June 2022

Crypto Contagion

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This month we will investigate the contagion that has been felt by the crypto industry in the wake of the collapse of the Terra ecosystem and now the spill over into companies like Celsius and Three Arrows Capital. We will explore how contagion has resulted in correlated price movements between digital assets and how it illustrates the interconnectedness of the crypto ecosystem.

Crypto is creating the first truly global monetary system. Artificial national boundaries do not exist on the Internet; there is no such thing as a cross-border email. Similarly, digital assets do not adhere to borders. While there are enormous benefits to this unified global financial system, single failures can have far-reaching knock-on effects. This month we will investigate the contagion that has been felt by the crypto industry in the wake of the collapse of the Terra ecosystem and now the spill over into companies like Celsius and Three Arrows Capital. We will explore how contagion has resulted in correlated price movements between digital assets and how it illustrates the interconnectedness of the crypto ecosystem. We will also look at how the underlying blockchain technology has held up in this period of intense volatility.

Digital asset markets have been highly correlated since their inception. In the early 2010s, just as crypto was starting out, the default base asset in the crypto ecosystem was bitcoin. Stablecoins were not yet prevalent or trusted and as a result crypto exchanges offered trading against BTC. In these early days, price movements in BTC/USD resulted in price movements for basically all digital assets. Today, the primary trading pair for crypto is against USD or USD stablecoins, although trading against BTC is still prevalent. While trading against stablecoin pairs should result in a lower degree of correlation between digital assets, we are still witnessing a high degree of price correlation today.

From a structural perspective, as the importance of BTC as a trading pair has fallen, so the importance of stablecoins has risen. Traders use stablecoins for several reasons. Firstly, they can act as an intermediary between digital assets when no direct market exists. For example, there is no direct trading pair for Solana against Gnosis. A trader looking to move from one of these assets to the other would need to trade into a stablecoin as the intermediary step. Stablecoins also offer a way for traders to de-risk and step away from crypto markets, without having to move into fiat and leave the digital asset ecosystem.

Owing to the increased importance of stablecoins, the impact of the collapse of UST, a leading USD pegged stablecoin, was significant. This impact can be viewed from both direct and indirect perspectives. We wrote last month about the events surrounding the UST collapse and the immediate direct consequences. The first consequence was that as UST de-pegged, the team behind the stablecoin was forced to liquidate its BTC treasury. This put significant and immediate downward pressure on the price of BTC. As discussed, correlations in the ecosystem remain high and so a falling BTC price ripples across the market, pushing down prices across the board.

The second direct effect of the collapse of UST was that any asset trading against UST was immediately impacted. The Terra blockchain was built using the Cosmos SDK. This made UST interoperable with every Cosmos chain and as a result UST had become the default stablecoin for the Cosmos ecosystem. Many Cosmos assets such as ATOM and OSMO traded against UST on decentralised exchanges (“Dexes”). As UST began to lose its peg, an asset that traded 1:1 against UST might still have traded 1:1, although the 1 UST was now worth less than 1 USD. In addition, many centralized exchanges began to halt the deposit of UST. As a result, holders of UST looking for exit liquidity rushed to swap UST on Cosmos Dexes, crashing the price of trading pair assets further.

Thirdly, several crypto projects and non-crypto companies were holding UST on their balance sheet. The reason for this was the high yield that the Anchor protocol was offering on deposits of UST. As UST collapsed, these companies saw their balance sheets evaporate and many will struggle to survive. Similarly, there are reports of billion-dollar losses from some investors as LUNA fell to zero. Outside of feeling short term pain, these investors will now have less capital to deploy into the crypto ecosystem going forward. As publicly disclosed in the New York Times, CMCC Global did not have direct Luna or UST exposure going into the collapse. Despite being early investors in Terra, we decided to exit our position in March this year.

The direct results of UST depegging were unfortunate, but obvious. The indirect impact has been less obvious. With UST depegging, crypto traders began to question the integrity of all stablecoins. Tether, the leading global stablecoin, began to see significant sell pressure on its stablecoin USDT. For context, USDT has a market cap of over USD70bn and over half of all bitcoin traded on exchanges is against USDT. In fact, USDT is the most traded digital asset, with USD45bn worth of USDT traded daily verses bitcoin which trades USD24bn a day (as of the last week of May).

The collapse of UST spooked investors and on the 12th May many started to sell USDT out of fear, with it trading as low as USD 0.9335. Traders that trusted in Tether’s redemption process bought this USDT dip and since the start of May, USD10bn of Tether has been redeemed directly with Tether. The positive takeaway here is that USDT today continues to trade at USD1 and the company continues its 100% track record of always processing redemptions.

Despite continuing to function as intended, USDT redemptions have an impact beyond crypto. Tether holds real world assets to back its stablecoin. When USDT is redeemed directly with Tether, the company is forced to liquidate real-world assets to pay for the redemption. These assets include secured loans, corporate bonds, US Treasury bills and commercial paper. The sale of these assets can have a negative impact on broader financial markets. In 2021, the rating agency Fitch warned that a mass exodus from USDT could destabilise short-term credit markets.

The timing of the Terra collapse has coincided with a broader downturn in the macro environment. This has accentuated the downward pressure and we are now seeing other market participants suffer. Celsius is one of the largest centralized gateways to crypto. It raised USD864m of venture capital and at one point custodied over USD3bn of funds for over 1m customers. The company offers high yield deposits on stablecoins and cryptocurrencies. It is effectively an asset manager, taking deposits and generating returns for clients. Today Celsius is facing a bank run and has halted withdrawals.

Similarly, Three Arrows Capital, a leading crypto hedge fund, is undergoing solvency issues. While no official statement has been made by the fund, the Financial Times reported that Three Arrows Capital was liquidated by BlockFi and other crypto lending firms after it failed to top up its loan collateral. The company likely suffered heavily from the collapse of Terra, a project that it publicly supported. On-chain data suggests that the company is selling its existing crypto positions to lower collateral requirements for certain positions. One of the Three Arrow’s wallets has debt totaling USD183m, blockchain data shows.

There is a chance that crypto contagion may have seeped into traditional markets. Investors with large crypto loses now have less money to spend and invest. In some cases, investors may have been forced to liquidate investments in traditional markets to cover their crypto losses. It is difficult to measure the impact and at this stage is unlikely to be meaningful from a global macro perspective. However, in the long run, we anticipate that moments like this in the crypto markets will have direct effects on traditional assets. This will, to some degree, be a sign of the success of digital assets, illustrating their role in the global financial system.

The collapse of Terra and the ensuing contagion has been one of the most significant events to have ever happened in crypto. It has dominated crypto and mainstream media and has had a huge effect on the digital asset markets. The one overarching positive of this episode is that in the immediate wake of the collapse the Terra blockchain continued to function as programmed. Blocks were created, transactions were validated and the Cosmos technology that Terra was built on operated flawlessly. This will be of little consolation to market participants who have lost large amounts of wealth. However, in the long run, episodes like this will help to battle test and harden blockchain technology, enabling a truly global financial system to be created.

The second positive takeaway is that long term investors with conviction in digital assets and crypto are now presented with an opportunity. We have spoken to many institutional investors over the past year, many of whom have been exploring investment opportunities. Investors interested in entering the market in late 2021 are now being offered the same opportunity at over a 70% discount. Of course, investor psychology is such that falling prices induce fear and rising prices induce fear of missing out (“FOMO”). With a 3+ year time horizon, we are confident that today’s crypto prices offer an excellent investing opportunity, and we look forward to scooping up leading projects at bargain prices over the next 6 months. In the words of Warren Buffet, today we have the chance to be “greedy when others are fearful”.