Q9 Markets | De-Peg, Deep Red
13th May 2022
Q9 Capital: www.q9capital.com
- Major cryptocurrencies fall >30%; global markets slide
- LUNA crashes nearly 100% after TerraUSD (UST) falls to 7 cents on the dollar
- Coinbase NFT platform attracts only 150 traders on launch day
Crypto and traditional capital markets were hammered during one of the worst weeks in years. Bitcoin dropped to $29k(-19.4%) after it rebounded from its lowest 18-months print, with most other crypto assets falling further. Global equities posted their worst day since June 2020 on Monday and have swung wildly since.
The big news in crypto this week is the TerraUSD (UST) algorithmic stablecoin de-pegging, which caused it to trade at a gigantic 80% discount to the dollar at one point. It’s sister token, LUNA, which is used as a ballast for UST, has lost almost 100% of its value in the past seven days. Much more on this debacle below.
The total market cap of crypto has dropped to ~1.25tn and Bitcoin’s dominance rose above 44%, a pattern we have seen in the past during sharp sell-offs. In our recent notes, we have highlighted that ETH had held stronger than BTC over the past few weeks. ETH/BTC printed a 3-month high earlier this week before sliding down in the past two days.
In extreme bearish conditions, we have seen investors flocking to cash, stables and blue chips — BTC & ETH. As a result alts get hammered hard. Amongst large cap L1 names, AVAX and SOL posted losses of -46.8% and -45.4% week on week, even darling of the NFT world APE plummeted -41% this week.
Major Tokens, 5 Days
There were rumours about funds (exposed to LUNA & UST) suffering damage beyond repair — risk management and survival were the priority among many market participants this week. Contagion fear was well reflected on the spike in put skews. However, at this point we have not seen any failed payments or defaults. Funds will lose money, there is no such thing as ‘Up Only’. If they survive and trades and loans settle then we move on. A bigger concern will be retail and if they were overexposed. Regulators will want to know and top dogs are talking about it. Sensible regulation will be an advancement, but events like these often make good sense a low priority.
Crypto options market saw a massive uptick on implied vols, peaking on 12th May over UST/LUNA contagion risks. 1 week ATM vols shot up to YTD highs. Short vol covering, reluctance in vol selling and insurance buying was visible in option premiums. Yesterday vols were moving in the order of 10–15% within few hours, largely driven by shar spot moves. As we mentioned previously in our weekly note, low implied vol environments often end with violent moves in either direction.
Coinbase (COIN) missed analyst expectations reporting revenue of $1.17bn for Q1. The platform’s overall trading volumes have fallen 44% compared with its fourth quarter. And it’s NFT market place has not started well.
It’s not just crypto having a tough time in 2022. Major household name tech stocks have fared worse than the majority of crypto majors. Netflix, Zoom, Lemonade, Robinhood and Peleton are all down >50% YTD.
Corporate credit markets are telling the same story as equity and crypto markets. Below is the spread over Treasuries for the ICE BofA CCC index, which tracks the lowest-quality publicly traded bond issuers:
ICE BoA CCC Option-Adjusted Spread
It seems clear enough that the market turmoil is tethered to the Fed’s commitment to raise interest rates amid a period of surging inflation. The economy is now slowing by design.
There’s really no good outcome in the near term. If central banks are too dovish, inflation gets out of control, but if they focus on inflation and raise interest rates, which is one of the few tools they have, that will have a big impact on growth.
You cannot change the Fed’s policies, but you can act with conviction and position your portfolio for the inevitable volatility that’s likely to last a while.
Luna to Venezue(Lun)a
The $60bn ecosystem of Terra, Luna, and projects built on top of it are now in freefall. TerraUSD, or UST, plunged to as low as 4.1 cents today morning. The so-called stablecoin is meant to maintain a 1-to-1 peg with the U.S. dollar. It was trading at around 7 cents at the time of writing.
Sister token LUNA lost roughly all of its value in the past seven days and now has a smaller market value than its stablecoin counterpart. This is a huge vote of no confidence.
UST/USD, 1 Month
LUNA/USD, 1 Month
UST is what’s known as an “algorithmic” stablecoin. It uses a complex system of minting and burning tokens to adjust supply and stabilize prices. Instead of being backed by assets like dollars or bonds, algorithmic stablecoins are intended to maintain their dollar peg by what looks to be some like financial alchemy. It does this by working with a crypto token in the same ecosystem, LUNA, which can be swapped for UST and vice versa by traders to keep the price of UST where it should be.
But even though it is billed as a “decentralised, algorithmic stablecoin”, it is actually none of these. It isn’t decentralised and is clearly run by a central authority, it isn’t algorithmic and now requires a massive bailout, and it certainly isn’t stable.
