The crypto market crashed about a month ago and this can only be news to those living under some rocks or too busy with the Heard vs Depp lawsuit to notice the obvious staring them in the eyes. So, here’s the story of the most volatile week in the history of cryptocurrencies, a story of arrogance and greed, the domino effects of unregulated markets and the depressing story of the “Lunatics”, a (now-extinct) group of irresponsible gold diggers who thought they had discovered the philosopher’s stone, only to find it was a worthless amethyst. But hey, who said life was fair? A certain change of pace and tone will be noticeable for the ones who also read the 1st article on cryptocurrencies. I will first explain the concept behind stable coins and then focus on algorithmic stablecoins (i.e., TerraUSD). Ultimately, we will analyse the crash per se and go through the juiciest theories on the street. Hop on and enjoy the ride!
For an overview on Bitcoin, Ethereum and the blockchain technology, you can read this. Since writing that article, certain developments have occurred in the market. In other news, Bitcoin, a.k.a. “digital gold" or "hedge against inflation", plunged below $US25,500 a couple of weeks ago, far from the record high $US 69,000 price tag it commanded back in November. All jokes aside, I do see the reason behind Bitcoin’s “inflation hedge” tag as there’s no more need to worry about inflation (even when skyrocketing past 10%) if you're losing money faster than you can count. At a price decline in excess of 50%, an inflation of 10% or so seems like a laughing matter! And to make things worse, remember when everyone was in awe with the tiny Central American country of El Salvador and its futuristic president making Bitcoin a legal tender last year? As Bitcoin’s price has continued to fall, there are raising concerns about whether the country will be able to meet its next debt payment. Bitcoin and then a national debt default. Absolutely poetic!
Stablecoins
Now, let’s see what a stablecoin is and as before, the name is no accident. The raison d'être of stablecoins is to remain stable, as they are supposed to be pegged to fiat currency, such as the dollar or the euro. Nonetheless, the definition of stability, especially when applied to such a frenetic market as crypto, seems to lose its potency. In all seriousness, the safety and stability originate from the assets’ peg to a certain fiat currency (can be exchanged for a fixed amount of said fiat currency, and vice versa). Essentially, stablecoins i.e., UST, Tether and USDC function like bank accounts for the crypto ecosystem, allowing investors to easily trade other assets in the crypto ecosystem.
But just as some people are more equal than others (disclaimer for those ignorant enough not to recognise the reference to George Orwell’s Animal Farm), some stablecoins are more stable than others. This distinction is caused by the way the coin is pegged to the fiat currency; there are three possibilities. First, the safest stablecoins (i.e., Tether) are pegged to the fiat currency via cash reserves as collateral. For instance, Tether claims its tokens are pegged at one-to-one matching with US dollar and are backed 100% by its reserves, the majority of which are made up of cash and “cash equivalents”. What those cash equivalents consist of, nobody knows! So even Tether’s stability is relatively questionable. Second, some stablecoins keep their peg by being backed by reserves of cryptocurrencies. It doesn’t take a doctorate in astrophysics to recognise that due to the highly volatile nature of cryptocurrency, (alas, much more volatile than cash and its obscure equivalents) it is harder to maintain the peg. Thus, maintaining a one-to-one ratio requires these coins to be backed by more than 100 percent of their value, given the high risk of the collateral plummeting in value. Third, there are the algorithmic stablecoins (i.e., TerraUSD), which are at the epicentre of last month’s crash and will be discussed next in more detail.
The tale of two brothers: Terra and Luna
We’ll now zoom in on the algorithmic stablecoins and the particular case of the two cryptocurrency siblings, TerraUSD and its sister Luna. Through some complex engineering, TerraUSD (UST) was designed to maintain its 1-to-1 ratio with the dollar through the creation and destruction of UST and Luna, which would theoretically help balance supply and demand. Thus, the algorithm adds tokens to the supply if the price gets too high, to bring the price back down, or removes tokens from supply if the price falls below the peg. Spot the problem yet? One man did spot it even before the TerraUSD and Luna were launched and warned of the “death spiral” hidden in the stablecoin’s algorithm that was supposed to guarantee its peg to the dollar. Did anyone listen? I expect not, given that at their height, Luna and UST had a combined market value of almost $60 billion. More than that, the project had the backing of credible venture capital firms, i.e., Arrington Capital and Lightspeed Venture Partners. In turn, this could only have made matters worse, giving the investors a false sense of security.
