Last Man Standing

South Korean based stablecoin project, Terra Luna, imploded this past week creating disastrous rippling effects across the cryptocurrency ecosystem. The second crypto bank run in recent memory, trailing behind the Mark Cuban promoted Iron Bank, fomented a potential contagion which saw billions of dollars in "value" wiped clean from the system. Terra's network fell in market cap from $40 billion to $200m in less than a week that helped drag Bitcoin from $750 billion to $580 billion. Its visionary, Do Kwon, perhaps experienced the greatest comeuppance on social media ever, following months of rampant and unfettered egotism. Lets take a look at the rise before the fall!

Wordbank

Some phrasing is used redundantly, this should help build a better picture:

• Terraform Labs - company behind the Terra blockchain protocol

• Anchor - DeFi platform supported by Terraform Labs promising 19.5% APY

• Do Kwon - founder of Terraform Labs and the Terra protocol

• LUNA - Terra governance token used to peg and "stabilize the price of stablecoins"

• UST - algorithmic stable coin pegged to USD, once valued at $18 billion

• LFG - Luna Foundation Guard. The non-profit supporting Terra ecosystem

• LUNAtics - retail investors supporting the Terra protocol

• Mike Novograts - idiot

*If we tattooed our investments we would be Purple

Unstable Roots

DeFi investors dream that one day a digital USD not controlled by any one entity might exist. With this economic freedom they could run from platform to platform pilfering yield pools in worthless tokens across multiple channels for a few basis points or even a percent every now and then. There is the idea that a stablecoin can assist with leverage, liquidity, settlement times, and everyday usage. But if the idea of Bitcoin is to escape the existing banking system, why should we build a connection back to a system of fiat currencies with an inflationary mindset? The Terra collapse was the result of volatility between Bitcoin and stablecoins mixed with some casual fraud stacked on illogical risk-reward scenarios. We can do much better to avoid the situation altogether.

Stablecoins have been around since 2014. The first iteration was BitShares with its token BitUSD, conceived by Dan Larimer (EOS & Steemit) & Charles Hoskinson (Ethereum & Cardano). This type of digital asset made it easy for people to access Bitcoin without using a bank account or linking your name to an exchange. A user would deposit fiat into a treasury controlled by the creator of the stablecoin in exchange for an amount of coins. The user may have access to leverage and a functional token while the treasury can maintain or take the most conservative investments with funds deposited. What could go wrong? Greed. As you can imagine, the managers of the treasury eventually decide they can have a better return than U.S. treasuries and take risky investments (usually in other crypto assets), losing their 1:1 backing and causing the stable coin to de-peg. Other stablecoins like USDC and USDT update their websites monthly with new language alluding to the fact that their initial promises were retracted in the quest for prosperity. BitUSD started a depegging that eventually occurs with all under collateralized assets. The project quickly collapsed after Larimer abandoned the network when a scammer launched a fake bank ICO named AriseBank with BitShares.

*As stable as the Earths crust

Although BitUSD failed, it's successor, Tether (USDT), had become quite the hot topic prior to the Terra collapse. Behind a rotating management team exist two Italian gentlemen who accidentally had $850 million of their treasury assets seized while simultaneously being fined $18.5 million by the New York AG's office for fraud and failing to deliver an audit of their treasury since 2017. Tether had removed redemptions, yet still maintains itself as the predominant market maker and accessible across all exchanges. You can always bring money in, but not out. How are they printing more Tether with few to no real deposits or redemptions? Truly bizarre. It is also difficult to hold faith in any entity that openly admitted to commingling assets with an exchange they own (Bitfinex). The $74 billion stablecoin originally spawned from "Mighty Ducks" actor Brock Pierce (young Gordon Bombay) survives constant attacks from critics who claim their reserves are not fully backed. Although they have always failed to produce evidence of a 1:1 treasury backing, they farce on. Famously, Tether released a pie chart in 2021 indicating that treasury assets were heavily allocated to Chinese commercial paper, specifically development and construction companies. When several Chinese companies collapsed in 2021 due to interest payment default, Tether was unaffected. Regardless of all the facts (or lack thereof), the main issue with stablecoins like Tether or BitShares could be solved by following Bitcoins' model of decentralization. Remove the helmsmen.

