The UST stablecoin and the Terra ecosystem dramatically collapsed last week. This has resulted in devastating losses for investors in the project. It has also had ripple effects across the broader industry, with plummeting prices and several flash crashes for digital assets across the board as market sentiment turned to ultimate fear. CMCC Global was a seed investor in Terra back in early 2018 and we are deeply familiar with the project. This month, we will offer our perspective on what took place last week and why the project failed. We will reflect on the longer-term implications of this event and the lessons that can be learned.
In early 2018, we met with two entrepreneurs from South Korea, Daniel Shin and Do Kwon. Daniel had previously built one of Korea's leading e-commerce unicorn companies TMON, which he sold to KKR. While working on this he saw that ecommerce companies operate on razor thin margins and give up large amounts of potential income to payment providers. Understanding the promise of blockchain technology, Shin realised that integrating stablecoins into ecommerce could radically lower payment processing fees. This became the original vision of Terra. Shin and Kwon would spend the next couple of years building out a stablecoin platform that targeted the South Korean ecommerce market.
There are three distinct mechanisms for building stablecoins: asset-backed, crypto-backed and algorithmic.
The simplest model is the “asset backed” stablecoin. This is where there are actual dollars or fixed income products in a bank account that back every stablecoin token. The godfather and current king of asset backed stablecoins is Tether. In the last week alone, Tether has successfully processed USD7bn of USDT redemptions. The reason that Tether does not fall from its peg is that if the price of USDT drops below USD1 on exchanges, arbitrageurs can step in and profit by buying USDT and then redeeming directly with Tether at a price of 1-to-1. At CMCC Global, we hold the opinion that USDT is the most secure, proven and trustworthy stablecoin in existence.
The second stablecoin model is “crypto-collateralized”. This is where the stablecoin token is backed by crypto. The DAI stablecoin is the market leader in this category. DAI was originally backed by ETH but is now backed by a basket of different crypto assets. Should these collateralized crypto assets start to fall in value, then the MakerDAO platform (which underlies the system) will start to liquidate vaults to ensure that the DAI in circulation is fully backed. This mechanism will be important to remember for later.
The third stablecoin model is “algorithmic”. This is where the stablecoin token is not backed by any collateral, but dynamically adjusts its supply to maintain its peg. In November 2020, we hosted an interview with Do Kwon who explained how Terra was designed. In summary, the system has a dual token architecture. On one side of the market is the Luna token and on the other side is UST (and other stablecoins). Luna absorbs any volatility that UST may encounter. For example, should the price of UST be priced above one USD, then arbitrageurs will mint more UST by burning Luna. The protocol will always allow minting to happen at the pegged price, meaning that arbitrageurs will continue to mint and sell UST at a profit until the spread has vanished. Should the price of UST fall below the peg then the process can be reversed, with traders able to burn 1 UST in return for 1 USD worth of Luna. This removes UST from circulation until the peg is re-established.
Over the last year, the amount of UST in circulation ballooned. This was largely due to the Anchor Protocol. Anchor is a lending and borrowing platform that was offering 20% returns on deposited UST into its savings pool. Crypto users as well as some traditional finance companies started to buy UST aggressively to earn the 20% yield. This put upward demand on UST, leading to increasing amounts of UST being created for UST to hold its peg.
In January 2022, Terraform Labs, the company behind Terra, announced the creation of a new not-for-profit entity called the Luna Foundation Guard (LFG). This new entity raised USD1bn from notable investors like Jump Capital and Three Arrows Capital. The purpose of this funding round was to buy bitcoin, which would then be used as partial collateralization for UST. At CMCC, this set alarm bells ringing.
As discussed earlier, crypto-collateralized stablecoins are not the same as algorithmic stablecoins. The mechanism to achieve price stability is entirely different. The move by Terra to start collateralizing UST with bitcoin meant one thing – the team no longer had conviction in the design of their stablecoin. We found this to be extremely concerning.
In addition, in early 2022 we started to worry about regulatory action against Terra and UST. Asset-backed stablecoins, like Tether’s USDT, are derivatives of the USD. Tether does not “mint” USD. It buys USD and creates a token that represents the USD that it holds – this method does not impact the overall amount of USD in circulation as governed by the Federal Reserve. In the Terra ecosystem, UST was being “minted”, effectively adding to the supply of USD – an action reserved for the Federal Reserve.
