Crypto Carnage

Research May 12, 2022

Key take-aways

  • The macro backdrop is more challenging than prior to the Great Recession.
  • Barring some unforeseen economic equivalent of deus ex machina, a fairly significant downturn/global recession looks to be on the cards.
  • For crypto this is very much uncharted territory. Rising price correlations with equities implies the short-term outlook is still negative even though the long-term outlook remains bullish.
  • More surprising is the contagion to other cryptocurrency assets – one algorithmic stablecoin, in particular, comes to mind. I am sure most readers will know what I am referring to.
  • Were the LUNA-tics really running the asylum?

Global financial markets have a distinct whiff of 2007/8 about them. For those young enough not to recall those days, after an eight year bull run global stock markets were breaking sharply lower, crude oil prices surged to almost $150 p/b and inflation pressures were rising as evidenced by headline US CPI inflation topping more than 5% - its highest level in over 20 years.

Sound similar?

If only.

We are in a much worse position today.

Crude oil prices have doubled (one of the more reliable indicators of US/global recessions), CPI inflation is running even hotter in most economies around the globe than in 2007/8 and global stock markets are all down markedly from their recent highs. That’s where the similarities end……. unfortunately.

In the mid-naughties with the exception of Japan, global interest rates - both at the short-end and the long-end of the yield curve - were significantly higher than where they are today. There was, in other words, scope for them to decline, which provided some offsetting monetary stimulus.

As it transpired this was not enough to prevent the recessionary headwinds and eventually global central banks were forced to slash their key policy rates to zero before engaging in quantitative easing – or, as it was originally called, unorthodox monetary stimulus.

This time around central banks are playing catch-up having, for most of last year, incorrectly assessed the inflation acceleration as “transitory” due to supply chain disruptions following the Covid pandemic shutdowns. Monetary policy is being tightened, not loosened, and long-term interest rates (ie, government bond yields) are tracking higher, not lower, generating a counterproductive tightening in financial conditions.

What’s more, government finances are in worse shape now. This is hugely significant because the way the contractionary forces were short-circuited during the Great Recession was via the government injecting substantial fiscal stimulus and, in effect, nationalizing the debt of an over-extended private sector and transferring it on its balance sheet (the insolvent backing sector was saved during the process). As I mentioned in a recent article, global public debt levels currently stand at record highs, meaning there is simply not enough fiscal headroom for a replay of what transpired during the Great Recession.

Deus Ex Machina

Not good would be a very polite way to describe the current situation facing the global economy. Barring some unforeseen economic equivalent of deus ex machina, my strong suspicion is that we are heading towards a fairly significant downturn/global recession.

For crypto this is very much uncharted territory. Bitcoin may have been released into the wild in late 2008/early 2009, but it was very much a tech plaything during the Great Recession. And, while the Covid pandemic certainly caused a slump in economic activity, it was very different in nature to typical recessions. It was more like a pause button was pressed on the global economy. The truth is we have no precedent for crypto behaviour during a global downturn.

What is clear, however, is that cryptocurrencies have been trading very much like a risk asset over the past year or so. Indeed, in a recent piece examining the evolution of Bitcoin narratives, I included a chart showing the price correlation between Bitcoin and the SP500 was on a rising trend. Updating this chart it is clear that this positive relationship has continued to strengthen – see chart.

100-day Rolling Correlation Bitcoin vs. SP500

Source: Author calculations

Correlation may not be causation, but the rising correlation between Bitcoin – a proxy for crypto – and the SP500 – a proxy for global stock markets - strongly suggests Bitcoin, and crypto more broadly, will go where global stock markets lead. Given the headwinds facing the global economy at present that direction is down.

This negative short-term dynamic is something I anticipated when I wrote the Fed Fears piece mentioned above. To wit,

“Monetary policy cannot succeed on its own. This is something I think a lot of people fail to appreciate. (In terms of cryptocurrency implications, the Fed going it alone is bearish in the short-term, but longer-term because of the implied rise in the debt-to-GDP ratio, it is bullish as it keeps alive the fiat failure possibility).”

[Ed note: By “going it alone” I was referring to demand-side policy being solely driven by monetary policy ie, unchanged fiscal policy].

