Good Morning!
Before we jump into what was a wild couple of weeks, I wanted to highlight two quick notes. The first is NBC did a good piece on how crypto has become a lifeline for many Cuban citizens amid heavy financial sanctions. If you are interested, you can watch that video here.
The second is a follow up to our last newsletter where we dove deep into the benefits bitcoin mining can have for the environment. The day we released our last newsletter, Bloomberg also published an article on how methane is a big climate problem that bitcoin is helping to solve. Then a few days later, Nima Tabatabai published this article on how bitcoin is the first global market for electricity and will accelerate the adoption of renewable energy. It’s exciting to see the facts get out there and the narrative slowly starting to change for the better.
On Chain Analysis
Video of this week’s On Chain Analysis
Last week included one of the wildest three day stretches in crypto’s history, even by crypto standards. Let’s explore what happened with Terra’s stablecoin UST and the impact it had on the rest of the crypto markets.
In our April 5th edition, we explored the rise of stablecoins, the drawbacks of asset backed stablecoins, and the risks of algorithmic stablecoins. In that piece we went into depth on how Terra and LUNA work so if you would like a refresher, please go read that article. In addition, we discussed how LUNA acquired over $3 billion of bitcoin to use as a reserve asset to help prevent the dreaded “death spiral” that had plagued previous attempts at creating a decentralized stablecoin. Last week we saw this model put to the test and fail spectacularly.
Starting on May 9th, the on-chain data shows that there was a coordinated attempt to de-peg UST from the dollar. Before we get into how this was executed and the impact it had on the crypto market, we need to understand the confluence of events that created a perfect storm for this event to unfold.
The first thing to understand is that the more liquidity there is for a stablecoin, the more useful that stablecoin becomes which leads to greater adoption which leads to more liquidity. This self-reinforcing cycle can lead to rapid growth for a project. Thus, many protocols have incentivized early users with high yields to attract more capital into their ecosystems. This competition for liquidity is playing out across a variety of platforms but has been the most intense on a decentralized exchange called Curve and has affectionately become known as “The Curve Wars.” In an effort to increase adoption, Terra decided to partner with three other stablecoins to form a new liquidity pool on Curve called 4pool which in theory would be one of, if not the largest, liquidity pools in the market. As part of this agreement, Terra committed to moving a large portion of UST from its existing Curve liquidity pool called 3pool, into the new 4pool.
The second thing to know is that the Luna Foundation Guard (LFG), the organization responsible for supporting the Terra ecosystem, acquired over $3 billion worth of BTC to help stabilize the price of UST in times of volatility. However, the plan to connect the reserve to the blockchain with a smart contract was still weeks away from launching. According to Vetle Lunde, an analyst at Arcane Research, “The reserves had reached its desired size, but the infrastructure to utilize the reserves was not in place.” This meant that LFG would have to step in manually should volatility hit rather than having an autonomous system in place should UST ever fall below $0.98.
The final piece to this puzzle is that the person or group behind this move had built up a large position of UST on Curve, presumably in preparation for this attack, prior to Terra transferring a large portion of UST from 3pool to 4pool. This set the stage for Terra’s collapse last week.
On the morning of May 9th, Terra moved $150m of UST out of the original liquidity pool on Curve as planned. Soon after, the person or group behind the attack also pulled roughly $350m worth of UST out of the same pool. The result was UST breaking its peg for the first time and falling to $0.92 within hours. Remember, there was no smart contract in place to step in using the BTC reserves to defend the peg in real time.
Source: Dune Analytics
News of UST losing its peg quickly spread throughout the crypto community. After months of collecting 20% annual yields by staking UST, a large portion of users began to withdraw their tokens in fear of a possible “death spiral” scenario. There are even reports that some market participants, likely even the original attacker, continued to use their reserves to dump UST on the market. With so many market participants selling, there was essentially a run on the bank, which further exaggerated the de-pegging. By the evening of the 9th, UST had fallen to as low as $0.61.
