Q9 Markets | Stick a Fork in Your Eye

20th May 2022

Q9 Capital: www.q9capital.com

• BTC ends 7-week losing streak
• Do Kwon proposes Luna hard-fork
• Regulators focus their gaze on stablecoins

Volatility in crypto option markets remains elevated (but softer vs previous week) following the Terra UST bloodbath last week. Bitcoin reclaimed $30k and closed in the green for the first time in two months (ending its longest losing streak since the early 2010s), and most over tokens posted positive gains.

Traditional markets remain weak, and that’s not a good sign for crypto, given the strengthening correlations to US equities. However, concerns of a crypto winter are unfounded, and contagion risks are overdone, according to America’s second largest Bank, BofA. They also noted the collapse of the Terra network was due to prioritization of mass adoption over price stability.

We’ve received a huge amount of inquiries over the past ten days regarding stablecoins, their uses and safety following the fallout of the UST debacle. As such, we thought it would be worth going back to basics and explaining what they are, what are the risks, and why they are a crucial component of the crypto ecosystem.

Back to Basics

Stablecoins are a type of cryptocurrency pegged 1:1 to other assets such as the US dollar that essentially exist to solve three fundamental issues:

1. Interoperability between traditional currencies and crypto. Using regular dollars to buy crypto can be difficult as settlement is slow and the price of currencies such as Bitcoin can change significantly. Traders instead purchase stablecoins with traditional currencies (fiat) before they can trade.
2. A safe harbour for crypto traders from volatility. Cryptocurrencies such as BTC and ETH are notably volatile. Stablecoins allow investors to easily switch between crypto and an asset pegged to a real world asset and provide shelter from exuberant markets.
3. Efficient global payments. Sending cash cross-border through traditional payment rails can be slow and expensive, especially when concerning emerging market currencies. Stablecoins allow for instant payments at low or zero cost to any wallet anywhere in the world.

Stablecoins are often backed by reserves of assets, such as US government bonds, short-term corporate debt, and cash — and, in the case of USDC, audited and regulated. Tether (USDT) is the largest such reserve stablecoin.

However, historically it has not fully disclosed the fiat assets it holds, so it has been difficult to gauge the resilience of its peg. However, just last night, Tether released its quarterly assurance opinion hoping to quell further questions and slow recent redemptions.

Regulators worry about a wave of mass redemptions on Tether and its peers — an old-fashioned bank run. A run on Tether would be particularly dangerous because it is fundamental to overall crypto market liquidity. It is the primary medium for moving back and forth between crypto-assets and dollars. Its failure could bring the whole crypto ecosystem to its knees. However, as reserve assets, fiat or near fiat-backed stale coins are very straightforward.

If the reserves are largely in the same currency as the coin and the reserve is liquid and short dated and this is transparent then they either have enough reserves or they don’t. This is why Tether is being more open and USDC, as traditionally the most conservative and transparent, is gaining market share.

However, many crypto natives don’t love fiat-backed coins. You still have to go through the banking system at the end of your round trip. So then it’s not really a new form of money, is it?

One solution has been the attempt at algorithmic stablecoins. They should have no fiat backing but only digital assets, and not rely on traditional financial securities. While over-collateralised crypto assets as reserves is one solution, these are not capital efficient and leave users feeling cold.

The holy grail idea has been algorithmic stablecoins which are backed by crypto and not overcollateralized. A working model would be capital efficient, decentralized and capital efficient. This is what Terra network attempted with UST and Luna. In some ways, this can be understood a bit like a gold-backed token where the ‘gold’ is Luna, and the mechanism to make redemptions whole is completely algorithmic. However, the crucial difference here is that Luna is sort of a made-up gold and completely dependent on the trust and belief in the Terra network. When people start heading for the exits, the algorithm creates and sells Luna to make them whole (this mechanism worked perfectly in the debacle by the way). However, traders quickly realize that Luna’s whole thing is kind of a supporting UST, so nobody wants to own it with infinite supply and trust gone and things got convex very quickly.

Another way to understand it might be to think of it as a company issuing shares to cover debt. At some point nobody wants shares. (See more info on this in an analysis of how they work from last week). If a central bank fiat currency loses its gold peg, gold has value outside this particular peg. This has happened many times historically. Gold is independent. Luna was not. Can crypto get there with a BTC version? It has the most independent value in crypto and is large enough. However, for now it’s probably too volatile. Certainly there will be future derivations attempted.

The top two stablecoins, USDT and USDC, make up around 80% of the market.

Source: Q9 Capital

LUNAtics

The main point though is solving for stability. Nobody invests in a stablecoin to 5x. Investors expect stablecoins to hold their peg and be able to move money around with the confidence they won’t suddenly lose a large sum of it. Losing your peg in a hurry is the whole thing you are avoiding. It’s happened before. It’s bad luck until it becomes a threat of contagion. When a stable coin is big, everyone wonders whose holding the bags. And Luna and UST got big fast with a combined total market cap of $60bn at one point. This is why the implosion of LUNA and UST is so extraordinary.

Big names in the space will have to answer for how they could get behind such a disaster.

The project boasted an “all-star roster of investors” including Arrington Capital and Pantera Capital. It’s also a sponsor of the Washington Nationals baseball team, and has a huge army of self-described “Lunatics” who avidly promoted the project across social media.

Galaxy Digital CEO Michael Novogratz, who invested millions in the endeavor, unveiled a Luna tattoo back in January.

Hashed, a South Korea based early stage venture capital fund, accounted for losses over $3.5bn according to a report from Coindesk.

