WTF LFG?...crypto crash explained
Monday, May 9 was a pivotal day in crypto history. I explain what happened and why it's a big deal.
All markets have sold off considerably lately on the backs of rising inflation, rate hikes and looming recession. Monday, May 9, was a bad day…especially for crypto.
UST and LUNA look out of place on the table above. They’re what exacerbated the crypto market gyration on Monday, May 9. UST was the 3rd largest stablecoin and 10th largest cryptocurrency. Stablecoins are digital representations of fiat currency pegged to a specific value. Algorithmic stablecoins use incentive mechanisms to keep their peg. Collateralized stablecoins typically use fiat assets to maintain their peg. LUNA is one part of the algorithmic stablecoin ecosystem of Terra. US Terra (UST) is the stablecoin part. UST is supposed to have a pegged value of US $1. On May 9, that peg broke….badly. UST traded to $0.69.
What happened:
UST started losing its peg over the weekend and collapsed entirely on Monday. It has since recovered but I believe that the damage has been done.
UST and Luna are supposed to work in concert. UST stays pegged at $1 while Luna absorbs the volatility and incentivizes arbitrageurs to monetize a price mismatch to maintain UST’s peg. For example, when UST <$1, say $0.95, arbitrageurs can buy UST at the spot price of $0.95 and redeem it at par value of $1.00 of newly minted LUNA netting the profit of $0.05. Spot buying of UST drives the price back to its $1 peg. Minting of new LUNA increases LUNA supply, which is dilutive for LUNA.
It works until it doesn’t. UST was caught in a stablecoin death spiral:
Demand for UST falls.
LUNA is minted to offset the UST price fall.
LUNA price falls from newly minted LUNAs.
A loss of confidence in the ecosystem causes people to sell.
⟲ back to step 1.
It appears to have been a coordinated attack. Over the weekend one entity sold $285m of UST, which started the depegging, and shorted LUNA. By Monday, people panicked and sold UST. Arbitrageurs didn’t come in because the LUNA price was collapsing. It fell 52%. There was no buying demand for UST to hold its peg. The cycle fed itself.
At its peak last week, the Terra Defi ecosystem TVL was nearly $22 billion. Approximately ⅔ of which was in Anchor. Anchor is a lending protocol developed by Terraform Labs, who also developed UST and LUNA. Lenders deposit their UST and get 20% APY. It’s unclear how that 20% was generated. The suspicion is that it was funded through Terraform Labs’ coffers and done to drive demand for UST, which subsequently increased the price of LUNA, which Terraform Labs and its employees own ~30% of LUNA outstanding worth $12 billion at LUNA’s peak market cap of $40 billion. The Terra Defi ecosystem TVL has now collapsed to $7.4 billion.
Why it’s a big deal:
1. Contagion
The de-pegging of UST forced LFG to deplete its entire $4 billion of reserves to support the UST peg. At least $3 billion of the reserves were in bitcoin, which was either sold or the market feared it being sold. On a typical day, bitcoin trades $4-8 billion worth of volume. A ~$3 billion selling pressure is huge, that sent bitcoin -12% to $30,000. Then rumors swirled that Microstrategy, the largest holder of bitcoin with 128,219 bitcoin (worth $3.9 billion) at an average cost of ~$30k, could be forced to sell to cover a margin loan. Surprisingly, bitcoin didn’t fall even more.
LFG, the Luna Foundation Guard, was set up by Terraform Labs to oversee UST’s peg. In the last few months it acquired $3 billion of bitcoin to protect UST against de-pegging. The reason is that in a death spiral instead of minting more LUNA to save UST, it could swap UST for bitcoin.
The widespread risk caused all crypto to sell off as people panicked.
2. Losing its peg completely undermines UST
UST is not the first algorithmic stablecoin to lose its peg. BAC and AMPL lost theirs but their market caps were in the hundreds of millions. UST market cap neared $19 billion. If UST can’t be relied on to keep its peg, then it’s not useful.
3. Stablecoins are killer apps for DeFi
Stablecoins are necessary because they provide instantaneous settlement at low cost. That is useful for traders and payment networks. Since crypto markets trade 24/7/365, traders need a digital equivalent of riskless cash (ie stablecoins) when they want to take risk off. It is too costly and time consuming to switch to fiat. Stablecoins could also provide new payment rails for fast low cost global transfers, which could replace the old, costly and slow payment rails used to transfer $650 billion annually around the world.
4. Algorithmic stablecoins promised rapid growth
Collateralized stablecoins represent ~80% of the $170 billion market cap of all stablecoins. But, unlike algorithmic stablecoins, collateralized stablecoins require capital to grow because roughly $1 of USD, or its equivalent, is set aside for every $1 worth of stablecoin. The growth of collateralized stablecoins was no match for UST’s meteoric growth. UST grew from $180 million market cap in January 2020 to $19 billion market cap in May 2022.
During that same period LUNA’s market cap went from $300 million to a peak of $41 billion, a 137x return.
The death spiral challenge was well known but ignored because so much money was being made and the market hoped that algorithmic stablecoins could turbocharge crypto adoption.
Where do we go from here?
I suspect some of the following will happen:
Slows overall crypto adoption - Algorithmic stablecoins were the emerging killer app that was driving crypto adoption. That’s no longer the case, which will slow overall crypto adoption. The ultimate adoption may be the same, but it will take longer to get there.
UST market cap shrinks - Trust has been lost. More money is coming out, not going in.
Collateralized stablecoins and CBDC benefit - The need for stablecoins remains. The UST de-peg will drive adoption of collateralized stablecoins and potentially Central Bank Digital Coins.
Regulation will increase - The breach in trust of this scale will be used to enact regulation. Regulation for the industry is a necessary and good thing. But it’s a shame it came at the hand of UST de-peg.
Wash out - A failure of this size will wash out many investors. I don’t expect a rapid price recovery for crypto.
The stablecoin conflict
Stablecoins are a necessity for crypto. They provide a “safe” store of value to facilitate low cost instantly settled transactions and a way to keep assets on chain with no (supposedly) volatility. However, stablecoins also undermine the US dollar. Janet Yellen and Fed have been outspoken on their concerns of stablecoin and the need for regulation. If the world moves toward settling transactions with a stablecoin instead of USD, the US dollar would no longer be the reserve currency of the world.
The US government will not let that happen. There is too much at stake. The US share of world GDP is 20%, yet 60% of all international reserves (cash held by non-US entities) is denominated in USD. The world operates on USD. All foreign countries and companies need USD to operate, which is why $7 trillion, or 33%, of US Treasuries are owned by foreign entities. Roughly $1 of every $3 of debt issued by the US government is bought by foreigners. No other country in the world benefits from that kind of demand for its debt. That’s why the US is able to fund itself better than any other country. The US government is not going to give that up. Doing so would undermine the US hegemony. Any stablecoin that even moderately threatens the position of USD as the global reserve currency will be regulated regardless of the party in power.
We should get used to a world of regulated stablecoins. It’s the only way forward.