After a much-needed vacation, our newsletter is back in your inbox. I certainly had my day in the sun, but the same can't be said for the crypto market, which is experiencing an extraordinary period of volatility following last week's sudden collapse of UST and LUNA.
Bitcoin has declined by more than 20% this past week. Today, the asset briefly slumped as low as $25.4k – its lowest level since December 2020. ETH has fared even worse for the week, having plunged 28%. At $1.8k, ETH is trading 65% lower than its record high of around $4.8k in November 2021. In fact, since the highs of November '21, a total of $1.7T has been erased from the global crypto market cap.
Unsure about how the chaos in the crypto market came to be? Read on as we'll break it down below.
UST and LUNA crumble. Is trust in the Terra ecosystem irreversibly gone?
Where to start. Huge drama is unfolding in the markets as the algorithmic stablecoin, TerraUSD (UST), which is supposed to be pegged to $1, blew up on Monday. At the time of writing, the aglostable is trading at $0.57. Meanwhile, Terra (LUNA), the cryptoasset backing UST, shed 95% of its market cap in less than 24 hours, in what is undoubtedly a catastrophic chapter in crypto’s history.
Before the implosion, both UST and LUNA were top ten crytpoassets by market cap. So how did we get here?
For those of you who haven’t been keeping up with the news cycle recently, to understand why the depeg of UST has caused a market fiasco, it’s important to have a basic idea of 1) how the Terra ecosystem works, and 2) some of the factors behind the popularity of UST.
The Terra ecosystem
I'll preface out of the gate that studying the mechanics of LUNA-UST is no easy feat. But in short, UST is the algorithmic stablecoin, and since mid April, was the world’s third-largest stablecoin by market cap. UST is backed by LUNA, the native asset of the Terra blockchain. And in order to maintain the peg, LUNA is either burned or minted.
Other key names in this saga include Anchor (ANC), a lending protocol on the Terra network, and Luna Foundation Guard (LFG) – the treasury that backs UST. Notably, since the end March, LFG has been actively accumulating the asset – adding $1.6bn worth of BTC to its reserves to date.
Why UST rose through the market cap ranks
UST was able to accumulate significant market dominance thanks to an incentive that attracted a ton of users to the Terra ecosystem. Those who deposited UST into Anchor were rewarded a very juicy rate of return – approx 20% APY – which is absurdly high, even for DeFi. And as our friends at Blockworks pointed out, is 300x higher than the national average of a traditional savings account.
So that’s the surface high-level view of Terra. Which brings us to what actually took place.
Why did UST depeg?
On Sunday, a single wallet sold $285m of UST on Binance and Curve, followed by large shorts on LUNA. Panic ensued as tweets emerged that this was a 'coordinated attack’ a well resourced entity. Whether or not this was a massive coordinated attack is irrelevant, as these systems are supposed to be robust. Anyhow, this fear led to users frantically withdrawing billions of UST from Anchor. As people fled for the exits, this caused UST to lose its 1:1 dollar peg ratio.
LFG responded with an announcement that it would be lending out $1.5bn in bitcoin from its reserve to OTC trading firms so they could support the market activity and help UST reclaim its peg. But LFG emptying its treasury wallet of its bitcoin created meaningful sell pressure on BTC that dragged down the entire crypto market.
This past weekend, BTC was trading above $34k, while this Thursday morning, below $28k. Meanwhile ETH was $2.9k on Sunday, and has dropped more than 38% to below $1.8k today.
We’re still in the midst of chaos so time will tell the fate of UST and the rest of the Terra ecosystem. But as I’m writing this, it seems that attempts to recapitalise UST have failed.
Even if UST regains its peg, will people actually want to buy the stablecoin and deposit into Anchor protocol? I doubt it. Investors, after all, buy stablecoins because they’re looking for predictable and resilient.
This fiasco was a stress test for UST and it clearly failed.
As for the Terraform Labs co-founder (and prolific Twitter shit-poster), Do Kwon, I’m a tad conflicted on whether I respect his fight to defend the peg, or condemn his decision to throw more capital at a sinking ship – given that this market move proved that UST, by design, is fundamentally flawed.