Longer-term, for reasons that I outlined at some length in the piece, the longer-term bullish case for Bitcoin and other cryptocurrencies with similar set-ups, remains intact. Nothing that has happened in the interim changes that in any way. For those holders in need of some solace I would strongly recommend reading the article in full. Indeed, I would go as far as to consider the down draft we are currently witnessing in crypto prices as the market offering crypto fans a much better entry level to exploit the next wave higher, when it eventually comes.

What has, however, been surprising to me is the contagion to other cryptocurrency assets – one algorithmic stablecoin springs to mind. I am sure most readers will know what I am referring to.

Stable Defined

Stablecoins are cryptocurrencies whose value is supposedly anchored to a fiat currency or other assets. The vast majority are pegged to the US dollar. I have previously written about these cryptocurrencies so to avoid going over old ground let’s just note that they come in three flavours: fiat-backed, crypto-backed and algorithmic.

The most popular use of stablecoins is to provide a cheap and convenient way for cryptocurrency investors to find safety during times when cryptocurrency prices are falling by remaining within the crypto ecosystem (the time and cost of off-ramping is avoided). At times such as these demand for stablecoins should, one would tend to expect, be increasing.

Fiat-backed stablecoins, like USDC – the stablecoin we use on the Trakx platform - are backed by holdings of high quality liquid assets within the traditional financial system. These stablecoins have been rock solid with their prices showing almost no volatility versus their one-for-one peg to the US dollar.

The same is not, however, true for the other types of stablecoins. Terra has seen its USD peg severely tested, with its price dropping below $0.50 at one stage this week - a very unusual definition of stable, at least in my world.

Stable Not Stable

Source: Joaquin Gutierrez and Coindesk

Terra (UST) is the largest algorithmic stablecoin. Unlike fiat-backed stablecoins, its valuation anchor comes from either burning or minting its sister coin Luna and relying on arbitrage opportunities to keep UST at, or close to, its US dollar peg. Essentially Luna’s supply adjusts to compensate for demand shocks (both positive and negative) in Terra so that its price remains stable.

Illustrative Example

If 1 UST is trading at $0.99, users can buy 1 UST for $0.99. Users then utilize Terra Station’s market swap function to trade 1 UST for $1 USD of Luna. The swap burns 1 UST and mints $1 of Luna. Users profit $.01 UST from the swap. This arbitrage continues, and UST is burned to mint Luna until the price of UST rises back to $1.

Source: https://docs.terra.money/docs/learn/protocol.html

This is how the arbitrage mechanism works in theory, clearly this mechanism hasn’t been working so well in practice of late.

Death Spirals

As originally conceived, the Terra ecosystem was supported by its use within the Chai payments system. Bootstrapped on this payment network, Luna had value because increasing usage and demand for Terra resulted in Luna getting burnt, supply restriction that helped to drive up the price of Luna. Such usage should be relatively sticky – after all, people do not change their banks or credit cards that often. Failure of Terra to maintain its pegged value could certainly have undermined confidence and discouraged its use as a payment method, but until very recently this was not the case. The source of Terra’s problems lies elsewhere.

As mentioned, over the past couple of years, Terra been one of the most successful algorithmic stablecoins and the Terra ecosystem has expanded way beyond its original set-up with 114 projects being built on the Terra network. By April this year, Terra became the 14th largest cryptocurrency, which helped propel Luna’s market cap to more than $40bn.

On the way up networks effects are very powerful. The problem with network effects is that they are equally powerful on the way down – this makes them susceptible to the so-called “death spiral”.

In the event that people reduce their demand for Terra, for whatever reason, Terra gets burnt and Luna gets minted. This increase in supply of Luna undermines its price (not an especially desirable property for any investment product). Because Luna provides the backing for Terra, declines in the value of the peg’s asset base (Luna) has the potential to undermine confidence in the stability of the peg prompting even less demand for Terra. Wash and repeat.

One useful metric for gauging death spiral risks are the differences in market caps between the two coins – see below – because it gives some indication as to how much capital is backing the Terra stablecoin. What is apparent from the chart below is there have been two occasions over the past two years when the market cap of Luna was very close to that of Terra, in May 2021 and over the past week. During both of these periods, Terra’s 1:1 peg with the US dollar came under pressure.