In the early days of the project, we did not perceive this regulatory risk to be overly concerning as the amount of UST in existence was small. However, from November 2021 to February 2022 the amount of UST increased from UST 2bn to over UST 10bn. The rate of growth was staggering, and it seemed to be only a matter of time until UST would be subject to serious regulatory scrutiny. We did not anticipate that Jerome Powell of the Federal Reserve would watch as a private initiative added USD 10bn to the monetary system. As the circulating supply of UST kept growing – reaching UST (aka USD) 18bn shortly before the collapse, we considered this a time bomb.
As a result of these technical and regulatory concerns, we decided to exit our Luna position in March 2022.
On the weekend of 7th May, things started to unravel. It is unclear whether this was a targeted attack or an unfortunate series of events. What we know for sure is that some very large UST sell orders started to hit exchanges. Some crypto whales withdrew their Anchor savings positions and dumped UST. These sales totalled hundreds of millions of UST, which were sold rapidly and caused UST to fall from its USD peg. Terra’s rebalancing system was not able to react fast enough to handle the severe downward pressure on UST.
Panic set in. The more that UST fell from the peg, the more that market participants tried to exit the market by selling UST, pushing the price further from the peg. It became clear that the system was broken. In particular, the market cap of LUNA combined with the BTC held by the LFG was less than the circulating supply of UST. Neither the algorithmic design, nor the newly purchased crypto-collateral would be enough to re-peg the system.
It was at this point that the broader crypto market started to quake. It was well known that the LFG was sitting on billions of dollars’ worth of LUNA and BTC. It was also apparent that the only option available to the LFG was to sell these to try to maintain the UST peg. The market braced for billions of dollars of sell pressure and traders (looking to profit) likely pre-empted and exacerbated the sell-off.
The LFG depleted its treasury in an attempt to regain the peg and the supply of LUNA exploded as traders redeemed UST for LUNA. In the span of about 3 days, the supply of LUNA went from 345m LUNA to 6.5 trillion LUNA. The price of LUNA also fell 100% (quite literally to 0). It was taken off most crypto exchanges and was not at all able to trade anymore. The broader crypto market saw extreme volatility to the downside, with Bitcoin down around 20% and many smaller assets down over 50%.
In the last few days, market volatility has subsided with most assets trading at a steep discount to where they were two weeks ago. Market participants seem to be taking a breath and surveying the damage caused by this implosion – an implosion in terms of market capitalisation of a similar size to the Lehman Brothers collapse back in 2008. We believe that there are several takeaways from this event ranging from micro to macro implications.
At the micro end of the scale, algorithmic stablecoins remain unproven and an unsolved design space. This is the most significant failure to date, although other attempts at algorithmic stablecoins such as Empty Set Dollar and Basis Cash, have also failed. In theory, algorithmic stablecoins are incredibly capital efficient and we will see other attempts at building them. The Terra experiment will be a stark reminder of the huge risks involved, but also the huge potential if successfully implemented.
On the macro side, the collateral damage of this implosion has highlighted the interconnected nature of the crypto ecosystem. Crypto is creating the first truly global monetary system. While there are enormous benefits to doing this, the failure of single projects can have significant knock-on effects. As Terra failed, it sent the price of BTC spiralling downwards due to forced treasury sales. There were also several assets in the Cosmos ecosystem that traded exclusively with UST. As UST lost its peg, the price of these assets also fell heavily.
The longer-term impact of this episode remains to be seen. Given the huge losses sustained by retail investors, it is inevitable that regulators will now step in. There is risk that they will look to over-regulate to prevent future catastrophes. On the positive side, there is also the chance that this will force regulators to come up to speed more quickly with the crypto space, which will lead to better regulations in the future.
In the shorter-term, sentiment has shifted. Prices have come down across the board and the ecosystem has been cleansed of leverage. In the private markets, we have already started seeing valuations fall as founders confront the new market reality. As an investor, this presents a big opportunity. In 2019 there was a similar calm, with subdued investor interest and lower valuations. This was the best time to be a crypto investor. Should prices remain depressed, this could again become an excellent moment to invest in projects with strong fundamentals and long-term minded teams. Some of our best investments and most staggering returns resulted from investments made during the last bear market of 2018/19. As a long-term minded investor, despite being painful in the short term, we somewhat hope that crypto markets stay depressed for a few months longer as we plant the seeds for our next big winners in Fund 4.
At CMCC Global, we have been reminded that continued due diligence is an essential ingredient to long term success. We have always held the belief that we would rather hold a small number of high-conviction assets than take the “spray and pray” approach to investing. This means that we have a high bar for new investments and closely monitor investments in our portfolio. We will be quick to divest when we lose conviction. But at the same time, we are not afraid to take big bets on innovative and exciting new projects that are pushing new technological boundaries.