It’s now being debated whether one stablecoin’s failure is going to be used to stifle innovation in the (very) important area of stablecoins. Making an example of UST to roll out draconian regulation that’s unfit for purpose and doesn’t appropriately deal with fundamental issues, is the worst case scenario. Crypto commentator, Nic Carter, voiced this same concern yesterday, tweeting: “regulators will use the failure as a stick to bash the rest of the industry with, most likely causing reprisals against useful and functional stablecoins.”
During a Senate Banking Committee hearing on Tuesday, Treasury Secretary, Janet Yellen, pointed to the run on UST as evidence of the potential threat to financial stability posed by crypto. This suggests that heavy-handed regulation in the US could be on the cards.
This brings up a key question: With confidence in algostables shaken, do stables such as USDC, USDT and USDP win from Terra’s fall? Or are they set for aggressive intervention from regulators?
On Crypto Twitter meanwhile,wordis that UST’s collapse will likely be a big W for CBDCs. According to a BIS survey published this month, 90% of central banks are now exploring CBDCs, with 26% of the central banks already running pilot programs on fiat digital currencies.
I’ve rambled on for long enough, so I’d like to close with this: The same innovation that makes the crypto industry so promising and exciting also brings with it new risks. Speaking frankly here, experiments like UST are necessary to figuring out the best solutions to building a resilient decentralised aglostable – which DeFi needs. But as an industry, we need to do a better job at fostering an environment that caters to thoughtful risk-taking and failing in a controlled way. Rather than, in the name of innovation and learning, push the envelope on experiments that show signs of causing systemic risk.
As I alluded to earlier, the inner workings of the Luna-UST ecosystem are no peaceful zen garden. Perhaps this is what doomed the project from the start. I strenuously agree with my colleague, Fadi Aboualfa, who said and was quoted in Bloomberg yesterday: “The simplest protocols with a clearly defined economic structure will win.”
Coinbase regulatory filing sparks fear for safety of user assets. What happens in Coinbase goes bankrupt?
Coinbase on Wednesday announced losses of $430m, a 19% drop in monthly users, and 44% decline in trading volume in a single quarter. Meanwhile, its share price has lost 78% of its value this year. But remarkably, none of the above is the Coinbase news that rattled people most this week.Hidden away in the exchange's 10-Q form, as part of its mandatory filing with the SEC, was a disclosure stating that: “the assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors.”
In other words, in the event of a Coinbase going belly-up, all assets would be sized to pay off debt, including customer holdings. The fact that Coinbase holds a whopping $256bn in both fiat currencies and digital assets on behalf of its clients, speaks volumes about the level of progress that needs to be made in educating industry participants on the importance of secure custody.
As someone who works for a leading decentralised custody solution provider, I often can be found spieling off about the dangers of keeping digital assets on exchanges. This is because the safekeeping of private keys is an essential component for anyone who wants to invest in digital assets or make use of the diverse possibilities of blockchain tech. So if your crypto is on an exchange right now – *ANY* exchange – that's a major risk to your assets being hacked, seized or frozen.
While retail investors are advised to move their crypto from exchanges into a private wallet of which they own the keys, for the institutional community, self-custody isn't a viable option for a host of reasons. These participants require a different and more sophisticated custody solution that technology providers like Copper specialise in.
At Copper, all client assets are held separately and segregated on the blockchain level using MPC. When signing a transaction, keys are distributed between multiple dedicated hardware devices, meaning that no one single device or person has private keys to assets held in custody.
Switching gears back to Coinbase, the company's CEO, Brian Armstrong turned to Twitter yesterday to address that while the exchange's Prime and Custody customers have “strong legal protections in their terms of service,” retail customers do not. He tweeted: “For our retail customers, we’re taking further steps to update our user terms such that we offer the same protections to those customers in a black swan event. We should have had these in place previously, so let me apologize for that.”
The retail community will have to wait and see what Armstrong means by 'further steps', but obviously it's concerning that they've lacked clarity about the legal status of their assets for so long.
This past year, crypto exchanges have increasingly come under fire for the risk of conflict that comes from wearing multiple ‘hats’ as as exchanges, brokers and custodians. In a speech last month, Gensler said he had asked staff to work on "getting the platforms themselves registered and regulated much like exchanges, in particular whether it would be appropriate to segregate out custody.” As Gensler hires 20 more lawyers and staff to regulate digital assets, industry participants might have to brace tighter for what he has in store for the industry.
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