As long-term investors in cryptocurrencies, we would like to provide some context on recent market events. Below are excerpts from what we recently shared with investors:
2022 will be marked by macroeconomic uncertainty and a global sell-off, affecting tech, cryptocurrencies and other markets. Bitcoin and ether are down 49% and 58% year-to-date, respectively. Other crypto assets have been hit harder, with Coinbase stock down 71% year-to-date. The sell-off exposed unhealthy leverage across the crypto ecosystem, triggering a series of woes and bankruptcies. Crypto headlines and market sentiment have turned noticeably negative, and while reminiscent of the so-called bear markets prior to 2018 and 2015, these events are now playing out alongside cryptocurrencies on a larger stage.
Despite market volatility, our long-term belief in crypto and the asset class remains strong. The quality of talent entering the crypto space has never been stronger. Meanwhile, fortunately, speculators have pulled out. We believe the next 12-24 months will be a fruitful time for building and investing in cryptocurrencies.
A full description of the ongoing crypto deleveraging requires hindsight. Right now, based on what we know so far, it is clear that certain crypto entities have grown into unsustainable positions under the implicit assumption that asset prices can only rise. As 2020-2021 heats up, companies and funds get bolder, risk limits become moving targets in pursuit of scale and yield, and explicit and implicit leverage builds. The exogenous shock of the global sell-off is a reality check. While these events are certainly negative, we are optimistic that the lessons learned will translate into a healthier crypto ecosystem in the long run.
Terra, LUNA, UST
The Terra blockchain was the first to fall in this cryptocurrency domino storm. Simply put, Terra is known for its native blockchain assets LUNA (similar to ETH on Ethereum) and UST (a dollar-pegged stablecoin built on top of it). The UST peg is maintained through a two-way redemption process to LUNA: when UST falls below $1, you can “burn” $1 of UST to “mint” $1 worth of LUNA, and vice versa, when UST falls below $1 When it goes above $1, you can “burn” $1 worth of LUNA to “mint” $1 in UST. In theory, this process will keep UST around $1…as long as confidence in the system remains strong.
As with many previous “algorithmic stablecoins”, if confidence in the value of UST and LUNA is lost, UST is designed to have a potential death spiral that will cause everyone to sell for the exits. In fact, the problem with algorithmic stablecoin design is so pervasive that the most compelling question is probably not “Why did UST collapse?” but “How did UST get so huge before it went bust?” This is what we at LUNA/ It’s a question UST has been asking itself during its meteoric rise.
While it’s hard to pinpoint the root cause, the combination of a charismatic founder (Do Kwon), many outspoken investor backers (including the now bankrupt Three Arrows), and a 20% yield that is too good to be true The confident Anchor protocol, flashy attempts to acquire large amounts of BTC as collateral, and many other factors have sparked frenzied speculation by both retail and institutional investors on the underlying LUNA asset and the seemingly low-risk 20% UST yield. The rising value of LUNA makes people more confident in the stability of UST, and more UST deposits make people more confident in LUNA.
Positive feedback loops are very strong during ascents, but negative feedback loops are even more powerful during descents. LUNA has now fallen from over $100 per LUNA in April to less than $0.01 today. The UST stablecoin broke the $1 peg and is now worth close to $0. Over $18 billion in UST deposits and $40 billion in LUNA market cap have disappeared.
With LUNA and UST collapsing, clearance sales of cryptocurrencies may accelerate and the problem starts to spread to other cryptocurrencies.
Three Arrows Capital and Crypto Lenders
Three Arrows Capital (3AC) started out in 2012 as a traditional FX arbitrage fund and then expanded into cryptocurrencies through arbitrage and directional strategies. With their own capital, the founders of 3AC (Su Zhu and Kyle Davies) have grown their initial assets from less than $1 million to billions in 10 years – an incredible amount anyway Phenomenon. However, the track record achieved without much risk awareness arguably paved the way for the demise of the 3AC.
