The ocean’s tides are caused by a gravitational pull, ebbing and flowing from high to low based on proximity to Luna (Latin: “moon”). Replace “ocean” with “crypto” and you have a perfect summary of today’s market. Less than seven days ago, a now renowned blockchain project known as Terra ($LUNA) collapsed, wiping out more value on a fully diluted market capitalization basis than Lehman Brothers commanded at its peak. Many have been calling this crypto’s “Lehman moment” but thankfully Terra was not yet deeply entrenched in the broader crypto or “real” economy to have mass contagion effects. However, $LUNA’s demise does have real financial impact and we will provide a bit of history, insight, and views as to why $LUNA’s current tidal force is likely to subside.
Blockchain as a payment rail is simply better than existing systems. It offers nearly instant settlement, globally, in a censorship resistant manner to anyone with an internet connection. However, fluctuations in bitcoin price quoted in traditional currencies makes in unusable as a stable medium of exchange. This issue was tackled by the “stablecoin,” which aims to leverage the benefits of decentralized blockchain rails while pegging a token to a fiat currency such as the US Dollar. This is achieved by backing each token with dollars or US Treasuries sitting in a bank account, allowing par redemption for the token at $1. Within the crypto market, stablecoins can be borrowed against appreciated assets, and allow traders to reduce risk by trading from a volatile token into a stablecoin without needing to leave the crypto ecosystem. Stablecoin issuance has risen dramatically over the past few years to over $160 billion in issuance today (source: coinmarketcap.com). However, proponents of decentralization and “bitcoin maximalists” point to the fact that stablecoins issued by a centralized authority may still be seized, censored, or take on credit risk of the issuer, and that a “decentralized economy needs decentralized money.”
Enter Terra, whose founders aimed to create an Algorithmic Stablecoin $UST meant to be pegged to $1, backed not by dollars in a bank but by code and a secondary token $LUNA which had the function of governance and validation rights to maintain the network. In theory, $1 of $UST could always be redeemed for $1 worth of $LUNA and vice versa. This redemption process meant that as $UST demand grew, the supply of $LUNA decreased, driving $LUNA price appreciation. To grow demand for $UST, developers built impressive applications that rival any fintech or bank applications in existence, with slick user interfaces to easily borrow, lend, and save $UST. Additionally, to subsidize user growth, the Terra team offered an eye-popping 20% annual yield on $UST through its Anchor application. That sort of yield amidst a negative real interest rate environment on what seemed to be a battle-tested algorithmic stablecoin found broad adoption, with the Anchor app reaching over $14 billion in $UST deposits as of Friday, May 6th. The growth of $UST meant the $LUNA supply continued to fall, with the price of $LUNA jumping from $0.60 on January 1st 2021 to a peak of $118 in 2022. Everything was great in Lunaland, with incredible price performance of the governance token and mouth-watering yields on the stablecoin.
Critics, however, pointed to the fact that Anchor’s 20% yield was unsustainable, and the reserve meant to subsidize the yield was quickly running dry (thank you, blockchain transparency!). Additionally, if the stablecoin was mainly pegged to $1 by faith and arbitrage, many pointed out the potential for a bank run scenario, where significant redemptions and sales of $UST could cause a depegging, leading to new issuance of $LUNA and a certain death spiral. $UST was not the first algorithmic stablecoin backed entirely by a secondary token, and to date all prior attempts have failed. However, $LUNA far surpassed prior versions in terms of adoption, led by a charismatic founder, best-in-class applications, and investors with deep pockets that could step in during periods of stress. The risk that $LUNA could follow the path of these prior projects was known, but to many, the prospect of a decentralized stablecoin represented an asymmetric opportunity to capitalize on what should be the highest TAM in crypto.
Knowing the risks, the Terra team (TFL) aimed to diversify the collateral backing the $UST peg to more than simply $LUNA, with a stated goal of buying $10B worth of bitcoin to support the peg in any downturn. But disaster struck before that goal was met.