Boutique investor Delphi Digital lost 13% of its net value after it made a $10mn investment in Luna Foundation Guard’s funding round in February.

Delphi Digital wrote in a research note this week “We always knew something like this was possible, and we tried to stress the risks to a system like this in our research and public commentary, but the fact is we miscalculated the risk of a “death spiral” event coming to fruition. We’ve taken some heat for this over the last week, and we deserve it. The criticism is fair and we accept it,”

Regulators have been sharpening their blades for a while ready to dissect the stablecoin space, with concerns about consumer protection and stability. The UST collapse is going to speed up this process. Central bankers around the world are also wary that the impact of a collapse of a stablecoin could spread into traditional financial markets. Last week US Treasury secretary Janet Yellen warned that Terra’s falling value illustrated that stablecoins were “a rapidly growing product and there are rapidly growing risks”.

Put a Fork in it

Do Kwon, the founder of Luna, is now attempting to rescue the project after the metaphorical horse has bolted. Terraform Labs will put forth a new governance proposal to hard-fork the Terra Luna blockchain.

The new chain will not be linked to the TerraUSD (UST) stablecoin. Meanwhile, the old Terra blockchain will continue to exist with UST and will be called Terra Classic (LUNC). Under Kwon’s plan, if passed, the new LUNA blockchain will go live on May 27th.

The Terra Community is divided on Do Kwon’s ‘authoritarian’ hard fork proposal and Binance CEO, CZ, has said the plan won’t work. Vitalik Buterin has said that Terra should protect the small investors, not the whales or institutions that supported it. Meanwhile, their in-house legal team has fled.

Seeing Clearly

The Terra episode is a huge black eye for crypto and one that might not be forgotten for a long time. The scale of the human wreckage and pain inflicted through the collapse of the fatally flawed Terra blockchain continues to reveal itself. Not to minimize the suffering of some retail investors who lost everything, but there is a silver lining here. Despite all the loss there have been (so far), no major defaults or credit issues to further threaten the ecosystem. If anything Crypto, once again, handled itself well. Time will tell but this doesn’t seem to be Lehman or even Bear Stearns. Big names are coming out saying we lost money but are still alive. This usually means they expect to be alive in the near future too. In fact, crypto has outperformed equity in the last few days. People are buying again, Coinshares reported inflows in their latest weekly fund flows report.

One major criticism about crypto industry is that the infrastructure doesn’t work, last week’s sell off in fact showed us that it works pretty well. Exchanges, custodians and crypto trading platforms ran more or less like clockwork in managing the volumes during this sell off when the 7 day daily exchange volumes peaked to levels not seen since November when BTC printed all time highs. Exchanges ran liquidation engines non stop 24x7 without break, letting market participants derisk fast while it took years to unwind the entire Lehman bankruptcy event. The most used blockchain networks (Ethereum & Bitcoin) were congested due to which transfers were slower (than usual) but the ecosystem is well aware of these issues and are constantly working to solve them.

Each time markets have suffered big sell offs (which happen in days not weeks or months) we continue to be impressed at how well the entire ecosystem is able to manage the demand while being a free market. It bends but doesn’t break. We saw it first hand. We had zero downtime on the platform, no delays in settlement and were able to provide liquidity to our clients. For Q9 and its clients this was an opportunity and we saw a pick-up in YIELD and Spot trading.

It was a very bad event, but clearly it could have been worse. Better that this happened now than when UST grew to $100bn or even bigger. This all looks like it might slow crypto growth, but we probably still grow nonetheless. Crypto will continue to innovate and adapt. At Q9 we are all about education. We hope investors do more DD and keep investing instead of following the crowd and then shutting off when they get scared. You’ll get many chances in crypto if you are alive to take them.

In the News…

• China’s underground Bitcoin mining operations are thriving despite ban, data shows
• M&A is coming for DeFi
• Podcast. Saifdean Ammous: Bitcoin, anarchy, and Austrian economics
• Revolut’s planned native token will reward customer loyalty, Storonsky says
• Nomura confirms plans for new digital asset company
• El Salvador holding meeting on BTC with participation of 44 countries
• Binance confirms its working to win German regulatory approval
• BTC and ETH trading gets green light on Brazil’s largest digital bank
• Portugal’s status as a crypto tax haven appears to be ending
• EY unveils supply chain tracking service on Polygon Nightfall
• Singapore High Court blocks potential sale and transfer of rare NFT
• How do you tax an NFT?

Crypto Markets

• BTC bounced back posting weekly gains of +4.4% while ETH rose +2.9% respectively on the week (8am). At the time of writing the total market cap of the crypto market was north of $1.25tln mark and Bitcoin dominance was just shy of 45%.
• Among other majors, SOL rallied +16.9% this week. Among top DeFi names AAVE rose +18% and MANA led the metaverse large cap posting a standout +59% rally week on week
• Realised volatility (annualized) in crypto markets subsided this week, rose above 40% for BTC and 44% for ETH

Legacy Markets

• US Equities (SPX) dropped -0.7% week on week as markets continue to worry about an economic growth slowdown in a high inflation environment
• The US Dollar index retraced -1.8% week on week
• 10 year US treasury yields fell 4bps and the Gold & Silver index rallied +6.4% on safe-haven bids

Our Flows

• Our client pad was skewed towards sellers (9.5x sellers vs buyers) during last week
• Flow dominated by sellers in BTC & ETH and SOL buyers
• Buying activity in FTM on modest volumes