Heading into 2022, the 3AC’s growing overconfidence is dangerously combined with a cryptocurrency lending ecosystem that is more than willing to expand unhealthy leverage to grow the loan book in search of higher yields. Incredibly, a cryptocurrency lender, Voyager Digital, appears to have provided 3AC with up to $350M USDC and 15,250 BTC (worth a combined $1B+ as of March 30) to 3AC completely unsecured. Such a large, zero-collateralized loan clearly indicates a misjudgment, but it also hints at the intense competition among lenders to grow their assets and their relative comfort in working with a large and reputable fund like 3AC.
Not all lenders are so inattentive. Celsius and Genesis loans appear to be partially collateralized, while BlockFi loans appear to be overcollateralized. Nonetheless, in aggregate, 3ACs are able to accumulate billions in debt on top of billions of assets, which is highly leveraged for continued growth in cryptoasset prices. Once the market sell-off and the subsequent LUNA/UST crash arrived, what happened next was inevitable. 3AC went from billions in net worth to over $1 billion in net debt, eventually going bankrupt and leaving a huge hole in the balance sheets of cryptocurrency lenders.
While the 3AC has caused the most damage, cryptocurrency lenders have also made various other mistakes. Some engage in risky trading strategies with client assets (for example, so-called “yield mining” across DeFi protocols). Others locked funds in seemingly low-risk carry trades (such as bets on the price convergence of GBTC and BTC) that implicitly assumed long-term maturities did not match the short-term nature of customer deposits. For the surviving crypto lenders, it seems likely that risk management will gain a new emphasis internally.
The cryptocurrency ecosystem is reimagining money, financial systems and internet applications based on new technologies and economic primitives. Such a basic and ambitious process is bound to be messy. Every failure is an opportunity to learn, and we are optimistic that the crypto ecosystem will become smarter and more resilient.
This is not the first crisis for cryptocurrencies (nor will it be the last). In 2014 MtGox was the largest Bitcoin exchange, handling more than 70% of the world’s trading volume, and a hack caused a loss of more than 7% of all BTC in circulation. In 2016, a smart contract application called “The DAO” held almost 15% of all ETH supply when it was hacked. At the time, both events seemed to exist: Fear spread and asset prices collapsed. In our experience, however, such events ultimately do not stop the fundamental driver of crypto advancement: developers and entrepreneurs committed to building the future.
These crises have also spawned positive change. The decline of MtGox gave way to safer and well-run exchanges such as Coinbase, and spurred the development of fully non-custodial exchanges such as Uniswap. DAO hacks give way to more focus on smart contract security. Hopefully the LUNA/UST debacle will give way to a broader understanding of algorithmic stablecoin risks, and the 3AC and crypto lender debacle will give way to better risk management.
The relative performance advantage of decentralized finance (DeFi) protocols compared to centralized finance (CeFi) lenders and funds is an underrated fact. DeFi lenders like MakerDAO, Compound, and Aave are all able to stay solvent through pre-programmed mechanisms to liquidate collateral when margin limits are reached. These systems are on-chain, transparent, code that can be inspected by anyone, and have little chance of accumulating unhealthy leverage. DeFi has a long way to go to match the existing financial system, but some of its fundamental advantages are starting to emerge.
Beneath the headlines, in our day-to-day work, our optimism has not been altered by recent events. Not a day will we meet a talented college student or a seasoned tech executive who is thinking about building a cryptocurrency for the next 5 to 10 years of their career. Crypto infrastructure and development tools are maturing. The opportunity for new DeFi protocols is huge, especially after CeFi relaxes. We see a lot of emerging sprouts in consumer areas such as gaming, digital art, and social networking. Progress and opportunities abound, largely unaffected by public asset prices and ongoing deleveraging.
Going forward, we will continue to focus on the multi-decade opportunity for cryptocurrencies. Our team and the entrepreneurs we support find it easier to focus in a quiet environment that focuses on substance and lacks distractions. The speculative hot money has gone, and valuations have begun to rationalize. Strong companies find it easier to hire good people. Overall, we are optimistic that the next 12-24 months will be a fruitful time for building and investing in cryptocurrencies.