When confronted with said fault in his algorithm, UST’s creator and black-belt arrogant replied that he did not “debate the poor”. Such behaviour is certainly not something to aspire to, but alas, I find no fault with arrogance under the condition that it is the side-effect of genius. Now, certainly Mr Kwon and thousands of his “Lunatics”, as he affectionately called the poor people that invested in his utopic house of cards, believed that UST was the flawless product of a genius. Mr Kwon did not even consider nor evaluate the threat when confronted exactly with the problem which a month ago caused his whole metaphorical house of cards to come crumbling down, erasing a trillion dollars in the process. Just a week before Terra's demise, he told a YouTube crypto channel that "95% (of coins) are going to die, but there's also entertainment in watching companies die too". The irony of it all is just exquisite, too bad he didn’t foresee his own company being one of those 95%. Wait, it gets even better! Just before his $60bn creation began to implode, he tweeted to his nearly one million followers on Twitter: "I love chaos." And there are still people doubting the existence of karma?
Now, let’s zoom in on the crash. In early May, UST plummeted below its $1 peg. The system broke on May 8, when $2 billion in UST was extracted at once, with hundreds of millions of that sold. UST reached 98 cents, and the mechanism of exchanging UST for Luna couldn't keep up and UST was thus forced to depeg. This play should bring to mind Soros’ masterstroke when he “broke” the Bank of England. This incited a cryptocurrency sell-off, leading to both TerraUSD and Luna to crash to effectively 0. And to go back to our main character, what was Mr Kwon doing when UST lost its peg? No one knows, really. But I can tell you what he was not doing at the time, for he was certainly neither calming his investors nor providing a rational explanation for what was happening on the market. He doesn’t “debate the poor” even when he is one of them, that’s what I call a man with principles!
The collapse of the Terra project led to combined losses of about $60 billion between the stablecoin and its sister Luna. For instance, Luna went from trading at a high of around $119 just a couple of months ago to being worth a mere fraction of a cent. This is volatility, folks! Luna recorded a 99.9% price correction during a 2-day white swan sell-off on May 11th – 12th (why white swan and not a black one? while the rarity of said event is not debatable, the sell-off itself was predictable ever since the faulty algorithm was identified), then a further 99% and finally another 90% drop to reach $0.00000112 against BUSD (Binance USD), the last trading pair to not be delisted by crypto exchanges. As you can imagine, both Luna and TerraUSD investors lost everything. In turn, this had ripple effects throughout the crypto market, i.e., the price of Bitcoin plunged to its lowest point since 2020 while Coinbase, the large cryptocurrency exchange, plummeted in value.
Let’s see what really caused the crash. Nobody knows for sure what happened for sure, but we’ll go through some theories and see what makes sense and what not. One such rumour is that this was a coordinated attack to exploit Terra and cause a Bitcoin crash, so that ‘whales’ would be able to buy in at a cheap level. First part of the rumour seems reasonable as such a huge trade certainly requires grand coordination and ample resources. But regarding the target of the attack, I am not so sure. It is not like the price of Bitcoin was sky high anyhow, for it had been fluctuating around $US30,000 and a bit over $US40,000 for months before the crash. Another rumour states that this was a personal attack on Mr Kwon. Now, this seems a wee bit more reasonable. Imagine giving that arrogant the lesson of his life and making a humongous profit in the process? Who in their right mind would say no to that?
The most popular and logically sound theory was put forward by the founder of Cardano, Charles Hoskinson, although he later deleted the tweet. He hypothesised that a large institution had borrowed 100,000 Bitcoin from Gemini exchange (approx. $3.5 billion), basically shorting it. Then, a large amount of that BTC was exchanged over the counter (OTC) for UST at a discount from our very own Mr Kwon who accepted the trade and sold, thus lowering the UST liquidity. That institution then timed the market, waiting until a Saturday night (May 7) when trading volumes were very low, and allegedly dumped large amounts of both BTC and UST on the market causing a liquidation cascade of leveraged longs and panic selling by investors in a low-volume market that broke the US dollar peg. As you probably surmised, this is textbook market manipulation. But guess what, because the markets are unregulated, this is not illegal! Nor were the monies of the investors protected by anyone, really. Anyone still a fan of deregulated markets? Well, maybe Bernie Madoff. For those of you who didn’t get the joke, it’s explained in the meme below and spoiler alert, there’s a Luna 2.0.