THE Algorithmic Stablecoin

Terraform Labs created the Terra blockchain protocol in 2019 with the goal of listing not just USD, but all fiat related stablecoins for investors wanting to enter crypto with their native currency. Instead of someone managing a collateralized treasury like the previous USDC or USDT examples, the protocol would automatically burn and mint UST (or another fiat based currency), based on the market's demand for the tokens. Genius. Terra would operate as an algorithmic stablecoin where the issuance and redemption would not depend on a pseudo-crypto bank in stark contrast to previous attempts. Terra's UST was not the first algorithmic however, MakerDAO and it's stablecoin, DAI, had successfully weathered storms by attaching itself to the Ethereum network. Terra was different in that it had its own network with a decentralized delegated-proof-of-stake consensus mechanism. More importantly, Terra and UST created bridges to every DeFi platform making it the go to asset for an investor looking to access leverage or stake in a liquidity pool. The user would be safe to access a digital fiat coin while simultaneously avoiding high fees which often bogged traders on Ethereum. Most importantly, the user avoids dependence on single governing body, or so they thought.

Case closed, new and risk-free stablecoin that is fully decentralized and mechanically collateralized! That is until Terraform Labs decided to create a non-profit In January 2022, the Luna Foundation Guard (LFG), whose goal is "mandated to build reserves supporting the UST peg amid volatile market conditions and allocate resources supporting the growth and development of the Terra ecosystem." Effectively taking a decentralized system and centralizing it under a new holding company that also now has control of a treasury of assets that subsidies the network. Sacrificing decentralization put full control of defending the Terra ecosystem in the hands of Do Kwon. Kwon had realized that the network itself was not resilient enough to handle a depegging. The main issue with holding the peg is that under heavy stress or volatility, the protocol could fall into a negative feedback loop we discuss below. Terraform Labs also gifted LFG (themselves) $4 billion in LUNA to assist in holding the $1 peg. Would this one LUNAtic be strong enough to resist the entire market?

Arbitrage and the UST Peg

Terra maintains the $1 peg of USD to UST by using its governance token, LUNA, to stabilize the price. Stabilize a stablecoin with another coin through a burn and mint arbitrage mechanism. When the price of UST is over $1, you can mint 1 UST by burning LUNA in the protocol and selling the UST above the $1 peg. If the price of UST is below $1, you can burn 1 UST in exchange for LUNA. In both scenarios the spread from $1 is profitable for arbitrageurs. Most importantly, you can always redeem $1 of UST for $1 of LUNA. A smoking gun part of the mechanism that plays a key role in the depegging.

Anchor on a Burning Ship

Initial desire for stablecoins was built on the idea of investing in crypto while avoiding taxes. Users could for a time access older stablecoins without divulging any information. That time had long since passed given regulation of crypto exchanges by the federal government demanding Know Your Customer and Anti-Money Laundering documentation. The major draw with UST and LUNA, was the ability to engage in DeFi and earn yield by staking in liquidity pools. Where does this yield come from? Generally it doesn't. Most of the time, DeFi projects require new users to enter the "ecosystem" in order to pay yield to initial investors. In this Madoff strategy the VC groups who helped support the project are usually the only people that make out with any positive returns or are the first ones out the door while the ship is burning. With UST and LUNA, the main utility was the Anchor Protocol who paid its yield out from the LFG treasury.

The Anchor Protocol is a safety deposit box or lending platform owned by Terraform Labs. It offered risk-free 19.5% annual percentage yield on UST deposits. By comparison, Bernie Madoff offered 12% returns. In this Kwonzi scheme (Freddie Raynolds TM), users are heavily incentivized to deposit UST into the Anchor platform and gradually collect collect yield. UST can also be borrowed from Anchor as well as other platforms for 2-3%. In essence assuming that the investment is risk free, why not continuously borrow against UST to increase your position. At a 5x leveraged position, 97.5% risk free return sounds much juicier or insane when compared to single digit borrow rate. This is known as recursive lending. So long as LUNA and UST remain stable there should be no cascading liquidation.

