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The failure of a large algorithmic stablecoin tied to a top smart contract platform caused panic and contagion early last week, with a “Lehman” moment finding stability by Sunday’s close.
- Last week’s focus was heavily on the failure of LUNA, a top smart contract platform tied to the failed algorithmic-stablecoin UST, resulting in a downward spiral that caused contagion early in the week
- We offer key takeaways from the collapse, provide an update on pending stablecoin regulation, and illustrate the size and differences of various stablecoins
- We conclude with an update to our intra-year drawdown table - despite an average peak to trough drawdown of 55% per year for bitcoin, the asset still finished positive in 9 out of the last 11 years. Bitcoin has shown resilience through multiple market cycles, and this time will likely be no different
THE BIRD'S EYE VIEW
A top five smart contract platform declined in rapid fashion last week as a popular algorithmic stablecoin lost it’s USD peg in a severe decline that caused both panic and contagion across digital assets. With nearly $60 billion of market capitalization between LUNA and UST wiped out, bitcoin and ether declined 9.4% and 16.2% on the week.
While the same macro uncertainties had price action already negative, this decline resulted in now six straight weeks of digital asset and equity losses in a row.
So, what happened? To simplify, LUNA is a smart contract platform with a focus on stablecoin issuance, the largest being the algorithmic stablecoin UST. UST became popular as a 20% interest rate offered through DeFi application Anchor attracted nearly $18.7 billion in UST market capitalization.
As an algorithmic stablecoin, UST’s peg was dependent on arbitrage between the redemption of $1 in UST for $1 in newly-minted LUNA (and vice-versa). The redemption of UST led to inflation in LUNA’s supply (while the creation of UST burnt LUNA’s supply) and this was viewed as an attractive technology for many as LUNA reached a market capitalization of $41 billion at its highs.
Until, a trader found an opportunity to short UST, causing panic, de-pegging, and ultimately a “run on the bank” type scenario. As LUNA’s market cap fell below UST’s, there was not enough “equity” to back the UST “debt,” and a death-spiral occurred. LUNA’s supply skyrocketed from 375 million to 6.5 trillion, sending the asset to nearly $0, while UST fell to a low of around $0.05.
This led to panic and contagion, with a drawdown to $25,424 for bitcoin and $1,706 for ether. However, the two quickly recovered with a bounce and a weekly close of $31,019 and $2,130, respectively. As markets have since returned to a semblance of normality, this offers an attractive opportunity for bitcoin investors, given Luna-specific volatility.
TAKEAWAYS OF THE FALLOUT
- Unlike the downfalls of Lehman ($60 billion), Bear Sterns ($25 billion), and Enron ($65 billion), the LUNA & UST collapse ($60 billion) did not cause systemic issues within digital assets, nor across broader capital markets. Bitcoin did not need or ask for a bailout – the asset bounced off it’s lows rather quickly and has shown resilience since, even as ~$60bn of wealth was wiped from the system.
- While bitcoin has established itself as a fully-decentralized, hard-coded, and immutable payments network and store of value, many digital assets were created within the last five years, and the space will naturally experience growing pains. Many of these altcoins are experimental projects that combine software and money; success will not come without failure. But this type of risk profile is what attracts investors to the VC-type returns seen in prior bull markets.
- Stablecoin regulation was already coming, but this speeds up the process, and for the better. As we say, regulation provides a runway for growth and investment. Greater confidence in stablecoins will support further investment and use of digital assets.
A stablecoin regulatory framework has been a key theme as the segment quickly amounted to now $160 billion in market capitalization. While not set in stone, the President’s Working Group on Financial Markets recommended stablecoin issuers be insured depository institutions in November of 2021. Most recently, Sen. Pat Toomey rolled out draft legislation of a three-path framework: the PWG’s recommendation, registration under state-level money transmitter regimes, or new federal licenses under the OCC. Senator Lummis and Gillibrand’s comprehensive crypto framework will also include stablecoins as well.
What doesn’t kill digital assets, only makes them stronger; each boom and bust ultimately improves infrastructure and stability of this rapidly emerging asset class. This will likely be no different.
Broadly, there are three types of stablecoins: fiat-backed (USDC, USDT, BUSD, GUSD), debt-backed (DAI), and algorithmic (UST, FRAX, FEI).
Fiat-backed stablecoins have an equal amount of USD or cash-equivalents held in reserves. Despite controversy around Tether’s lack of audited financial statements, fiat-backed stablecoins are generally the safest of the bunch. Those concerns have led to the significant rise of USDC (issued by Circle) as a centralized, yet fully-audited stablecoin. While Tether momentarily declined to a low of $0.94 before quickly resolving, fiat-backed stablecoins were not impacted by UST’s fallout. CBDCs would fall under the fiat-backed category.
Debt-backed stablecoins are backed with collateral, such as ETH, which is locked in a smart contract to receive DAI (for example) in return. These debt-backed stablecoins are overcollateralized, 150+% in DAI’s case, and loans are liquidated if investor collateral falls below a certain threshold. As a result, DAI did not face any issues during the UST downfall.
Algorithmic stablecoins, such as UST, use algorithms to peg against a selected currency. Often, this is through utilizing another token, such as LUNA, with a redemption process used to maintain the peg. While the most capital efficient, algorithmic stables pose the greatest risks, as seen in the downfalls of Iron Finance and now, UST. These are, however, much different than fiat-backed and debt-backed stablecoins and should be treated as such.
UPDATE TO DRAWDOWN TABLE
Given that the brunt of this most recent decline was much-to-do with the LUNA & UST downfall, an attractive opportunity is now presented for long-term bitcoin investors.
Below, we illustrate intra-year drawdowns as well as annual returns. While bitcoin certainly draws down, it also disproportionately recovers.
Despite an average 55% intra-year drawdown, bitcoin has ended positive in nine out of the eleven years since 2011.
This is for one evidence of bitcoin’s outstanding resilience, and two, illustrative of the significant opportunity that long-term investors have when investing in bitcoin off its highs.
History doesn’t repeat itself, but it often rhymes.
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Joseph Orsini, CFA
Director of Research
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