The bottom fell out from one of crypto’s fastest growing blockchains, LUNA, which promised to succeed where bitcoin failed. Its predictable collapse reverberated across the entire crypto market and is forcing investors to pick up the pieces.
Crypto’s history has been defined by five resets. The first came in 2014 when what was basically the only bitcoin exchange in the world, Mt. Gox, imploded following a nearly half-billion-dollar hack. The second, in 2016, was The DAO Hack, when an attacker tricked a smart contract into giving away $60 million worth of ethereum, worth $8 billion today. The third, in January 2018, occurred when the ICO bubble popped, starting a year-long decline, wiping out 60% of the crypto market or more than $700 million mostly in the form of worthless junk tokens. The fourth took place in March 2020 when crypto lost 40% of its value along with most other global financial markets.
Each reset not only led to price-market capitalization increases, they also cleared the way for rapid innovation. The two biggest exchanges in the U.S., Coinbase and Kraken, were developed out of the ashes of Mt. Gox’s implosion because their CEOs knew that people needed trustworthy places to buy bitcoin. The DAO’s implosion and the ICO crash set the groundwork for the growth of DeFi and the popularity of DAOs today, and it’s hard to imagine companies like Tesla buying bitcoin before Covid.
The fifth reset started last week. It may shape up to be the most important yet. This time the trillion-dollar market collapse was caused by a steep selloff in risky assets and the sudden evaporation of a $40 billion digital token called LUNA that backed the $16 billion stablecoin TerraUSD (UST). In contrast to the free-floating Luna tokens, each UST was designed to be worth a single U.S. dollar. A perfect storm of greed and immature technology led to the stablecoin losing its peg, and between May 7 and May 12, about $56 billion went poof.
Severe bear market crashes in the nascent market for cryptocurrencies have become almost commonplace. Consider that in the last century the U.S. stock market has only experienced five bear markets in which stocks declined more than 30%. Bitcoin is only 12 years old and the cryptocurrency market has had as many severe crashes.
At its most basic level, the most recent crypto collapse is another reminder of how get-rich-quick schemes can overwhelm common sense. The loss of so much capital is forcing the industry to reckon with the entire concept of leverage in cryptocurrency markets, forcing it to be honest with itself as to whether innovation is just dressed-up leverage and could be the death knell for an entire category of asset, called algorithmic stablecoins.
“Leverage can never make a bad investment good, but it can, and often does, make a good investment bad,” says Mark Yusko, founder of Morgan Creek, an institutional and family investment advisory firm. “And so that’s what we’re seeing in the past couple of months, particularly in the past week, just an unwinding of ridiculous levels of leverage. And in the case of the Terra problem from this past week—the Luna problem—it’s just a bad idea, bad structure. You can’t collateralize an asset, that’s supposed to be stable, with an unstable asset.”
The South Korea-based Terra Foundation sought to solve this by using an algorithm to replace many of the techniques that give the U.S. dollar its stability. When price goes down, it creates an arbitrage opportunity to trade a UST token worth less than a dollar for $1 worth of Luna. Theoretically. The Luna blockchain also hosted a DeFi lending protocol, called Anchor, which paid depositors 20% yields.
For context, the Great Recession of 2008 was triggered by a housing bubble in which subprime loans were packaged and sold as new securities with pristine ratings. Their collapse triggered a loss of confidence in the market and a domino effect on financial institutions with potential exposure losses. Similarly, stablecoin TerraUSD was thought to be foolproof—until its collapse. Losses were amplified because it was backed by software few understood but piled into because it promised quick riches, says Caitlin Long, a former Morgan Stanley managing director, now building Custodia, a Wyoming-based crypto bank designed from the ground up to make money without leverage. “So much of what was cloaked as innovation was in fact leverage dressed up as something else,” she says.
One of Terra’s most high-profile investors is Lightspeed, the Menlo Park-based venture firm with $10 billion in assets under management, according to Pitchbook. They’re also one of the earliest VCs to back crypto, investing in Ripple in 2013 and recently expanding their total crypto portfolio to $600 million. A spokesperson for the company struck a defiant tone about the fallout surrounding what will likely go down as one of their most notorious investments. “We see this as a computing paradigm shift that is bigger than the ebb and flow of the short-term price of Bitcoin,” the spokesperson said. “We are doubling down, specifically in infrastructure, DeFi and emerging use cases.”
The co-founder of another big backer, Su Zhu of Three Arrows Capital, said on Twitter that LUNA’s downfall was rooted in its execution, not its fundamental value proposition. Zhu continues to proudly display the #LUNA hashtag on his Twitter profile.
At least Zhu did not get a Luna tattoo on his arm like Galaxy Digital founder Mike Novogratz, another big backer. There is no word yet on what he plans to do with the ink.
