Scepticism pays during "crypto's lehman's"
Crypto suffered a Lehman’s-esque event in May 2022 as UST and the Luna ecosystem unravelled in spectacular fashion. The collapse highlights the ever present risk in crypto and the importance of Sound Money’s conservative approach in the face of “too good to be true” investment opportunities. I am optimistic on stablecoins but Luna’s UST had the opposite impact to what I expected, which provides a great opportunity to reflect on the future. TLDR: Conservatism pays in crypto winters as creative destruction generates stronger long-term foundation.
Summary & Conclusions
Positive on stablecoins despite USTs failure.
UST and Luna $50bn reflexive unwind is the biggest failure in crypto history.
Crypto contagion post Luna as retail, funds and BTC are all impacted.
Regulation probability increases after false advertising of crypto risks.
Creative destruction within crypto is one of its biggest strengths.
Bitcoin remains as secure as ever despite the volatility.
Indiscriminate selling of BTC and ETH tell us that we are closer to the bottom of this cycle than top.
Sound Money Capital conservatism is justified as crypto markets unravel vs. BTC.
Commitment to deeper monitoring of wider crypto risks.
I recently visited Yosemite National Park and I was astounded by the giant sequoias. It boggles the mind to know that some of these trees have lived for thousands of years. That means they were standing before Moses parted the Red Sea. And it shows! The black burn scars right up the tree trunks indicate that these giants have lived through hairy times. The forest is resilient to nature elements. Winds blow down weak trees, fire burns the brush and rains turn ash into nutrients for new plants to grow. Investors have long used this same analogy with financial markets. Recessions and market crashes rid us weak companies, sowing the seeds of a more productive future. The trouble is, traditional financial markets rarely experience the full force of nature, because of repeated monetary and fiscal intervention. Until crypto! No regulator is trying to save us… I hope it stays that way! As challenging as current conditions may be, this is the right lense through to which to view current market conditions.
all Stablecoins are not created equal
Governments’ “war on cash” is an attempt to remove bearer assets, over which they have less control, from circulation. But freedom is a human right so it is unsurprising that the market has found alternatives. Stablecoins are one such alternative. I am optimistic about stablecoins because US dollars on crypto payment rails with instant settlement are useful. I view stablecoins as crypto’s Pandora’s box, sucking investors into crypto markers where they will learn more about the exciting decentralised technologies. I stand by these views. I continue to think that centralised collateralised stablecoins, like USDC, USDT, GUSD, etc will grow over the coming years.
I did not write much about algorithmic stablecoins in the past because they had not been widely used and they are riskier than the centralised and collaterlised versions. Conditions changed in late 2021 as UST grew into a $18bn market cap coin, bringing with it risks to the crypto ecosystem.
Background: Reflexive growth unravels
UST is an algorithmic stablecoin and a key part of the Luna ecosystem. It offered unsustainably high yields (20%) to grow market share. Unlike most other stablecoins, UST was pegged rather than backed by underlying USD assets. I.E. it is uncollaterlised. The credibility of the peg is dependent on the credibility of the Luna ecosystem to fulfill on the commitment to transfer 1UST for $1 worth of Luna.
I was no Nostradamus. I did not predict the Luna crash, but I was sceptical as I dug into the weeds in recent months. This is what I said about it on 2 April 2022:
This sounds great in theory, but there are potential issues and some of these (algorithmic) stablecoins have crashed in the past. Essentially, the system is reliant on Luna maintaining its value and being able to keep the peg. If Luna loses value for an extended period of time and investors question the viability of the whole project, a self-fulfilling prophecy emerges where USDT will very likely trade at a discount and arbitragers will consistently deplete Luna of its reserves until the whole project fails.
All seemed fine for 6 to 12 months when global liquidity in traditional financial markets and crypto was abundant. While liquidity is flush, all sorts of investments seem like a good idea. At the extreme, with zero interest rates, what investment is not “worth a punt”?
During this time UST adoption supported the price of Luna in a reflexive manner, keeping the market cap of Luna elevated relative to UST. Luna benefited from the rise in UST, which in turn enhanced the credibility of UST, leading to a further rise in UST demand. An elevated ratio between Luna and UST market cap created the suggestion that Luna would be able to cover the value locked into UST.
However, when global liquidity is withdrawn, it is like the tide being withdrawn in the ocean, exposing the shoreline. We get to see who has their pants on.
When the UST/USD peg was tested the reflexivity worked in the other direction. USTs were transferred for Luna and sold repeatedly, pushing the price of Luna lower and lower. And once the UST peg fell, investors pulled capital from UST en masse, leading to a form of a bank run. From a combined market cap of almost $50bn at the start of May, the project unraveled in less than a week.
