#19 The Context: Terra-rising the Neighbourhood
Terra Labs collapse quietens a few voices, but raises many questions
Hi there, after an interesting week or two. This week’s newsletter is consequently a bit longer in certain places, where we’ve tried to dissect Terra’s collapse and the wider crash, as well as to explore what happens next, immediately but also in the longer run. A crypto winter ahead, or a nasty blip?
The usual disclaimer: This newsletter collates the main themes and headlines of the week in DeFi/crypto/metaverse/web3/NFT land and tries to provide unbiased context. It’s aimed at anyone who wants to keep an eye on the space but isn’t following it too closely, or is on the hunt for story ideas and angles. It’s put together by a team at YAP, and doesn’t contain any promotion of our clients (if one is mentioned, we’ll flag that).
Your feedback is as always welcome. Ping us at thecontext@yapglobal.com. Old newsletters can be found here.
[tl;dr]
Terra and Luna’s ride has been a wild one. What happened and why?
Terra part II: And where does it take us?
Governments and crypto: friends with benefits?
[Terra: What happened?]
One blow-by-blow account is here. (My only quibble would be calling it a Black Swan event. There have been quite a few people who predicted this event (and have the receipts), so it's hard to suggest this came totally out of the blue.) Other analyses: here, here
A stablecoin is like a currency. A currency’s credibility rests on its value relative to other currencies. To do that it has to be able to credibly argue that it has enough assets to be able to guarantee that exchange rate. In Terra’s case, the peg was 1 UST to 1 USD. To guarantee that 1/1 would always be the case, it developed an algorithm and a token, LUNA, that would in theory rely on market mechanics, i.e. arbitrage, to return both UST and LUNA to parity. Hence an algorithmic stablecoin.
In Terra's case, the strategy was to maintain demand for UST via Anchor, a saving protocol on Terra’s own blockchain which offered 20% annual yield, or interest. For many it was a no brainer to buy UST and then stash it there, despite questions about the unsustainability. This created huge demand for UST.
When the attack came, selling pressure grew until the market cap of Luna was lower than that of UST. Efforts by a recently set up treasury, Luna Foundation Guard, which had bought Bitcoin to create a “forex reserve” to prop up UST by releasing its hoard of Bitcoin weren't enough. (LFG CEO Do Kwon has released two revival plans, the most recent of which proposes forking the current Terra blockchain from a snapshot taking before the attack. You can find the plan [here.](Terra Ecosystem Revival Plan 2 \[UPDATED AND FINAL\] - Governance & Proposals - Terra Research Forum))
None of this should be too surprising. A paper by Ryan Clements, Chair in Business Law and Regulation at the University of Calgary argued that “[a]lgorithmic stablecoins are inherently fragile… [they] exist in a state of perpetual vulnerability.” This is, he argues, because algorithmic stablecoins require a “support level of demand”, which cannot be guaranteed, especially in a crisis. They also rely on price-stabilising arbitrage by independent actors, something that history has shown to be fragile. Finally, it relies on perfect information, something which rarely happens in a crisis. In short, they rely on a series of assumptions and incentives, without really addressing the question of what happens when that breaks down, when reality deviates from those assumptions. But it was only a handful of brave and smart souls who saw the problem and publicly called it, like Kevin Zhou, the co-founder of crypto hedge fund Galois Capital. Others are now rushing to say the same thing after the fact.
[Terra: What happens next?]
The short term question is about contagion within DeFi. Crypto has been rocky for months, and other parts of the ecosystem are wobbling: A GameFi token like Crabada is down 93% from its November peak, Axie 86%. NFTs have also been falling, and other stablecoins are being watched. Algorithmic stablecoin Deus Finance’s DEI lost its peg on Monday and is now trading at around 60 cents. Tether, another stablecoin, while under siege, seems to be holding up better, but as John Paul Koning points out, this may largely be down to public and regulator criticism which forced them to buy safer reserve assets. It has redeemed some $7 billion in Tethers so far, but does have $5 billion worth of crypto on its asset list, which is causing some anxiety.
Then there’s the inevitable post-mortem about Terra. The Luna Foundation Guard (LFG), which managed the treasury of reserve assets for Terra/Luna, spent some $3.5 billion of Bitcoin trying to prop up the UST and LUNA. Holders of the two lost $42 billion over the past week. Some have questioned this; Elliptic Labs said it had traced the movement of more than 52,000 Bitcoin from LFG wallets to a single address on a U.S.-based crypto exchange Gemini, while another 28,205 BTC in Terra’s reserves were sent to Binance, another exchange. Elliptic is not able to identify whether these assets were sold or moved to other wallets. The LFG, a Singapore-based non-profit, has said it would look to compensate the smallest holders first from the few-hundred bitcoin still remaining.
How regulators and others react may be decisive in the extent of the fallout: Singapore, crypto-friendly but wary of encouraging retail investors to dabble in crypto, has not yet said anything about the debacle but could well do so. A police report has been filed in Singapore against Do Kwon on behalf of LUNA and UST investors. South Korean regulators, however, have said they are looking into Terra, and Do Kwon may be summoned to appear before parliament. (A big Korean law firm plans to sue him; that was made harder by news that Terraform Labs’ legal team had resigned.) U.S. lawmakers also called for the urgent regulation of stablecoins last week following the fall of Terra. However, Treasury Secretary Janet Yellen believes that stablecoins are currently not a real threat to U.S. financial stability. Britain has made clear it will press ahead with plans to regulate crypto, including allowing stablecoins to be a form of payment, certain varieties of what “are not suitable for payment purposes as they share characteristics with unbacked crypto assets.” At the same time it wants to be a crypto hub. Indeed one CEO argues that what is holding crypto back is a lack of “regulatory clarity”, and that Terra's collapse provides “the impetus to see that happen now.”
