The cryptoverse was front page news again on Wednesday, when algorithmic stablecoin TerraUSD briefly plunged below $0.30.
To the uninitiated, that’s just indecipherable cryptospeak, but bear with me. This is a big deal.
TerraUSD is supposed to trade at $1 all the time. It’s a stablecoin. But unlike fully-reserved stablecoins, which are backed by real cash and cash equivalents, TerraUSD depends on automation, arbitrage, active management of treasury assets and incentives to maintain the peg. Its market cap was near $19 billion before the peg broke, beginning over the weekend. For those interested in more details, I discussed this at some length on Tuesday in “My Algorithmic Stablecoin Broke. Who Do I Call?”
The figure (below) illustrates the severity of the problem. The assumption of a 1:1 dollar peg underpins stablecoins’ use cases across various blockchains and decentralized finance protocols. If that assumption fails to hold or, in this case, falls apart altogether, the ripple effects could be substantial.
The market was waiting on a recovery plan from backer Do Kwon who, along with a consortium of investors, has variously pledged to help restore the peg. But to call this a crisis of confidence would be to materially understate the case.
I’d mention (only in passing, because this is a rabbit hole that most readers won’t be interested in going down) that this started with a withdrawal from Curve ahead of the planned deployment of “4pool,” a liquidity pool which Terra described early last month as “the new gold standard for stablecoin liquidity.” The pool was supposed to be composed of UST (TerraUSD), FRAX (a coin with substantial buzz) and two reserved stablecoins, USD Coin and Tether’s USDT. Frax and Terra are the two largest protocol holders of Convex, which I mentioned on Tuesday in the linked article above.
Confusion around a separate, $84 million transaction fueled intense speculation. Do Kwon confirmed that Terra withdrew $150 million from Curve “to get ready” for the deployment of 4pool, but denied any connection to the address that bridged $84 million of TerraUSD to a newly-opened Ethereum wallet, only to dump it all four minutes later, according to one researcher. “Obviously, [Terra] has no incentive to depeg TerraUSD,” Do Kwon said, on May 8.
The point in regaling readers with that delightfully obscure backstory is to underscore the fact that stablecoins are more than volatility shelters for crypto traders and NFT buyers who, for whatever reason, want to temporarily hold some of their blockchain assets in a coin that doesn’t swing wildly on a daily basis. Stablecoins serve a variety of purposes across decentralized finance and Curve is perhaps the most well-known hub for stablecoin liquidity and trading. TerraUSD’s problems, if they persist, won’t be confined to TerraUSD.
“I understand the last 72 hours have been extremely tough on all of you,” Do Kwon wrote, in a social media post on Wednesday, adding that,
I am resolved to work with every one of you to weather this crisis, and we will build our way out of this. Together. A review of the current situation: TerraUSD is currently trading at 50 cents, a significant deviation from its intended peg at $1. The price stabilization mechanism is absorbing TerraUSD supply (over 10% of total supply), but the cost of absorbing so much stablecoins at the same time has stretched out the on-chain swap spread to 40%, and Luna price has diminished dramatically absorbing the arbs. Before anything else, the only path forward will be to absorb the stablecoin supply that wants to exit before TerraUSD can start to repeg. There is no way around it. We propose several remedial measures to aid the peg mechanism to absorb supply.
He then detailed a community proposal that involves increasing the base pool and minting capacity which, he wrote, “should allow the system to absorb the [TerraUSD] more quickly.”
“Isn’t that Kwontitative Easing?”, one clever netizen wondered, in a reply. “Terra Luna has value because its supply is limited, If you bring about Kwontitative Easing (KE), what difference is there with the USD and QE?”
LUNA, Terra’s native token and an integral part of the arbitrage process, traded as low as $2.20 on Wednesday. At the highs, on April 4, it traded above $115.
TerraUSD’s market cap has fallen by some $10 billion since the peg broke five days ago. LUNA’s market cap decline over the same period comes to around $20 billion.
This all feels very Dot-comish to me.
Canary in the crypto coal mine?