As the price of UST began to fall, the Luna Foundation Guard (LFG) started selling the bitcoin reserves and buying UST in an effort to restore the peg back to $1. All in all, LFG deployed nearly all 80,000 BTC in their reserves (worth approximately $3 billion) and by the middle of the night, UST was back up to $0.95.
However, the damage was done and the next morning, panic began to set in. Investors began pulling money out of Anchor, the largest yield-earning protocol built on the Terra blockchain that drove the majority of demand for UST. Nearly 60% of the total deposits were pulled from Anchor in less than 48 hours.
Source: https://app.anchorprotocol.com/
The result of so much UST being sold into the market caused UST to de-peg once again only this time much more severely. UST fell to as low as $0.28 on May 11th causing validators on the Terra blockchain to stop operating in order to prevent governance attacks due to the severe devaluation of the network. Terra validators temporarily pulled the plug on their network for a second time on Thursday following a technical glitch caused by an influx of LUNA tokens meant to help restore the value of the stablecoin. As of writing this, UST is trading around $0.06.
Source: Messari
So why would anyone try to de-peg UST? Money of course. Given the attacker knew there was a small window of opportunity and likely had built up a large UST position over time to avoid any suspicion, it’s also very likely whoever initiated the original de-pegging also shorted both UST and LUNA. Not only did UST fall dramatically, the companion token LUNA, which is the mechanism used to help keep UST stable, fell 99% last week. Like George Soros made billions of dollars shorting the British pound back in 1992, someone or some group likely made hundreds of millions, if not billions of dollars last week shorting UST and LUNA.
The Terra Collapse & The Crypto Ecosystem
First, BTC held up fairly well despite the enormous sell pressure. Remember, in a matter of hours, LFG dumped nearly $3 billion worth of bitcoin onto the market. In fact, as a result of LFG selling bitcoin, May 10th was the largest day of net inflows of bitcoin onto exchanges since 2017. Over the last several months we have discussed how bitcoin has been coming off exchanges at record levels. Last Wednesday saw a reversal in that trend. May 10th appears to be an anomaly but if we start to see a broader trend of coins coming back onto exchanges, that would be cause for alarm.
Amidst the Fed’s interest rate hike, sell off across almost every major market, and having to absorb such a large bitcoin dump due to Terra, BTC managed to stay around $28k – $30k for much of last week. This price level is only slightly below the range bitcoin has been trading at most of the year which speaks to the strong support at these current levels. Despite these recent events, numerous long term macro indicators are still signaling historical undervaluation for bitcoin.
Second, the crypto ecosystem as a whole just lost a $40 billion asset in a matter of days and yet, Terra wasn’t “too big to fail.” To put that in context, Lehman Brothers had a market cap of $60 billion and on a relative basis, was a smaller portion of the traditional financial system than Terra was within the crypto economy. And yet, bitcoin is still going strong. Ethereum is still on schedule for its merge to proof of stake later this year. Other stablecoins are still maintaining their pegs and other DeFi protocols are working as intended. Yes, the free market can be brutal at times and I in no way want to make light of last week because many people lost a lot of money. However, crypto is the closest thing we have to a truly free market economy and while it can be ruthless at times, it also avoids situations that require a bailout caused by a centrally regulated financial system. The crypto ecosystem as a whole once again proved its resiliency last week.
Third, stablecoins have already been a hot topic among policy makers. Expect Terra’s collapse to add more fuel to this fire. In fact, U.S. Treasury Secretary Janet Yellen has already publicly highlighted last week’s events as further reason for stablecoin regulation. Hopefully, policy makers will be able to distinguish between the different models of stablecoins (asset backed vs algorithmic) and accompanying levels of risk inherent in each model.