Luna was not systemic, but it was getting THERE
The community is trying to reboot the project in another guise, but it is highly unlikely it will get anywhere close to its previous glory. Serious capital allocators will not touch this project with a 10-foot barge poll because it is much easier to focus on newer untarnished protocols. For all intents and purposes, Terra Luna is a failure and it is one of the biggest failures in crypto history. Luna and UST were both in the top10 by market capitalization at the start of May and have effectively fallen to zero now. This has sent shockwaves through the industry. So, what are the implications?
crypto Contagion
Crypto markets were already weak leading into May 2022, largely due to tough macro economic conditions placing pressure on risk appetite. The unravelling of Luna and UST caused contagion in crypto markets.
Facing large losses in UST and Luna, investors and fund managers were forced to derisk across crypto markets,
Luna held bitcoin, ETH and AVAX in reserve and were forced to indiscriminately sell these positions in an effort to protect the peg causing further weakness,
Fear gripped markets as many people fled UST and Luna and then questioned the viability of other projects. For example, tether briefly depegged.
2. burnt Retail puts the pressure on regulators
Large investor losses and the failure of a large project are unfortunate. They negatively impact risk appetite and could hamper retail interest in this market, which heightens the risk of a more prolonged bear market.
Regulators could step in to provide clarity in stablecoins over the coming quarters in an attempt to protect retail participants. I am spectical that regulation will achieve its intended goals, but that is a topic for another conversation. For now, the optics are not good and I can understand why some naysayers view crypto as a scam if they focus on projects like Luna.
One of the biggest shames of the UST and Luna debacle is that some platforms advertised UST as a low risk investment because it was pegged to the USD. No investment is without risk! Anybody who says so is misinforming you of the risks. I was angry to learn that Binance, one of the world’s largest crypto exchanges was advertising an investment into UST as “safe & happy”. This is almost comical but in truth, it is criminal. Regulators ears will surely perk up following the UST unwind.
It is possible that regulators could overreach when they finally make a pronouncement on regulation, but I still suspect that net-net stablecoin regulation will be a good outcome. I do not think the US government is going to turn away from the incredibly useful centralised, private, US-based stablecoin market, which they could very easily regulate. And, just in case you are pondering the risks of an outright bitcoin ban, I think the prospects of that outcome is somewhere between very unlikely and impossible (follow link for more details).
3. Creative destruction is one of the most powerful aspects of crypto
The failure of experimental stablecoins says nothing about the success of bitcoin, which continues to operate seamlessly. In fact, bitcoin's resilience through this period of market turmoil is just another feather in its cap. Bitcoin has fallen >90% numerous times in its history and has been declared dead each and every time. Bitcoin has it recovered time and time again, and the downside volatility is declining because an increasing number of investors appreciate its store of value qualities and hold it long-term. Approximately 80K bitcoin ($3bn worth) were indiscriminately absorbed into the market as Luna suddenly sold all the collateral they had bought in previous weeks. Indiscriminate selling of BTC and ETH also tell us that we are closer to the bottom of this cycle than the end.
While painful, failure cleanses crypto, making it stronger long term. Schumpeter’s ‘creative destruction’ is at work. Capital will be reallocated towards more productive usages and lessons will strengthen the collective knowledge in the ecosystem. The ability to experience both success and failure is one of the characteristics that distinguishes crypto from trad-fi where policymakers save dying companies to avoid political backlash. Crypto will rise from its Lehman’s moment without any government support, and it will be far stronger for it.
4. Conservativism is a double-edged sword
Sound Money Capital is justified in our cautious approach over the past 6 months. I have long been sceptical of most altcoin projects because I worry that many of them are not as de-centralised as they should be. I am also concerned that protocol risk is significant as many of these projects endeavour to create exciting but complicated user features on top of live financial assets. Additionally, we continue to think that digital scarcity remains the most important and underappreciated innovation in crypto so there is good reason to focus on bitcoin.
Rather than focus on altcoins, historically we have taken our high-beta risk through ethereum because it is safer relative to newer, smaller and less de-centralised alternatives. I have come under pressure for this approach because there are times when these higher beta projects outperform handsomely. However, there are clear risks when exposing investors to these protocols and those risks are currently surfacing. I am proud to be protecting client capital from the current landmines in crypto markets.
Despite the justification for our conservatism, it would be remiss of me ignore the other side to this coin. Less focus on smaller altcoins implies that my negative Luna views were not as bold as they could have been. This presents an opportunity for both returns but also investor protection. Going forward, I will redouble my efforts on the altcoin market to provide this value to clients, prospects and the broader community. It is a tragedy to witness the way in which friends and associates had their capital “rugged” (pulled out from under the feet) like this. I believe I could do more to address it, so I am looking forward to that as Sound Money evolves over the coming years.
Crypto is a bastion of free markets without centralised intervention. The full might of market shocks are felt and many projects do not make it. UST resembles the brush being burnt away in the forest, creating nutrients for new plants to grow in the years ahead. Bitcoin resembles the giant sequoias standing the test of time. Sound Money Capital’s conservatism allows us to protect client capital through these troubled times and I am looking forward to enhancing that value add over the coming years as we glean all there is to offer in these fascinating markets.