In my opinion: Probably. This stuff is more entangled via DeFi protocols than people realize. Just as implosions in traditional finance don’t happen in a vacuum, neither will these kinds of events. Of course, that doesn’t mean Bitcoin is going to go to zero next week. Morgan Stanley didn’t fail when Archegos blew up. The fallout could be so minimal that nobody outside of the cryptosphere even notices, or it could tip dominoes that nobody knew existed. Or, the whole thing could resolve itself over time via the algo/peg mechanism. There’s just no way to know. And that’s really the point.
Apart from the fact that this whole thing is outrageously ironic and downright humorous, why did any of this need to happen? I have several insured checking accounts that I can use for money any time and I don’t have to go through any of the shenanigans you described above. And by the way, why would anyone want anything to do with a “monetary” system so small and fragile that one private individual and a few drinking buddies can claim to “fix it” if it doesn’t work? This is astonishing!
Private money throughout history fails. Crypto is private money- it is built on blockchain protocol but fundamentally it is private money. Since regulation is so lax in this space it should not really surprise anyone that a so called stable coin has imploded. Based on what I can glean in the description, this coin was not truly backed 1:1 by cash/ust bonds or other highly rated sovereigns. So it was bound to implode at some point- and it did. I see that bitcoin is down big this morning- is it squeezing out speculative excess related to higher rates and tightening financial conditions or is it partly related to this problem? Not sure, but I continue to believe that crypto is one sign of speculative excess in financial markets- along with SPACs, NFTs and all kinds of other hair brained schemes. Caveat emptor.
If BTC is another “pandemic beneficiary”, then does the $11K pre-pandemic level beckon?
“automation, arbitrage, active management of treasury assets and incentives to maintain the peg” will be subject to boundary conditions that do not exist in an open market.
Crypto is like any other asset whose price is hyper sensitive to liquidity. Now that real yields are positive for TIPs maturing past 2027 investors do not need to buy crypto to protect themselves from hyperinflation and negative real rates of return. Things did not go well for crypto in 2018 when we moved from negative to positive real rates of interest.
Anyone have thoughts about the potential for spillover to other asset classes and/or other parts of financial system?
I’m only a bemused and amused spectator to crypto, so it’s spillover potential is what I really care about.
I was just chatting with another old dinosaur trader. I reminded him that time and time again we’ve seen such seemingly irrelevant difficulties in an obscure & hard to understand asset class suddenly spill-over into a full-fledged financial crises as the lenders who enabled the whole have to start writing down loans or worse. Like Steady Safe Taxi in Jakarta back in the late 1990s!
One of my fellow old dinosaur partners was prescient when he remarked that Fidelity’s announcement that it will allow plans to put cryto into 401K plans may have signaled a top.
Yep. It’s no longer a fringe market with limited particiaption. May “mainstream” financial firms felt compelled to dive in. Too bad they went all in at $$50,000 rather than $18,000 ….
Looking forward to reading how Ric Edelaman is doing with his career pivot.
https://www.redfin.com/news/real-estate-cryptocurrency-down-payments/
“One in nine first-time homebuyers (11.6%) surveyed in the fourth quarter said selling cryptocurrency helped them save for a down payment. That’s up from 8.8% in the third quarter of 2020 and 4.6% in the third quarter of 2019.”
Well, seems like some prospective down payments probably went up in smoke since that last 4Q2021 survey.
As if first-time homebuyers didn’t already face an uphill battle nowadays.
So far, commentators are saying that a bad thing about crypto now is that it is correlated to equities. Perhaps the story in a few months is that equities were correlated to crypto.
TerraUSD is the first domino to tip, next comes Tether: sure Tether “backed”, but the issuer makes redeeming USDT for USD extremely hard.
Shorting Tesla, Coinbase, and Binance, at this rate, will pay for my children’s college.
COIN just warned that if it goes BK, users’ crypto may become assets in the BK with the users merely unsecured creditors.
How likely a COIN BK is, I don’t know. CEO says this is just an SEC-required disclosure and users’ crypto is “safe”. But it did just report a large loss with sharply lower trading volumes. I guess crypto traders will need to learn to read financial statements.
I spent a day reading COIN’s filings some months ago, then deleted the contents from my brain as I decided I wasn’t interested in buying the stock. I do (vaguely) recall that COIN’s revenue/trade from institutional crypto trading was much lower than from individual traders, yet the bulk of its expected growth was on the institutional side.