Finally, we should be wary of any hyperbolic narratives regarding stablecoins in general. We will see a lot of critics argue that “Terra didn’t work, therefore all possible future decentralized stablecoins are doomed to fail.” While it may be a popular take today, I do not believe it is a particularly intelligent one. Terra was less than two years old and algorithmic stablecoins are still an emerging technology. Terra clearly had some critical flaws that a very sophisticated, well capitalized market participant was able to exploit, but that doesn’t mean an algorithmic stablecoin will never work in the future.
UST will go down in history as one of the largest collapses in crypto’s history along with Mt Gox and the Ethereum DAO hack. Valuable lessons were learned coming out of each of those incidents and both bitcoin and Ethereum not only bounced back but are stronger than ever. While my heart goes out to anyone who lost a significant amount of money last week, I also believe it is necessary to allow for experimentation because trial and error is essential to innovation and progress. It’s also a good reminder that beyond bitcoin, everything in crypto is still an experiment at this point.
As always, the on-chain data is provided by Glassnode. If you would like to have access to the data yourself, you can sign up here:
State Adoption
Crypto has always had a bottom-up adoption pattern. Bitcoin started in the cypherpunk community and was adopted by early retail consumers long before Wall Street or institutions started getting involved. Today, the same thing appears to be happening at the government level. Crypto is quickly being embraced by numerous states while the federal government has largely been reluctant to pass any national legislation. In past newsletters we have covered how Wyoming, Florida, and Texas have led as crypto advocates.
Largely spearheaded by Caitlin Long and Cynthia Lummis, Wyoming has some of the most crypto-friendly regulations in the world. The state has approved over 20 laws to make it easier for crypto businesses to operate, approved a new crypto banking charter which enabled Kraken and Avanti to become the first crypto banks in the US, and became the first state to adopt an entirely new legal framework for Decentralized Autonomous Organizations (DAOs). Beyond its crypto initiatives, Wyoming also has no state income tax and no state bitcoin tax.
Florida has not only become home to the largest bitcoin conference in the world, but the Governor of Florida also proposed accepting crypto for state tax payments. Miami’s mayor, Francis Suarez, has long been a crypto advocate and was the first to institute a city-based token that gives 30% of its revenue to Miami called MiamiCoin. The mayor is also already collecting his wages in bitcoin and is pushing hard to make Miami the crypto capital of the US.
And then there is Texas which has done an amazing job of attracting bitcoin miners with tax credits, training, and other incentives to become the bitcoin mining capital of the US, if not the world. In addition, the state has passed several bills to improve its crypto regulatory framework including a bill that recognizes the legal status of cryptocurrencies and paves the way for banks to provide custody services for cryptoassets.
The success of these three states is now leading to other states following suit. Enter California. On May 4th, California Governor Gavin Newsom issued an executive order to begin creating a comprehensive regulatory framework for crypto with the goal of “creating a transparent and consistent business environment for companies operating in blockchain.” The business and economic development office will collaborate with other departments to develop a transparent plan to incentivize more crypto companies to call California home. The executive order also lays out a road map for consumer protections and for the state to examine ways it can take advantage of blockchain technologies and digital assets.
Soon after Newsom’s announcement, Hawaii became the latest state to move toward passing pro-crypto regulations. The tropical state passed a bill establishing a blockchain and cryptocurrency task force with the directive of developing “a plan to expand blockchain adoption in both the private and public sectors.” The task force will include government officials, members of the crypto community, and professors from the University of Hawaii that specialize in digital currency.
California and Hawaii are just the latest in a long list of states moving to adopt crypto. In March 2019, Colorado passed the Digital Token Act that exempted cryptocurrencies from some securities regulations. In 2018, Ohio lawmakers legally recognized blockchain data for uses such as marriage licenses and birth certificates and enacted a law that allowed taxes to be paid in crypto. In fact, according the National Conference of State Legislatures, there are at least 37 states considering crypto-related bills.
With the exception of New York, nearly every state is beginning to embrace crypto. It’s fitting that a network that initially grew in a bottom-up manner is being embraced by the states first rather than top down.