The underlying hope is that this chaos will strengthen the ecosystem internally, requiring only a light regulatory touch. A down cycle usually allows for real innovation to take place–development, research, developer activity, academic research, infrastructural maturity, corporate adoption, public awareness, etc. “Zooming out, cycles can be reframed as volatile periods around a relatively consistent adoption curve,” wrote Fred Ehrsam, a co-founder of Coinbase. But that might is assuming the problem is confined to crypto. And it poses significant questions to the DeFi world itself, not least why supposedly savvy VC and other investors didn't do their due diligence.
Izabella Kaminska believes that much of the money flowing into crypto is money that would otherwise have flowed into bank share buybacks, banks’ preferred way of soaking up cheap money. Her conclusion is a stark one, and it has less to do with crypto and more to do withe ‘core financial system’. “The real question at hand is whether diverting this speculative craze into a largely unregulated ‘caveat emptor’ market that the lender of resort is not responsible for, will have helped to ring fence the stability of the core financial system and in this way protect those who didn’t fancy taking a punt with their life savings on something devoid of intrinsic value? I think it could well have done. How far any crypto contagion rips is going to be key.”
In the longer term, though, even those not right in the midst of the DeFi world see resilience, if only once crypto is stripped down to its fundamental purpose: to transfer value over a digital network without an intermediary. “It’s quite hard to send cash over the internet and, with the four-pillar model of cards or the percentage-plus costs of intermediaries, it makes absolute sense to try to move to a networked system that is fast and free,” writes Chris Skinner, a fintech commentator. “That’s what DeFi is trying to achieve.” Not everyone would define DeFi’s goals so narrowly, but any function will be based on that fundamental capability.
(Sources: Milk Road; Apollo Capital; The Blind Spot; Chris Skinner's blog; WIRED; SSRN; Riyad Carey; International Token Standardization Association; Bitcoin News; CoinDesk; Liam 'Akiba' Wright of CryptoSlate; Thomas Hum of Yahoo Finance; Danielle Balbi of Bloomberg; Yogita Khatri of The Block;)
[Governments and crypto]
Is there a role for government in crypto? It seems odd we’re still asking this question. Yes, governments want to woo crypto investors at the same time as regulating their excesses, but how about governments, local and national, who see in cryptocurrencies an opportunity to transform their economy, or as a source of finance in themselves?
El Salvador has been a poster child of the former, though not necessarily in the way it would like. But despite the setbacks, it’s still pressing ahead. This week 44 countries will meet in San Salvador to discuss bitcoin (more here when the meeting's started).
Adventurous mayors have sought to encourage local coins, but these haven’t worked out well: Miami and New York City coins have tanked despite the support of their respective mayors. Both use the same CityCoins system that uses Stacks, a protocol that rewards the government and in theory incentivises a network to create more coins. MiamiCoin is down more than 90% off its peak. Indeed, CityCoins noted in an email that Miami's mayor, Francis Suarez, may have tripped "a few regulatory wires” in interviews, according to Quartz. The company later denied Suarez had not not tripped any wires.
It’s a hard line for governments of all sizes to toe; the result is often mixed signals or grey areas. Despite its government implicitly banning crypto, Nigeria's Securities Exchange Commission last week ruled cryptocurrencies are securities. And China, despite banning all crypto operations, returns as 2nd top Bitcoin mining hub, accounting for more than 20% of total Bitcoin mining hash rate distribution. Either the government is distracted by other matters, or there is a tacit recognition crypto serves a purpose.
(Sources: Camille Squires of Quartz; Brian Quarmby of Cointelegraph; Solomon Oladipupo of Finance Magnates; Helen Partz of Cointelegraph;)
[Tidbits]
The U.S. has issued criminal charges in its first cryptocurrency sanctions case: A sign that U.S. judges are getting hip to the issues. And that the DoJ is not only actively going after actors attempting to use cryptocurrency, but that it's going to get increasingly hard to use cryptocurrency to evade sanctions. (Washington Post)
CloudFlare, the big cloud company that protects websites from DDoS and other attacks, has long dabbled in all things web3. Now, it will run Ethereum validator nodes using Proof of Stake on its global network. The idea is to build a testing ground for research on things like energy efficiency. (CryptoDaily)
Perhaps inevitably, all those celebrities pushing crypto are not so vocal now, according to *The New York Times.* Tiffany Tsu's conclusion: “Crypto’s instability underscores a basic fallacy of celebrity marketing: A famous person’s endorsement may be memorable… but it does not make the product being pushed inherently worth trying.” All the same, a little contrition might not go amiss.
[Reading]
The 2022 State of Crypto Report from a16z (Daren Matsuoka, Eddy Lazzarin, Chris Dixon, and Robert Hackett)
Do Kwon: How Terra Luna Founder Built a Crypto Cult a deeper dive into the fallen crypto celeb. (Kevin T. Dugan)
Kerman Kohli makes for a forthright read on the Terra collapse (last mention, I promise) in The Beginning of the End. “We’re still far away from the bottom since there are more truths to fundamentally uncover, we’ve only discovered one of many last week.”
[Shovers and Makers]
The FT's Izabella Kaminska has left to set up her own ‘media venture', The Blind Spot, which has “a two-part plan to try and help reconfigure how journalistic information is organised on the internet”. Best of luck, Izabella!
This newsletter is pulled together by a team led by Jeremy Wagstaff, formerly of the WSJ, BBC and Reuters and Samantha Yap, founder of YAP Global. Other members: Ruby Wu, Roslyn Tear and Becky Corbel. Many thanks to Joey Woo for production. Any views expressed here are not necessarily those of the writers, YAP Global or its clients.