UST’s price has crumbled under the pressure of a sell-off in cryptocurrencies recently, resulting in further panic, resulting in further selling, resulting in a loss of confidence in it, resulting in complete failure of the project. It’s not a run on the bank, it’s a death spiral, and its impacting the rest of the market.
Traders are now worried that the project will become a forced seller of Bitcoin, bringing the market down further. The project has amassed billions of dollars’ worth of Bitcoin through the Luna Foundation Guard fund to support UST in times of crisis. The fear now is that Luna Foundation Guard dumps those bitcoins onto the market to prop up UST, resulting in a huge sell-off of Bitcoin.
There are around 18.5bn of UST in circulation, a big enough presence that its swings could have systemic implications for other coins and protocols.
Exactly why all of Terra’s carefully-planned mechanisms failed to do their job remains unclear. Conspiracy theories are doing the rounds on Twitter about a hedge fund attack following the George Soros playbook that broke the Bank of England in 1992. No one really knows yet. What is clear though, is that many people may have lost their life savings.
In a Hail Mary proposal, Terraform Labs said it would burn 1bn UST to save the project. Although the markets are not full of confidence, one suspects this might not be enough to fix the hole.
Vote of No Confidence
The basic thing that makes Terra valuable is confidence in it.
The theory behind algorithmic stablecoins relies on three specific flawed assumptions:
- There is a “support level of demand” for the stablecoin and/or balancer token
- There’s a permanent supply of independent actors to perform price-stabilising arbitrage
- A market has near-perfect information to trade on
Algorithmic stablecoins are inherently vulnerable to losing their peg to the downside and falling into a “death spiral” if investors lose faith in the price stability. As has just happened.
For example, if you think that everyone else will treat Terra as worth a dollar, then you will treat it as worth a dollar, and you won’t sell it for $0.90 in a panic, which means that it won’t go down to $0.90. But if you think that everyone else will treat Terra as worth zero, then you will dump it as fast as you can at whatever price you can get, which means that it will go down below $0.90 (and the rest…)
As we noted in a commentary this week on the UST de-pegging, this event is hardly a black swan — the project’s growth has given traders nightmares, and the market has been considering this outcome for a while.
As ever, preeminent financial columnist Matt Levine shares some great insights on the event.
Proceeds with Caution
Anchor, the yield generating protocol built on Terra, advertising “fixed proceeds” of 20% APY on deposits, has also been hit hard, with about $12bn of deposits vanishing this week. Deposits on Anchor plunged to $2.17bn from $14bn, data by the protocol’s dashboard shows.
Anchor has been the main driver of UST demand. Investors flocked to the Anchor protocol to gain from the double-digit yields, catapulting the circulating supply of UST from $2bn to a high of $18.5bn in a year, as investors needed UST to deposit in order to get the returns.
Critics called out the protocol’s high yield for being unsustainable because interest revenue from borrows did not cover yield payouts and required an outside source to replenish the reserves. Mirror Tracker shows the Anchor Yield Reserve is on track to be depleted in as soon as a month.
Anchor has proposed temporarily cutting its interest rate from 20% to 3.5%.
Under the Spotlight
Unrelated but certainly well timed, the Fed released its annual Financial Stability Report this week, which contains some worries about run risk on stablecoins:
“Stablecoins typically aim to be convertible, at par, to dollars, but they are backed by assets that may lose value or become illiquid during stress; hence, they face redemption risks similar to those of prime and tax-exempt [money market funds]. These vulnerabilities may be exacerbated by a lack of transparency regarding the riskiness and liquidity of assets backing stablecoins. Additionally, the increasing use of stablecoins to meet margin requirements for levered trading in other cryptocurrencies may amplify volatility in demand for stablecoins and heighten redemption risks.”
The Fed also noted that just three stablecoins — Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) make up about 80% of the overall market. Each of these are physically backed with a mix of cash and short-dated credit and do not rely on an experimental algo. But this is a large concentration risk should there be idiosyncratic failure or a run on the tokens, causing a liquidity mismatch and asset sales unable to keep up with redemptions.
This week’s TerraUSD episode will certainly heighten regulatory focus on the stablecoin sector. It also brings to the forefront the differences between algorithmic coins and those backed by a basket of reserves.
Q9’s Position on UST
For the record, we at Q9 do not have any direct exposure to UST or product with UST as underlying asset. UST did not meet our risk parameters even after considering the staking rewards offering 20% APY (on Anchor protocol) that were (previously) considered to be a low risk strategy among many market participants. We work to provide our clients with innovative products with high standards to build crypto for everyone.