The Securities and Exchange Commission is ramping up its fight against crypto crime.
On May 3rd, the SEC announced that it plans to hire 20 new employees to its Enforcement Division’s Crypto Assets and Cyber Unit, which would nearly double the size of the division. The unit was created in 2017 with the goal of targeting cyber-related misconduct and establishing a task force to identify misconduct that impacts retail investors. Since the SEC created this task force, it has executed 80 enforcement actions against unregistered and fraudulent cryptoasset offerings and issued fines of nearly $2 billion.
It is important to note that the SEC does not consider bitcoin or Ether a security and thus has steered clear of any action against those specific tokens. Gary Gensler has, however, made it very public that he believes that the vast majority of other cryptoassets are securities and has been asking Congress for more resources since last September so that his team can carry out enforcement. Of course, the CFTC Chair disagrees with Gensler and believes most cryptoassets are commodities and thus fall under the CFTC’s purview. Back in November 2021, we covered how various financial regulators such as the SEC, CFTC, FDIC and the OCC all have different views on cryptoassets and thus all think they have a claim as the regulating body.
Based on Gensler’s public comments, its likely we already know what parts of the industry he wants to go after. For example, he has repeatedly raised concerns about unregistered securities masquerading as tokens on crypto exchanges, investor protections on decentralized finance protocols, and potential impact of stablecoins on the market. With the increase in staff, expect the SEC to set its sights on stablecoins, exchanges, non-fungible tokens (NFTs), or lending and staking protocols.
The problem with the SEC’s approach is that the rules and regulations aren’t very clear. For example, if bitcoin and Ether aren’t securities because they are “sufficiently decentralized” and thus do not pass the Howie test, at what point does a token become sufficiently decentralized? The SEC has never provided clear guidance on this or any number of other important topics that would give the market clarity on what is legal and what isn’t. Yes, some cryptoassets are clearly securities but a much larger number fall into this grey area. Shouldn’t the SEC focus on clarifying the laws and regulations before they start enforcing them?
Apparently, many within Washington DC and within the SEC for that matter, seem to agree. In a recent interview, SEC Commissioner Hester Peirce said that she opposes the agency hiring 20 new staffers and that “having an enforcement team that’s dedicated to this area is fine, but where’s the regulatory team dedicated to this area?”
In Other News
A recent wealth management survey found that more than three-quarters of surveyed family offices see benefit in crypto.
The possibilities the Lightning Network opens up for bitcoin.
Jack Dorsey, Michael Saylor, Fidelity and others defend environmental impact of bitcoin mining in letter to EPA.
Crypto Bahamas signals stronger ties between old and new worlds of finance.
Argentina’s largest private bank will offer bitcoin and Ethereum trading.
Coinbase issued a warning in its SEC filing on Tuesday that its custodial services could be subject to bankruptcy proceedings in a “black swan” event. Coinbase CEO Brian Armstrong said that the company’s Prime and Custody customers (which are institutional customers) are protected by their terms of service and that it would take steps to offer similar protections to retail customers. Friendly reminder, not your keys, not your coins.
Democrat Tim Ryan and Republican JD Vance are running against each other for Ohio’s open Senate seat but the two candidates are meeting eye-to-eye when it comes to cryptoassets and extending their support for digital currency.
In a first for the Wall Street trading giant, Jane Street has borrowed $25 million in USDC (with plans to up that to $50 million) through the DeFi marketplace Clearpool.
Crypto lobbying is not dying down on Capitol Hill, with $4.4 million of industry lobbying spent in the first quarter.
Block reports $1.73 billion in bitcoin sales via Cash App during Q1 2022.
Cryptocurrencies and blockchain-based tokens will not be taxed in Germany, according to the country’s first guidance document on these technologies.
Terra collapse fuels Congressional work on stablecoin legislation.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.
BACK TO INSIGHTS