's not going to be $40 billion of lost value. It might be $400 billion. That could be catastrophic. We should look to avoid that scenario at all costs.

What else did we learn?

On the bright side, somehow bitcoin didn't completely collapse. Over 80,000 BTC from that almost $4 billion treasury was potentially sold (we can't yet confirm if the bitcoin was actually sold, but it was sent to exchanges) during the mad dash to get UST back to $1. That caused a price reaction, sure, but then again, the broader crypto market sold off because bad things were happening to a big crypto project (LUNA was once the 10th most valuable cryptocurrency). Add on the tenuous macroeconomic environment and general risk-off sentiment in the market, and it feels almost impossible that bitcoin still boasts a market cap of over $500 billion.

I think we are numb to these large numbers given the unprecedented bull market of the last 13 years, and so this bears repeating. Bitcoin was a worthless, purely peer-to-peer version of electronic cash created by an unknown person in 2009. No big company or government put marketing, research or legal dollars behind it, and yet it is now a serious macro asset that important politicians and financiers feel the need to comment on.

A serious macro asset that can take huge swathes of selling volume and still … not … go … away. Bitcoin is here to stay. So is crypto. As long as we learn from this, that can be a good thing.

But if history is any indication, we still need to ensure that overconfidence doesn't get the best of "future us."

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Takeaways

Germany published a nationwide crypto tax guide for the first time.

TAKEAWAY: Germany's federal finance ministry issued guidance on the income tax treatment of crypto, the first nationwide instructions on topics including mining, staking, lending, hard forks and airdrops. The guidance indicated that selling BTC and ETH after holding them for one year will be tax free. Moreover, the one-year holding period to be exempt from taxes applies even to cryptocurrencies that have been lent out or used for staking. Read more here.

Sam Bankman-Fried bought a 7.6% stake in Robinhood Markets.

TAKEAWAY: According to a Securities and Exchange Commission filing on May 2, Sam Bankman-Fried, CEO of the FTX crypto exchange, bought 56 million shares of the popular trading app worth roughly $482 million. In response to the news of the investment, Robinhood's communications team said in a tweet, "We're doubling down on creating a multi-generational company where customers can build wealth for their generations." Read more here.

Nubank, Brazil's largest digital bank, has allowed BTC and ETH trading.

TAKEAWAY: On May 11, Nubank announced its customers will have the option to buy and sell bitcoin and ether. David Velez, Nubank's CEO and co-founder, said, "There is no doubt that crypto is a growing trend in Latin America, one that we have been following closely and believe will have a transformational impact on the region…" According to its 2021 annual report, Nubank has 53.9 million users in Brazil, Mexico and Colombia and generated $1.7 billion in revenue. Read more here.

Binance and OKX to halt trading of Terra's LUNA and UST.

TAKEAWAY: After UST lost its peg to the U.S. dollar and LUNA dropped more than 99%, Binance decided to suspend spot trading for LUNA and UST, while OKX decided not only to end spot listings but also to delist margin and borrowing services for Terra ecosystem tokens. On May 13 in a Twitter thread, Binance CEO Changpeng "CZ" Zhao indicated that the decision to suspend trading was to protect users who were unaware of the large amounts of newly minted LUNA outside of the exchange. Read more here.

UST wasn't Do Kwon's first failed stablecoin attempt.

TAKEAWAY: Do Kwon, CEO of Terraform Labs, was one of the pseudonymous co-founders behind the failed algorithmic stablecoin basis cash. Launched on the Ethereum blockchain, Basis Cash at its peak in February 2021 had a total value locked of $174 million, but it never achieved its target of dollar parity, sinking below $1 in early 2021. Hyungsuk Kang, a former engineer at Terraform Labs, said Basis Cash was a side project for some of Terra's early creators, including himself and Kwon. Read more here.

– Sage D. Young

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