Tumbleweeds…
After almost 7 months, having spent hundreds of millions of dollars and adding 8.4 million emails to the waitlist, Coinbase’s NFT platform launched this week, seeing a grand total of… drumroll… 150 users make a trade on the platform on the first day. The total number of transactions amounted to c.$75k of ETH. That’s less than the price of one Bored Ape. OpenSea saw $177.2mn of NFTs traded over the same period.
Coinbase isn’t offering users any dramatic financial benefits for making the switch from OpenSea. Plus the competition is huge. LooksRare, Rarible, Foundation, NiftyGateway, and SuperRare are all filling various niches in the market. Plus Kraken announced on Weds that the waitlist is now open for its marketplace Kraken NFT, which will offer zero gas fees.
The timing of the launch also isn’t great, with many NFTs largely off their perch…
Art Attack
The largest NFT collections by market cap are bleeding. Well-established collections are down over 20% in ETH terms and even more in USD terms. Blue-chip collections like Bored Ape Yacht Club’s average sales price plummeted 29% over the last seven days in USD terms, while transactions have tanked by 21% and user numbers are down 27%.
The average sales price for the Otherdeeds NFT collection by Yuga Labs also sank 23% and the average sale prices for Moonbirds, a collection of owl-themed NFTs, also dropped 19%. ApeCoin is also down about 41% this week.
In more positive NFT developments… A limited number of users in the US can now share digital collectibles and NFTs via Instagram. Similar functionality will soon be enabled on Facebook and other Meta apps, CEO Mark Zuckerberg confirmed in a Facebook post.
Who Paid for High Yields?
Algorithmic stablecoins are complicated, and understanding the risks involved is extremely difficult. It’s very easy to be attracted to these eyewatering yields, and we do not expect everyone to have done thorough due diligence. Especially when these projects are seemingly “validated” by multi-billion-dollar market caps, held by “smart money” hedge funds, and being promoted by “trusted voices” on social media. If everyone else is doing it, it can’t go wrong, right? This model of thinking has now come undone, and many people have paid for high yields.
When talking about events like this in terms like millions, billions and percentages, it can be very easy to overlook the impact on individual human investors. Many people went all in or borrowed money and invested in UST to pay off mortgages, save for their kids education or improve their lives. All of this is likely gone. Suicide hotlines have now been pinned to the top of various forums and websites associated with the token.
As mentioned above, we do not have any positions in UST and do not offer it on our platform. We seek to offer our clients innovative products with high standards that we believe to be robust. Risk management is part of our DNA, and building trust in crypto is at the core of our values. UST didn’t make the cut, even risk-adjusted for 20% yields.
When the dust settles
As for the rest of the market, it has sold off in unison and everything has gone down together. Crypto, NFTs, credit, equities, venture capital, hedge funds, etc. The tide has gone out and we’ll now see who’s been swimming naked. But times like this present huge opportunities for investors to reposition and seek out value. There are now a lot of bargains out there for savvy stock and coin pickers. Be wary of catching falling knives, but there’s opportunity in volatility.
We are seeing the below trend on client pad this week:
- Hawks who have been waiting for the dip have been active buyers on spot
- Auto Invest from clients who want to get a good entry price during this downtrend
- Yield traders look to buy the dip via Yield and monetizing the uptick in volatility, especially on the USDC (Linked ETH) product
In the News…
- List: All the international crypto events for the rest of the year
- Crypto critic Roubini working on a tokenized dollar replacement
- Chainalysis raises $170mn at $8.6bn valuation
- Argentina’s central bank bans crypto trading
- Scale model released of El Salvador’s Bitcoin City
- Kraken exploring stocks as part of ‘super wallet’
- UK PM empowers authorities to seize crypto ‘more quickly and easily’
- Installation of new crypto ATMs falls to lowest level since 2019
- ARK’s Cathie Wood says crypto nearing end of bear market
- El Salvador announces new purchase of 500 BTC
Crypto Markets
- BTC and ETH dropped -19.4% and -27.2% respectively on the week. At the time of writing the total market cap of crypto dropped to $1.25tn and Bitcoin’s dominance rose above 44%.
- Among other majors, SOL dropped -45.4% this week. The darling of May, Apecoin felt the pain and posted declines of -41%
- Realised volatility (annualised) spiked, rising above 70% for BTC and ETH
Legacy Markets
- US Equities (SPX) declined -5.2% week-on-week as markets led by tightening monetary policy concerns
- The US Dollar index continued to show strength posting +1.2% in gains
- 10-year US treasury yields slipped 17bps, and the Gold & Silver index dropped -13%
Flows
- Our client pad was skewed towards buying (1.7x buyers vs sellers)
- Flow dominated by buyers in ETH, BTC and SOL
- Modest sellers of AVAX, SUSHI, and EOS