The Big Kerfuffle

So decentralization is gone, unsustainable returns are being advertised, leverage is at a unfathomable level; the last element for catastrophe is to throw away the collateral. Kwon knew Anchor's 19.5% return on a digital dollar was unsustainable. We are still unsure of his end goal when Terra requires constant inflow of new capital to payback depositors. In March 2022, Kwon made an insane but inevitable decision. He decided to back the treasury with a basket of other cryptocurrencies, namely Bitcoin, Avalanche, and Solana. So instead of holding a digital dollar capable of 1:1 redemptions, he swapped out the stable treasury for highly risky and volatile assets. The risk to the entire cryptocurrency system went from one DeFi project to a few of the top coins. Kwon promised to purchase $10 billion in Bitcoin to back the reserves of Terra. $7 billion would be purchased by the Terra protocol and $3 billion would be purchased by LFG. When Bitcoin and the market pulled back Terra ran into liquidity issues with their treasury reserves. Unfortunately by the time of the depegging, LFG had accumulated only 80,000 Bitcoin or $2.5 billion to use as a backing. Their average price range for the BTC purchases was somewhere above $42,000 per coin meaning that when they went to defend the peg they would be selling for a loss.

*Big Words

The prelude to this crash was as musical for Do Kwon as the villain in a Hallmark movie being exposed as the grimy lawyer or real estate goon they truly are. His cult of personality had naturally attracted level-headed critics who pointed out flaws in the logic of Terra, the treasury, and the defense strategy. Kwon's rebuttals did not address any of these issues, instead:

• Kwon combated non-believers of Terra by labeling critics as "retarded" or "poor"

• Kwon referred to himself as the "King of the Lunatics"

• Kwon placed several bets against large crypto investors at $1 & $10 million respectively, that LUNA would not fall in value during 2022

• Kwon dared any and all billionaires to try and depeg UST. He was too smart and too rich to lose

Kwon's strategy from LFG's creation was to silence critics under the threat of rapid liquidation. Bitcoin being held in the reserves was thought to be "hard money," but the purchasing of Solana and Avalanche had the goal to build a too big to fail scenario. Should anything happen to UST or LUNA, it would force mass liquidations of their reserves, which are now comprised of other crypto assets. An 80,000 BTC market sell order could dramatically drop the price on the most liquid coin, Solana and Avalanche were more likely to see harsher falls.

Nuke Their Confidence

Uncharacteristically UST had fallen as low as $0.94 in 2021 when a heavily correlated DeFi project, Degenbox, in connection with the Abracadabra platform and the SPELL token & MIM (Magic Internet Money) stablecoin had caused large sales of UST destabilizing the Terra ecosystem. Investors kept their faith and correctly assumed UST would repeg. The exposure to Degenbox was much smaller and outside the ecosystem. The reflexivity was maintained.

The world ended for the LUNAtics starting on May 7th 2022. The momentum began when UST lost its peg to $1. It was not uncommon as the price naturally fluctuates in the arbitrage range of $0.99 to $1.01. UST then dropped to $0.98 and LUNA $61. Investors start to notice. By May 9th the price of UST was down to $0.75 and LUNA to $26. A full bank run was in process and investors were running to the exit. Do you hold your investment of UST in Anchor with the hope that everything will reset earning 19.5% or try to escape with whatever you have left?

As more UST is withdrawn and sold, more LUNA is being minted. Due to the volatility and market selling in one direction, massive amounts of LUNA are being printed. The supply is exponentially growing. Simultaneously the price of both assets are dropping. Users are more willing to sell their UST at lower and lower prices because they think the game is over. Not to mention it is palpable that most of them are leveraged into their positions, so most of the selling could be automated liquidation. All faith is lost. This negative feedback loop is the exact same death spiral that has occurred with every algorithmic stable coin. In traditional financing, this cycle is often referred to as fixed value convertible bonds that struggling companies might attempt to utilize. Both systems create a race to the bottom.

