A Lehman Moment For Crypto? Breaking The Buck In Terra's Stablecoin UST As LUNA Collapses.

Breaking The Buck In The Crypto Collapse

Crypto is a sea of red now, with even the blue chip of the bunch, Bitcoin, down 30% over the last week, but the most dramatic fall has been in the Terra LUNA coin, which is down about 99% over the same time frame. LUNA/USD is a complement to Terra's U.S. dollar "stablecoin" UST/USD, which until recently, was pegged to the dollar dollar. 

Izabella Kamiska, the former editor of the FT's Alphaville site, was one of the first journalists to write about the market risk of crypto stablecoins, and she has a comment out on this today. I have posted it below. Before we get to that, I have a couple of quick follow ups on yesterday's post, Victory Day In Moscow. 

Two Updates On Yesterday's Post

In yesterday's post, I wrote about reasons why it appears Russia is winning the war in Ukraine, and I also shared an update on a hedged portfolio designed to weather the risk associated with the war and the current bear market. In that post, I neglected to include one issue in Ukraine which benefits Russia, namely, the difficult history between the government of Ukraine and some of its most zealous military units, such as the Azov regiment. The video below, which has English subtitles, is from a few years ago, when Ukraine President Zelensky was trying to rein in Azov fighters and had a heated exchange with one of them. 

When Zelensky named the head of the Azov special forces in Mariupol a "Hero of Ukraine", some observers were reminded of Hitler promoting Friedrich Paulus, the commander of Nazi Germany's 6th Army besieged in Stalingrad, to field marshal: since no German field marshal had ever surrendered, Hitler's expectation was that Paulus would fight to the death rather than surrender. Ultimately, Paulus did surrender, while the Azov troops holed up in the Azovstal steelworks complex in Mariupol so far have not, but the point is some of Ukraine's most motivated troops are ones that President Zelensky might prefer to abandon to the Russians rather than risk having them threaten his power after the war. 

The second update relates to a portfolio I shared in an article last week using ProShares Ultra Bloomberg Natural Gas BOIL, Teucrium Corn Fund CORN, Direxion Daily Emerging Markets Bear 3x Shares EDZ, and ProShares UltraShort FTSE Europe EPV:

Let's say you have $50,000 to invest now, but you don't want to risk losing more than 20% in a worst case scenario. On Monday, our system might have presented this portfolio to you, which is essentially a hedged bet on natural gas and corn getting more expensive, and European and emerging market stocks getting cheaper over the next six months. 

Screen capture via Portfolio Armor on 5/2/2022.

The update is that the outperformance of that portfolio versus the SPDR S&P 500 Trust SPY widened as the market fell on Wednesday: 

This portfolio was up 1.57%, while SPY was down 5.24% over the same time frame. 

Now on to Izabella Kaminska's post. 

Authored by Izabella Kaminska at The Blind Spot

Is the Terra fail a Lehman moment for crypto?

I have been travelling so I haven’t been able to keep up with the Terra debacle as well as I would have liked to. The good news is, I should have a broader piece about this by the weekend. In the meantime what I will say is that I was one of the first mainstream journalists to write about the market risk being introduced by crypto stablecoins. From the beginning I likened them to MMFs or eurodollar-style liabilities. You can read my initial account of the dawning of the Tether phenomenon here. As I noted at the time (my emphasis):

“Today Tether remains — at least on paper — a fully reserved dollar-backed system, anchored to the US dollar-issuing banking system. Theoretically at least, however, there’s no reason why it can’t evolve into something more akin to Alibaba’s Yu’e Bao fund, the largest money market fund in the world, which manages its RMB peg through active asset management. In the crypto world, of course, some share of assets could theoretically be other crypto currencies or ICOs. While the risk of asset swapping in this way would obviously be huge, it’s nothing ETF managers or Delta One desks haven’t tried before. It is, as it has always been, a question of marking everything to market and hoping both liquidity and correlation sticks.

Terra was “different” in that it was allegedly backed by an algorithm. But this of course was always pure marketing. It wasn’t really backed by an algo. It was backed by an arbitrage which emulated a perpetual value-creation motion machine. The problem is, that perpetual motion machine was illusory, and entirely dependent on constant liquidity in Terra and its value-skimming counterpart Luna.

Being dependent on “liquidity”, however, is also just a euphemism for being dependent on there always being as many people in the market wanting to buy your asset as there are wanting to sell it. Liquidity disappears when there is a big imbalance either way. This is a known known risk. The fact that anyone could have been dumb enough to think you can algorithmically control for it speaks volumes about the naiviety underlying the stablecoin market.

What’s more, whether the founders knew it or not, they were synthesizing a type of central bank relationship that depended on sophisticated forecasting and signaling. These sorts of relationships are always subject to reflexivity and blowback. In Terra’s case, what was supposed to be a confidence building exercise in accumulating a bunch of bitcoin reserves to help bolster the value of Terra, probably sent the opposite signal to the market. Notably, it suggested there was a risk the stablecoin might have to draw on such assets, meaning the founders’ confidence in the algorithm wasn’t 100 per cent. This introduced a known known reaction pathway that could be arbitraged. Undoubtedly it will also have influenced the valuation of Terra and Luna itself, adding decorrelation risk.

What’s really cute, is that the crypto community is referring to the unstitching of the peg as a hacker style “attack” on the stablecoin. But by all accounts the “exploit” was simply the unpicking of a poorly constructed value system through a legitimate arbitrage-exploiting exercise.

I love that the worlds of crypto and finance have now collided in such a way that we can finally expose everyone engaged in arbitrage hunting, from Paulson to Soros, as nothing more than a hacker.

(Of course there is an element of truth to this. Good traders look for bad value assumptions or vulnerabilities in current arbitrage mechanics. They then exploit them and make squillions. This is seen as an exercise in making the market more efficient in the long run. As a result, I think this fusing of terminologeis tells us more about how we view computer hacking than it does trading. If most hackers — at least those who don’t depend on social engineering or disinfo — are just arbitrage hunters, it’s fair to say they have gotten a bit of a bad wrap for exposing vulnerabilities and making the market more efficient. Though, I guess, that’s the point of offering hacker bounties in penetration testing environments.)