Market Cap (US$ bn)

Source: www.coingecko.com

The issue with expanding the Terra ecosystem so quickly is that the “stickiness” of demand for Terra was much lower with these newer projects compared with the original use case, namely its usage within the Chia payments network.

Enter LFG

Interestingly, in January the Luna Foundation Guard (LFG) was set-up to support the growing Terra ecosystem. It raised $1bn through an OTC sale of Luna, the proceeds of which formed a Bitcoin reserve base for Terra. In March, LFG tweeted that due to high demand for Terra, it voted to swap five million Luna for US dollars and the proceeds of the sale would be used to purchase Bitcoin to grow the reserve further.

Moreover, in an interview in March on Youtube Do Kwon revealed that whereas before when Luna was swapped for Terra the Luna would be burned this would no longer be the case. Only part of the Luna would be burned with the remainder (40% was the example Do Kwon mentioned during the interview) would be “sent to the community pool so it can be used later to buy Bitcoin”.

It is through this combination of OTC Luna sale and the diverting of a percentage of the Luna burn that the $10bn BTC backstop Do Kwon mentioned in his pinned tweet (screenshot below) would be established.

The Icarus Analogy

For many Lunatics – as Luna fans like to call themselves – adding Bitcoin to the reserves backing Terra was a great idea, as it would serve to help support the ecosystem by providing a “decentralized forex reserve to safeguard the peg of UST to the dollar”. A less charitable interpretation for the creation of the LFG was that it was a defensive response to the realization that Terra had scaled so quickly, and in a manner that meant demand for Terra coins was less “sticky”, that the risk of a death spiral had increased. It was a form of decentralized insurance against such an outcome.

With much irony, however, what Lunatics thought was a smart play may in fact have been the trigger for its recent troubles. As one of my colleagues noted,

“The problem when you become more institutional and more vocal and visible as an asset class... the big boy traders with big guns will come and poke you...No place to hide and tweeting does not help.”

Rumour Mill

Twitter has been rife with rumours as to what caused Terra’s depeg. The following screenshot provides a very succinct outline of the presumed attack. (NB: The original tweet names a large financial institution, but because this is not yet confirmed I have redacted the name. Moreover, it is the mechanism that is more interesting than the identity of the presumed perpetrator).

Alleged Terra Attack Process

Source: twitter

I don’t know if this mechanism was deployed or not, but what is interesting is that not only is it plausible, but the risk-reward from it is very low, something that makes it more rather than less likely to have occurred.

By shorting Bitcoin and Terra at the same time, if the Terra peg is defended speculation that LFG could be forced to draw on its newly established Bitcoin reserves means the Bitcoin short pays off while the Terra short returns nothing (net positive for the shorts). If, instead, the Terra peg is not defended, the Bitcoin short returns nothing as the threat of forced selling by the LFG is removed, but the UST short pays off (net positive for the shorts). Best of all, and in fact what happened, if Terra attempts to defend the peg and this is unsuccessful both legs payoff (again, net positive to the shorts).

Timing the trade when the market caps of Luna and Terra were closing in on each other - meaning the death spiral risk was elevated - and when Bitcoin and the broader crypto market was declining due to rising risk aversion on the back of concerns about the global economic outlook was exquisite. It’s as close to a free-lunch as one is likely to find in the investing world.

Still To The Moon?

At the time of writing it is unclear whether Terra will be able to regain the mantle of leading algorithmic stablecoin or not. Given how the market caps of Luna and Terra have crossed over, and given how powerful the dynamics of network effects in reverse are, believing it will is very much a faith-based exercise at this point.

Not only has Terra’s price volatility undermined the stable part of its ethos, but the manner in which the defence of the peg has been conducted undermines the decentralized part as well. Indeed, the tweets below scream one thing loud and clear to me….

...Key Man Risk

Source: Twitter

If Terra does survive as a stablecoin, it will almost certainly have to be at a much smaller scale. Hopefully, it will also be based on a model where demand for the stablecoin is much stickier, thereby reducing the probability of sudden death spirals.  If not, I hope this provides a salutary lesson to other algorithmic stablecoin designers because, in my view, decentralized algorithmic stablecoins have a value to society, especially in a world where regulation is encroaching fast.

Until next time.

Ryan Shea, crypto economist at Trakx

Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io