Starting on Saturday, May 7th, amidst a period of low liquidity, a series of seemingly coordinated moves exploited the risk of a bank run on $LUNA, wiping nearly $100B of Terra ecosystem value off the map in days:
$UST liquidity drained, first on a stablecoin trading platform called Curve, then on centralized exchanges, notably Binance
Large sell orders of bitcoin, causing sell pressure across crypto
Large short interest on $LUNA
Large volume of transactions “spammed” to the Terra network, slowing down the programmed mechanism to regulate the $UST $1 peg
Repeated messages across social media platforms that the peg was at risk
The timing of these activities was not an accident. They occurred precisely at the time $UST liquidity was moved by the $LUNA team to establish a more liquid pool backing the stablecoin. That this was a known event can be credited to the hubris of $LUNA’s founder. Nevertheless, these activities were enough to push the UST price below $1, create fear in the minds of holders, and the redemptions from Anchor began. As a further depeg from $1 was feared, billions exited Anchor over the coming days to redeem $UST at any price, which simultaneously drove $LUNA supply upwards exponentially. By Thursday, May 12th the run on the bank outpaced TFL’s reserves to defend the peg, and both $LUNA and $UST cratered towards $0.
Where do we go from here?
With all of this, what makes us expect the crypto tide to rise again? As anyone following the market can tell you, these assets are prone to extreme booms and busts in fairly short periods of time. Typically, the boom is initiated by the introduction of a new application of blockchain technology or tokenization that has true promise to change economic models and create new ones. The bust happens when that promise turns to hype, welcoming irrational behavior (“fear of missing out”) and less focus on fundamentals.
What we have seen since the back half of 2020 is the introduction of new platforms and protocols that attempted to improve on earlier competitors or introduce entirely new use cases. Some of which have been very successful, but many either a) do not provide a claim on network activity or b) have no network activity at all. In recent conversations with many of you we have voiced the view that the majority of the top 50 fall into this latter group and have seen their prices fall dramatically in just the past few weeks. To us this is healthy and creates opportunities in a market that has not differentiated. In all cases thus far, what emerges from these types of broad market sell-offs are legitimate use cases that have value and drive material change. Below are some examples to provide context:
ICO Boom (2017 – 2018) – Notable Launches
NFTs – $16.7B current market cap
Maker DAO ($MKR) – $10.6B of assets on balance sheet
USDC – collateralized stablecoin with $52.1B market cap, $6.1B daily transaction volume
ZRX – infrastructure powering billions of P2P trade volume (i.e. Coinbase Wallet)
Facebook Libra first announced (remember that?)
CME BTC futures
Fidelity crypto custody
Decentralized Finance and Yield Farming (2019 – 2020) – Notable Launches
Uniswap (UNI) – $250MM of annual trading fees to liquidity providers
AAVE – $12.9B of assets on balance sheet
Compound – $5.7B of assets on balance sheet, first to receive S&P credit rating
We would be remiss to not mention that “don’t fight the fed” works in both directions, and the macro environment certainly makes it difficult to predict an exact timing of a reversal. However, the broader impact of the Terra implosion has been somewhat limited to the Terra ecosystem, and we now have a known seller of $3B worth of bitcoin (Terra) out of the way, with the market absorbing that sell pressure in an orderly fashion. At Motus, we see the correlation to growth equity as a sign of maturation of the market, growing into a true asset class of its own on the world stage. Ultimately, we see this correlation decoupling as more view crypto as an investable asset class with its own facts and circumstances. Likewise, we expect to see correlations within crypto fall as particular assets are assessed based on their own merit, but we are still in the early days. This is the reason we continue to see developer talent flock to decentralized finance, record-breaking venture capital funding focused on blockchain companies, and crypto continuously at the forefront of geopolitics. We are not short-term investors, and aim to discover the projects driving value creation with network effects that currently sit meaningfully off their all- time highs to drive long term capital appreciation while navigating volatility in the interim. Please don’t hesitate to reach out with questions or feedback.
Motus Capital Management
Past performance is not indicative of future results. This communication does not constitute an offer to sell or solicitation of an offer to buy the Interests in any jurisdiction where, or to any person to whom, it is unlawful to make such offer or solicitation in such jurisdiction. This communication is being provided solely as a high-level overview and is not intended to be relied on for the terms of any offering.