Behind the scenes Do Kwon was attempting to bring balance to the force. His strategy involved emptying the LFG reserves which was mostly Bitcoin. He sold $1.5 billion after the initial dip to buy back UST. The goal is backstop the run. Kwon was also reaching out to VC groups for $1 billion in funding to assist the LFG. By the second day, he had drained the majority of their remaining reserves. A key issue is their average exit price was around $31,000. Kwon and the LFG were selling all their Bitcoin at a 30% haircut from purchase, which exacerbated their ability to regain a peg. Since most cryptocurrencies are heavily correlated to Bitcoin, it seems obvious that selling Bitcoin to buy UST would drive UST and LUNA down. The LFG still has around $100 million left in a mixture of alt coins and less than 350 Bitcoin. Furthermore, it is difficult to say how well they were defending the peg at all. There is no data about what happened with LFG's Bitcoin when it hit the exchanges. The only source is from the King of the Lunatics himself, Do Kwon.

*Kwon's Bitcoin movement during the depegging

On May 12th the Terra validators decided to halt the blockchain citing the availability in accessing voting weight for a small amount of capital to strip whatever was left from the ecosystem. A collective agreement to halt the chain is insignificant and only occurred to formulate a way to win back approval or find a scape goat. Kwon had admitted in an interview that he had an "armageddon" switch that could nuke the chain and everything in it at any point. Were not too sure what this looks like. It is alarming that this idea does not appear in the diligence of major investors. At the end of the 5 day bloodbath $40 billion was lost and the total supply of LUNA mooned from 340 billion to 7 trillion tokens. Plans have been proposed to fork the chain in a apparent V2 network that offers little difference in terms of economical or operational sanity. No funds are recoverable.

*If sports makes it easier

Bad Conspiracy Takes & On-Chain Evidence of a Suspicious Actor

Seeing as the meme stock investment crowd and crypto traders are a perfect circle, it was unsurprising that an unverified post from a Discord channel reposted on Twitter caused many to believe Melvin Capital was behind the Terra collapse. Their diversification in investments is fairly close to their information on financial groups. Legitimate crypto analysts have circumstantial evidence that may paint a far more fascinating story.

The interconnectivity of UST to the rest of the crypto DeFi ecosystem is supposed to be a strength. Deepen liquidity, availability, stability in pricing. However, it is possible in Terra's situation it led to the networks undoing. A DeFi platform called Curve allows people to swap assets in liquidity pools. Naturally, many stable coins are listed in pools for people to swap among and supply liquidity to in order to conduct automated market services. UST was apart of a major pool called the UST-3 pool. The UST-3 pools contained UST, USDC, USDT, and DAI. In preparation for a new 4-Pool, which would include another stablecoin called FRAX, LFG withdrew $250 million from the UST-3 pool. Something strange happens on May 8th. An unknown party swaps $85 million of UST for USDC sending the pool into an imbalance. 50,000 ETH was sold by a different group to buy USDC to bring balance back to the pool. Someone else somewhere was moving tens of millions in ETH and USDC to defend this pool.

*Credit @mhankasalo. The spread between UST and other stablecoins in the Curve pool

The significance of the pool is that it allowed UST to depeg beyond $0.98. The fear created in this quick instance spooked enough people that $2 billion UST was withdrawn from Anchor. A chain reaction that would be irreparable over the course of the following week. Whether or not it was coordinated or coincidental only the exchanges know, particularly Binance and Gemini. They handled Kwon and LFG's assets last. The rest of the conspiracy involves OTC Bitcoin deals totaling over $1 Billion that did not appear through the blockchain. Either highly unlikely or this is the type of inefficiencies you will see exploited as experienced finance lunatics enter crypto.

Recent Developments

Instead of making an Irish exit during the collapse, an anonymous Terraform Labs employee revealed that Kwon was behind an earlier stablecoin iteration of UST, Basis Cash (BAC). Parading around under the moniker "Rick Sanchez," Basis Cash ultimately shutdown following a $130 million raise due to regulatory concerns with the SEC. Basis Cash was strangely enough, publicly criticized by Kwon saying "it is a trap for retail investors." Unlike Basis Cash's quiet adieu, Terraform Labs in-house counsel has publicly resigned. Civil and criminal lawsuits have been filed against Do Kwon with regulators initiating inspections into his operations. Kwon himself has requested police protection to fend off dissatisfied investors.