The tragedy here is that while greed was certainly a key part of Luna’s downfall, its creation came from a desire to protect crypto’s decentralized ethos, something that the growing stablecoin industry had actually been abandoning. The two largest stablecoins by market capitalization, Tether and USD Coin, have a combined market capitalization of $126 billion. However, while they operate on blockchains, they are run by highly centralized companies that have at times been very opaque about the assets used to collateralize their versions of digital dollars. Tether has been especially controversial, as it invests 40% of its assets in commercial paper of unknown provenance.
That said, Tether was one of several competitors that seem to have benefited from the Terra failure. The cryptocurrency behind the scenes of the DAI stablecoin, MKR, jumped 38% in the days following the collapse, and while Tether briefly lost its peg, it quickly regained its footing, returning to its status as a relative safe haven. “In the middle of last week, investors were rotating out of Tether to USDC for all their stablecoin needs,” says Raghu Yarlagadda, CEO of FalconX. “USDC was being bought at 2.5 times the normal rate. Toward the end of the week, what was very interesting was people were rotating out of USDC into fiat.”
Perhaps the most disappointed competitor was Dante Disparte, the chief strategy officer at Circle, who claimed that Luna’s downfall reflected poorly on the entire stablecoin industry, referring to the UST as a “stable-in-name-only” token. He claimed that Terra founder Do Kwon’s use of more than $3 billion in crypto collateral exposed the project as a centralized entity operating under a decentralized flag.
“The behavior of Terra and its meltdown really, really, really flew in the face of the argument that Terra was totally decentralized because it took a handful of people and a handful of promissory statements on Twitter to either unravel it or to try to save it,” Disparte says. “And that feels not only centralized, it feels capricious and arbitrary.”
It didn’t help that Luna founder Do Kwon went out of his way to antagonize competitors. In March he said that it was fun, or “entertaining,” to watch projects falter and tweeted that UST would destroy Dai, a similarly constructed stablecoin launched in 2014.
Other observers, such as Yusko and crypto analyst Yassine Elmandjra of Ark Invest, argue that algorithmic stablecoins will never succeed. While most past crypto resets were triggered by technological issues that were solved and implemented by other developers, consensus seems to be forming that the improvement in this instance already exists: fiat-backed stablecoins. “It’s probably a very humbling realization for a lot of the institutional investors and influencers who were pounding the drum on some of the more experimental initiatives that were going on in crypto,” says Elmandjra. “I think the whole concept of algorithmic stable coins as being a promising project can be put to bed.”
The pace and methods by which these questions may be answered will depend on how the market responds to this sudden shock. Crypto has already lost more than $1 trillion in value over the past six months, which has seen bitcoin fall from highs near $70,000 to below $30,000. Adding further urgency is the fact that this could be the first macro crypto bear market where institutions such as Tesla have the asset on their balance sheets. In fact, MicroStrategy, the world’s largest corporate holder of bitcoin, with a stockpile of 129,000 tokens with an average purchase price of $30,700, is now at a loss for the first time ever.
The good news here is that most investors don’t seem to be panicking, which should act as a shock absorber for the market. Ironically, that may be due to the fact that investors were already taking money off the table when Luna and Terra crashed. The industry had “some de-risking in the crypto space even before Terra’s collapse,” says Nikolaos Panigirtzoglou, JPMorgan Chase’s managing director of global markets strategy. “The mean reversion in bitcoin began in October,” meaning that investors started reducing their bets on crypto in late 2021.
The future of these flows will be a useful gauge of investor sentiment.
One other positive piece of news for the crypto market is the widespread belief that the Luna/UST crash will not lead to contagion throughout the crypto ecosystem or bleed into the traditional financial world. In fact, the industry passed a very big test last week when Tether briefly lost its peg on Wednesday morning, dropping to 95 cents before quickly recovering. Yarlagadda says that there were fears among his clients that Tether was being shorted by investors in a deliberate attempt to drive the price down, though those claims were unproven. If Tether were to lose its peg it would be calamitous for the crypto industry and could possibly bleed over into traditional finance as well.
Treasury Secretary Janet Yellen agrees with this sentiment. She told a congressional hearing last week that UST is a unique form of stablecoin that isn’t likely to impact the broader financial world by itself.
It would be nice if this saga served as a cautionary tale of excess and led to more responsible forms of innovation in the crypto industry. One test case would be the novel financial institutions being developed in Wyoming, where Caitlin Long’s Custodia is just one of several would-be banks that are looking to introduce responsible forms of finance by rejecting the rehypothecation of assets— that is, collocating deposits and lending them to debtors. She is even looking to offer a stablecoin of her own.
There’s also been growth in the DeFi space, which has had to deal for years with accusations of being nothing more than Ponzi schemes. It’s trying to become more corporate-friendly. Two leading platforms, AAVE and Compound, have both introduced versions only available to institutions, and Compound’s offering even received a B- rating from Standard & Poor’s. That’s not investment-grade, and the protocol itself only has about $150 million under management, but it’s a step in the right direction.