Capitalism at Work

IN THIS PUBLICATION:

• Whilst painful, the current correction within crypto assets is a great example of capitalism at work without the manipulation of Central Banks.

• The collapse of UST and LUNA led to more than $50 billion worth of investors’ money being lost in a matter of days.

• Despite all this turbulence, the percentage of Bitcoin (out of the total supply outstanding) held for longer than one year within the same address is now the highest ever.

Capitalism at Work

You’ve probably noticed, but if not, the YTD performance across crypto assets has been poor, to say the least. BTC and ETH are down c. 60% from their all-time highs set last November, and altcoins are down, on average, by 80%. In part, this is explained by the extremely challenging macro set-up (hawkish Fed and high inflation) that is currently driving the S&P 500 to its worst start to a year since 1939 and the NASDAQ down more than 25%.

Besides macro, crypto-native stories have also been adding stress to the sector. The overarching concern about crypto being nothing more than a liquidity bubble / Ponzi scheme tends to increase when large endogenous events take place. So, it’s no surprise that sentiment is down as we just saw $50 billion of value, held within projects backed by the human and investment capital of some of the smartest investors in the industry, evaporate in a matter of days (more on UST/LUNA below).

Worrying about these events is both fair and healthy, and it helps us (1) remain grounded and humble and (2) learn what works and what doesn’t.

There are some thoughts that have been going through my mind lately that I think matter within the context of the price action of all asset classes recently, but especially crypto:

• We’re currently witnessing capitalism at work. Given that since the Great Financial Crisis markets have generally moved one way (up), we tend to forget that whilst capitalism initially channels resources towards the most interesting ideas, it ultimately only rewards those that tend to be most resilient across multiple cycles.

• The cycles of boom and bust are as old as memory and are a perk, not a bug, of capitalism. Crashes happen when society finally determines it does not actually want to accept some of the ‘new ideas’ that the market was once so optimistic about (.com bubble).

• These crashes are necessary for progress to materialize through what Schumpeter called Creative Destruction, which, in his words, is the “process of industrial mutation that continuously revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”

• We’ve forgotten that cycles also have “busts” because Central Banks and Governments have backstopped the market at every sign of material weakness for the better part of the last two decades, driving a culture of “buying the dip”, “stocks only go up”, and reckless behavior from retail investors (from the GameStop saga to $DOGE), institutional investors (Melvin Capital, SoftBank), and corporations (debt-driven stock buybacks, balance sheet mismanagement).

• Without a doubt, there’s been excess capital floating around, and a large part of it has likely been channelled into crypto projects, especially as venture capital tends to receive a large portion of incremental liquidity, meaning that general partners will need to put that capital to work. But now that excess capital is drying up, it’s only normal that we’re seeing the broader tech market, as well as crypto, correcting.

• Ultimately, during these crashes, what we see is ownership of crypto assets moving from weak hands (usually short-term speculative investors) to strong hands (long-term holders with a fundamental view of the asset), until a new equilibrium between supply and demand is found (in this case, until we find a market bottom).

• In fact, long-term holders of Bitcoin have not been selling, with only 2% of daily transaction volume being Bitcoins that have been held in a certain address for more than a year, despite the most recent price performance registering some of the largest losses (in absolute dollar terms) ever.

I don’t know where that bottom is, and for now, it does seem that investors have been eager to sell. From NYDIG on May 19^th :

• The NYDIG trading desk had the highest spot volumes of the year last week, up 259% from its weekly average this year. Most of these volumes (71%) came from clients looking to sell. Investors were nervous going into the week as traders started de-risking as early as last weekend when bitcoin broke below $35K.

What’s most important to stress, however, in my opinion, is that when there is no Central Bank to backstop the market, the “bust” part of cycles always ends up happening, and as we’ve said, for a good reason. Additionally, in markets like crypto, we have daily prices for venture capital like projects, which is why cycles tend to be so brutal, both on the upside as well as the downside (can you imagine if start-ups were quoted in the stock market? How wild would their share price movements be? Well, that’s basically crypto).

That was a long-winded way of saying that these corrections not only need to happen but also represent what capitalism is supposed to do - bad hands get flushed out, good hands get a gut punch but will recover and likely come back stronger. Regardless of the sector, corrections are painful, and they have the tendency to feed off of themselves until a true bottom is found… so it’s important to take a step back, understand your risk tolerance, and act accordingly.

Terra and Luna's Legacy

The meltdown of both TerraUSD (UST) and Terra (LUNA) has been widely covered but we thought that an easy to understand explanation of cause and effect could be useful to those who didn’t follow the drama by the hour.

As a reminder:

• LUNA is a protocol that allows for the issuance of stablecoins, with UST being the largest that was built on it (becoming the third-largest stablecoin within crypto).

• Stablecoins matter in the world of crypto because, in theory, they provide price stability. They’re pegged, either to fiat currencies (like the US Dollar) or to cryptos (like ETH), and those pegs are maintained by holding a reserve of those currencies/cryptos, or via algorithmic stabilizers (buying and selling of the underlying to hold the peg).

• Having price-stable cryptos matters because it allows investors to get in and out of crypto assets without the requirement of taking money out of the crypto universe (which makes everything more efficient). Stablecoins try, in part, to replicate the role of fiat in traditional financial markets, and are thus a vital technology to continue to promote adoption.

• UST is an algorithmic stablecoin, which differs from the other types of stablecoins as its price stability is held by math wizardry rather than the backing of some reserve asset.