VC groups who were fortunate enough to invest in the Terra Luna scam early on included Coinbase Ventures, Binance (although the CEO says he cannot recall), Andreesen-Horowitz, and Galaxy Ventures. Mike Novogrotz of Galaxy Digital ($BRPHF - OTC, $GLXY - TSX) was the loudest supporter among the early promoters, even going so far to have a moon with a howling wolf tattooed across his shoulder. Thats the sigma male grindset that only Princeton wrestling could teach you. After emptying their initial investment when LUNA traded over $100/coin, Galaxy Digital claimed to net over $1 billion in profit. In a press release on Friday May 13th, Galaxy Digital relented that the recent market swings have caused estimated, unverifiable down swings of $300 million on their holdings. Luckily they had completely divested from UST in the knick of time. Novogratz penned a recent letter saying his heart wrenches for all the poors who unfortunately lost money in Terra.

Some not so lucky groups such as Delphi Digital and Hashed lost $10 million and $3.5 billion respectively. They seem to currently be the only institutions admitting to any loss from the end of Terra.

“95% Are Going To Die, But There’s Also Entertainment In Watching Companies Die Too”

Contagion to the Traditional Financial System

Secretary of the Treasury, Janet Yellen provided testimony to the Senate Banking Committee citing stablecoins as a major risk to the global financial system. In particular she mirrored how the valuation of the entire crypto market before the fall of Terra ($2.8 Trillion) had surpassed that of the sub-prime mortgage market in 2008 ($1.2 Trillion). We mentioned stablecoins tend to hold other assets in their treasury besides the deposited USD. Aside from USDC, nobody knows what assets actually back groups like Terra or Tether. If Tether were heavily exposed to any risky access class, their liquidation could ripple through other financial sectors. A cascading credit default process starting in crypto and moving to traditional markets is unlikely however. Barrow Downs has full confidence that a stablecoin like Tether is only partially backed with the assets they claim. Most of stablecoin treasuries probably hold cryptocurrencies.

As the owner of the second safest asset class in the world, Costco Wholesale Corporation ($COST) revealed on May 18th through a special disclosure with the SEC that they planned to raise the price of their iconic hot dog by $1, severely depegging itself from its once stable value. Arbitrageurs would not have the liquidity to bring the peg back. Costco stock tumbled 18% premarket the following morning. Costco is not tied to Bitcoin, but it is important to remember all major assets in an economy are capable of hyper-inflating. Proper risk-return expectations are important in order to avoid being tossed in the meat grinder. Co-Founder of Costco, Jim Sinegal, famously told acting CEO Craig Jelenik if the price of the hot dog were to increase "I will kill you." We wait solemnly until its safe repegging.

*Too many Blue Check Marks circulated this obvious joke. The satire became tragic

Impact on Barrow Downs

Barrow Downs takes an extremely pragmatic approach in selecting digital assets to invest in. After reviewing Bitcoin, the intelligent investor should ask, is there anything out there that is different and useful? Of the +10,000 existing coins or tokens, maybe 20 are worth anything. The blowup blockchains have the same VC characters promoting other nonsense. These same people are responsible for what we refer to as the West Coast Tech Dump. Take an unprofitable tech company disrupting the toilet bowl industry, build them up to a stupid evaluation, then IPO to retail investors and pensions. Rinse and repeat.

Terra's overall impact on crypto was not limited to having their treasuries drained and sold off. The volatility in the market caused Bitcoin to max out its mempool, slowing transactions. Ethereum fees became too costly flying over $200 in gas fees. The famous 2Miners pool we will not stop mentioning halted all payouts save for those opting for Nano.

The root cause of the Terra fiasco was leverage. The major difference between Terra and the previous iterations such as the Iron Token, is that Terra had better marketing and was well funded. The same hazards existed. We can survive sharp downturns by staying away from networks, projects, or other blockchains with illogical goals, systems, or leaders. These opportunities are generally more leveraged than others. It is all fun and smart on the way up, but there has yet to be a reflexive stablecoin that can survive volatility on the way down. Barrow Downs looks for utility in the real world. We will miss some massive "revolutionary" investments on the way up, but we will not be caught in the inevitable collapse.