Crypto’s Great Reset

Five resets have defined Crypto’s history. The first was in 2014, when Mt. Gox, the world’s essentially only bitcoin exchange, fell after a roughly half-billion-dollar attack. The DAO Hack, which occurred in 2016, involved an attacker tricking a smart contract into giving away $60 million worth of Ethereum, which is now worth $8 billion. The third came in January 2018, when the ICO bubble burst, triggering a year-long slide that saw the crypto market lose 60% of its value, or $700 million, primarily in the form of worthless garbage tokens. The fourth occurred in March 2020, when crypto, like most other global financial markets, lost 40% of its value.

Each reset not only increased price-market capitalization but also made room for quick development. Coinbase and Kraken, the two largest exchanges in the United States, sprung from the ashes of Mt. Gox’s collapse because their CEOs saw that users needed safe venues to acquire bitcoin. The implosion of the DAO and the ICO crash laid the framework for today’s expansion of DeFi and the popularity of DAOs.

Last week, the fifth reset began. It has the potential to be the most significant yet. The trillion-dollar market crash this time was triggered by a sharp selloff in risky assets and the abrupt disappearance of LUNA, a $40 billion digital token that backed the $16 billion stablecoin TerraUSD (UST). Unlike the free-floating Luna tokens, each UST was created to be valued at exactly one dollar. The stablecoin lost its peg due to a perfect storm of greed and inadequate technology, and around $56 billion was lost between May 7 and May 12.

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. Dramatic bear market crashes have become all too regular in the embryonic cryptocurrency market. Consider that the US stock market has only had five bear markets in the last century, with stocks falling by more than 30%.

“Leverage can never make a bad investment good, but it can, and often does, make a good investment bad,” argues Mark Yusko, founder of Morgan Creek, an institutional and family investment advising 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 Terra Foundation, based in South Korea, attempted to address this by developing an algorithm that would replace many of the procedures that keep the US dollar stable. When the price falls, an arbitrage opportunity to swap a UST token worth less than a dollar for one dollar of Luna arises. Theoretically.

To put things in perspective, the Great Recession of 2008 was sparked by a housing bubble in which subprime loans were packaged and offered as fresh securities with perfect ratings. Their failure resulted in a loss of market confidence and a domino effect on financial institutions, resulting in potential exposure losses. Similarly, until its demise, stablecoin TerraUSD was supposed to be impregnable. According to Caitlin Long, a former Morgan Stanley managing director who is now building Custodia, a Wyoming-based crypto bank designed from the ground up to make money without leverage, losses were amplified because it was backed by software few understood but piled into because it promised quick riches. So much of what was cloaked as innovation was in fact leverage dressed up as something else,” she explains.

Lightspeed, a Menlo Park-based venture firm with $10 billion in assets under management, and one of Terra’s most prominent investors. Lightspeed is also one of the first venture capital firms to back the cryptocurrency, having invested in Ripple in 2013 and recently increasing their entire crypto holdings to $600 million. A firm spokeswoman sounded defiant when asked about the impact of what will undoubtedly be one of their most infamous 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 representative explained. “We are doubling down, specifically in infrastructure, DeFi, and emerging use cases.”

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Su Zhu, of Three Arrows Capital, another major supporter, remarked on Twitter that LUNA’s failure was due to its execution rather than its basic value proposition. On his Twitter profile, Zhu continues to proudly flaunt the #LUNA hashtag. At the very least, unlike Galaxy Digital founder Mike Novogratz, another major donor, Zhu did not have a Luna tattoo on his arm. He hasn’t said what he wants to do with the ink yet.

The reality is that, while greed played a role in Luna’s demise, its inception was motivated by a wish to preserve crypto’s decentralized ethos, which the burgeoning stablecoin industry had been forsaking. Tether and USD Coin, are the two largest stablecoins by market capitalization, with a combined market capitalization of $126 billion. While they operate on blockchains, they are managed by highly centralized organizations that have been notoriously opaque about the assets used to back their digital currencies. Tether has sparked controversy since it invests 40% of its assets on commercial paper from unknown sources.

Tether was, however, one of the numerous competitors who appeared to benefit from Terra’s demise. In the days following the crash, MKR, the cryptocurrency that underpins the DAI stablecoin, rose 38 percent, and while Tether briefly lost its peg, it swiftly regained its footing, reverting to its role as a relatively 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.”

Dante Disparte, the chief strategy officer at Circle, was perhaps the most disappointed rival, claiming that Luna’s demise reflected poorly on the entire stablecoin sector, referring to the UST as a “stable-in-name-only” token. Terra creator Do Kwon’s use of more than $3 billion in crypto collateral, he argued, exposed the enterprise as a centralized corporation 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,” adds Disparte. “And that feels not only centralized, it feels capricious and arbitrary.”

The fact that Luna creator Do Kwon went out of his way to smear competitors didn’t help matters. In March, he stated that watching projects fail was “entertaining,” and that UST would destroy Dai, a similarly built stablecoin established in 2014.

Others, including Yusko and crypto expert Yassine Elmandjra, believe algorithmic stablecoins will never thrive. While most previous crypto resets were caused by technology difficulties that were later resolved and applied by other developers, it appears that the solution, in this case, is already in place: 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,” Elmandjra says. “I think the whole concept of algorithmic stable coins as being a promising project can be put to bed.”

How the market reacts to this abrupt shock will determine how quickly and how these questions are answered. Over the last six months, cryptocurrency has lost more than $1 trillion in value, with bitcoin falling from almost $70,000 to below $30,000. The fact that this could be the first macro crypto bear market in which institutions like Tesla have the asset on their balance sheets adds to the urgency. MicroStrategy, the world’s largest corporate bitcoin holder, is suddenly losing money for the first time ever, with a stockpile of 129,000 tokens at an average purchase price of $30,700.

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The good news is that most investors don’t appear to be panicked, which should help to cushion the market’s fall. Ironically, this could be because investors had already begun to withdraw funds when Luna and Terra plummeted. According to Nikolaos Panigirtzoglou, managing director of global markets strategy at JPMorgan Chase, the industry saw “some de-risking in the crypto area even before Terra’s collapse.” “Bitcoin’s mean reversion began in October,” implying that investors began to reduce their crypto investments in late 2021. The direction of these flows will be a good indicator of investor mood in the future.

Another encouraging piece of crypto news is the popular expectation that the Luna/UST meltdown will not propagate throughout the crypto community or into the traditional financial world. Last week, the industry was put to the test when Tether lost its peg on Wednesday morning, plummeting below 95 cents before swiftly recovering. Tether was being shorted by investors in a deliberate attempt to drive the price down, according to Yarlagadda’s clients, though such accusations were unverified. If Tether loses its peg, it will be disastrous for the crypto business, with potential spillovers into traditional banking.

It would be great if this drama acted as a cautionary tale about excess in the crypto business, leading to more responsible forms of innovation. The unique financial institutions being built in Wyoming, where Caitlin Long’s Custodia is one of several would-be banks attempting to bring responsible forms of financing by refusing rehypothecation of assets—that is, collocating deposits and lending them to debtors—would be one test case. She’s even considering creating her own stablecoin.

There’s also been an expansion in the DeFi market, which has been accused of being little more than Ponzi schemes for years. It is attempting to become more business-friendly. AAVE and Compound, two leading platforms, have both developed institutional-only versions, with Compound’s service receiving a B- grade from Standard & Poor’s. That isn’t exactly investment-grade, and the protocol itself only has approximately $150 million under management, but it’s a start.