• The math wizardry that ensured that UST’s price stability mechanism was on point was checked by some of the smartest minds within the industry (famously, Mike Novogratz tattooed LUNA on his left harm… but we’ve made worst decisions than that and are in no positions to make fun of him), meaning its collapse was at no point obvious to the majority of market participants (although some participants were on top of it all before it actually happened). This is THE primary danger of choosing your ‘tribe’ and surrounding yourself with an echo chamber.

Why did it fail?

• Without getting too tangled up in the workings of the protocol, the main reason why LUNA (the protocol) and UST (the stablecoin) collapsed mostly due to major withdrawal of USTs from a DeFi project called Anchor (there is an amazing thread written by Jordi Alexander that blames the asset/liabilities mismatch inherent within the workings of the protocol as the real reason for the collapse, with the Anchor protocol only being an amplifier of that – this is a recommended reading for those with a little more knowledge of the space).

• Anchor was LUNA’s most popular project, and it allowed holders of UST (the stablecoin) to earn a steady yield of 19.6% on their deposits (although we're not comparing apples to apples, current US savings account yields are currently 0.07%). The project alone constituted over half of all DeFi activity happening within the Terra ecosystem.

• Given that the yield could exclusively be earned on USTs, it led investors to buy UST (driving demand higher) and stake (i.e. deposit) it on Anchor in order to earn the outsized yield. Analogously, this would be like a new country issuing a new currency, saying that that currency has a flat exchange rate with US Dollars, and allowing investors to deposit that currency in a bank within that country that earns them almost 20% interest.

• Obviously, the yield was so enticing that it ended up becoming the main driver of UST demand (more than 70% of all USTs in circulation were deposited in Anchor).

• Demand for UST drove the price of the LUNA token higher given that, for every UST created, $1 worth of LUNA was burned (i.e. destroyed), and vice-versa – you can read more about the workings of this here.

• Given the high yield, Anchor found itself in a position where it had four lenders (looking for the 20% yield) for every borrower (wanting to lend from Anchor). Following up on our analogy above, this would imply that the bank that’s offering the 20% yield on deposits is attracting many more lenders than borrowers, which poses an existential threat to its business (banks make money through the difference between the interest rate they charge borrowers and the rate they pay lenders/depositors; if they’re paying lenders more than they’re charging borrowers, they don’t have a business).

• This led to a proposal being passed at the end of March which made the interest rate variable instead of fixed, potentially changing it by 1.5% every month (up or down) based on Anchor’s reserves (deposits from lenders and borrowings from borrowers). Given the imbalance between lenders and borrowers, this likely meant that the interest rate was going to fall by 1.5% every month until an equilibrium interest rate where borrowers outnumbered lenders, thus allowing Anchor (which, in the example is the bank) to have a viable business, and Mike’s tattoo to still carry [positive] meaning.

Whilst the exact catalyst is not super clear (although reliable sources point to the $150 million worth of UST being withdrawn from the Curve Wormhole pool followed by a $350 million sale of UST for USDC on Curve [Tim’s note: don’t worry, I also have no idea what the Curve Wormhole is and I’m not even going to ask Diego to explain further.]), what matters and followed was nothing short of a classic Tarantino shootout scene:

• Anchor’s UST deposits plunged by more than 93%, fear spread amongst the community, UST lost its peg (i.e. its math wizardry stopped making it a stable coin) driving it into a “death spiral” which eventually evaporated more than $50 billion worth of investors’ money in a matter of days. Maybe that’s why Mike’s wolf was howling… pain.

• The workings of the above paragraph are a bit more technical, but can be found here.

What matters most is that we’ve seen a project collapse on the back of unsustainable high rewards (in this case, the Anchor yield) being offered in order to drive adoption (in this case, demand for UST) and could only be temporary. Once they were forecasted to change, and coupled with some other more technical events, this led to a loss of demand for UST and a capitulation of trust within the protocol.

Fear spread out to other stablecoins as well, with c. $5.5 billion worth of outflows following the event (and a brief de-pegging of Tether as well). Whilst notable, that outflow only represents less than 4% of total stablecoin assets.

Another consequence of this has been a small rotation from Tether (who’s been opaque about the reserve assets that actually back its stablecoin) to USD Coin (pegged to the USD).

UST was nowhere near Tether in terms of importance for the crypto universe ($500 million of daily trading volume for UST vs $62 billion for Tether), and as such its collapse has not posed a systemic risk. There are important lessons to learn from this, but the fact that there was no central institution to backstop the fallout of a fragile project should be, in part, celebrated as allowing for capitalism to ensure that only the most resilient projects survive across cycles. This should help us, in the long run, have a more sustainable and efficient crypto infrastructure.

Three Important Charts

• Bitcoin investors aren’t really selling, and the percentage of Bitcoins held for longer than one year is now the highest ever.

• Exchange balances saw a spike recently, although that was driven by the Luna Foundation Guard (the foundation supporting the Terra ecosystem) moving c. 80,000 Bitcoins it held in its reserves to exchanges to sell in an attempt to protect the Terra peg (this, as we know, was unsuccessful). Overall, exchange balances continue to trend lower.

• The top 5 protocols within Decentralized finance (DeFi) have seen Total Value Locked (TVL) – the most important metric that highlights the interest and adoption of DeFi protocols – decrease by almost 50%. This reflects both the collapse of the value of some collateral, as well as fading interest in higher-risk segment of the crypto market. Again, we’re seeing Creative Destruction at play here, and we’ve probably not seen the whole of it yet.

Thanks for reading through!

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