This was all made possible by that algorithm of Mr Kwon and its alleged “death spiral” which had already been identified by Cyrus Younessi of Scalar Capital, a crypto investment firm, some years before. This meant that a crash in Luna’s price would bring the stablecoin down with it; the selling feeding on itself due to the algorithm. Just like an algorithmic ouroboros! So, when the death spiral kicked in, the algorithm started selling Bitcoin and other cryptocurrencies it had at hand (i.e., Avalanche), which triggered more selling. And if there are no buyers, the price goes down, then it starts to feed on itself as people start panicking and selling Luna. The timing of the market, trading during a low-volume one with few bids available and an already weary market affected by sky-rocket inflation and increasing interest rates, was absolutely crucial. But take this with a pinch of salt, for none of the aforementioned claims were verified and Gemini denied issuing any such loan. Also, while the word on the street was that the culprit behind the attack was BlackRock, the firm denied any involvement. If the theory is indeed right, then it must have been a huge asset management firm behind it, or maybe instead of a single entity, several “whales” trading against UST. As a slight note, the crash could have potentially been prevented if Terra had had enough BTC reserves on hand to preserve the peg, which emphasises the importance of the initial Bitcoin trade and why the theory makes so much sense.
This crash has had huge consequences. First and foremost, boxer want-to-be Logan Paul and British Youtuber KSI lost a combined $3m. My thoughts and prayers go to them as they go through such a disaster. Who knows, they might even have to put in an honest day’s work between them, mind you! Jokes aside, so many retail investors lost all their money. Twitter and Reddit were flooded with messages from investors describing how they lost most of their savings in the blink of an eye. Some of the comments expressed such desperation that it prompted the Reddit forum moderators to pin the number of suicide helplines at the top of the threads. It was that bad, yeah! Then, the crash had ripple effects through the whole crypto market, wiping $1trillion in the past month. In the wake of the crash, the price of Ether plummeted more than 30 percent. Other cryptocurrencies, i.e., Solana and Cardano, were also down. But you can understand the worry among crypto investors; if the value of a supposedly "stable" digital asset can be wiped out so easily in a few days, what could happen to a mere crypto coin? And who else is next in the crypto firing line?
Shockingly (really?), the regulators are becoming concerned of a true Lehman-like crypto moment, i.e., a major stablecoin issuer like Tether could experience a literal bank run. The Federal Reserve Chair Janet Yellen and European Central Bank President Christine Lagarde called for urgent regulation of the crypto market and especially of stablecoins. But it should not come as a surprise that regulatory hurdles loom close over the crypto ecosystem, making the huge profit margins resemble more and more of fairy tales rather than reality. There would certainly be several issues that need to be solved. For instance, what are the permissible reserves? Who can issue a stablecoin? How should an issuer be audited? What kind of disclosures should be made to consumers?
But all this shock and panic are unnecessary, for it is not like this is the first time a decentralised algorithmic stablecoin has failed. To add insult to injury, it’s apparently not even Mr Kwon’s first token that failed, for he was reportedly behind another failed cryptocurrency coin before starting the Terra project, Basis Cash. Remember Mr Kwon’s reply when confronted with the possibility of the Terra algorithm being faulty? “I don’t debate the poor.” Well, karma is a b****, isn’t it? So, let me take this chance to formally welcome former billionaire Mr Kwon amongst the poor!
It was to be expected that the regulators will use this crash to push ahead their own political agenda. And while I support the regulation of crypto markets, even though that beats the purpose of these digital tokens, it would be great to limit any such crashes from happening again. But the truth is that TerraUSD was never really a stablecoin to start with. UST was an attempt to make something appear stable, that tried to be pegged to the dollar as much as possible, but by being backed by its sister currency instead of fiat currency (i.e., US dollars), it was essentially a recipe for disaster. It's basically like printing money out of thin air through a complex mix of "smart contracts" that try to keep the value of each UST token as close as possible to $US1.
A spinoff to the tale of the two brothers: Terra and Luna
You’d guess that fearing the thousands of investors seeking retribution for his having ruined their lives, Mr Kwon would use the money left to get the fanciest state-of-the-art security system. Well, it wouldn’t have been as funny if he did, really! Instead, a new Luna blockchain (that does not support TerraUSD) and another token were launched on May 27, his “Luna 2.0” project. You have to give it to him, if anything, he is perseverant! I guess he won’t give up as long as there are still crypto investors with a positive PnL.
Call me a disbeliever, but I highly doubt we are witnessing a true resurrection of the Luna project. Luna, a Phoenix rising from the ashes? Only time will tell. Until then, be weary of self-absorbed genius pretenders. Ciao!