Perspective on Risk - June 28, 2022 (Crypto 1/2)
What Is The Crypto Value-Chain? Crypto-Apocalypse (Leverage & Hubris)
What Is The Crypto Value-Chain?
Crypto refers to digital “currency” in which a record of transactions is maintained and new units of currency are generated by the computational solution of mathematical problems, and which operates independently of a central bank. Bitcoin is the most notable.
Crypto relies on “blockchain” technology . Investopedia has a simple summary:
Blockchain is a type of shared database that differs from a typical database in the way that it stores information; blockchains store data in blocks that are then linked together via cryptography.
As new data comes in, it is entered into a fresh block. Once the block is filled with data, it is chained onto the previous block, which makes the data chained together in chronological order.
Different types of information can be stored on a blockchain, but the most common use so far has been as a ledger for transactions.
In Bitcoin’s case, blockchain is used in a decentralized way so that no single person or group has control—rather, all users collectively retain control.
Decentralized blockchains are immutable, which means that the data entered is irreversible. For Bitcoin, this means that transactions are permanently recorded and viewable to anyone.
Mining is the process by which new crypto assets are added to circulation. "Mining" is performed using sophisticated hardware that solves an extremely complex computational math problem (crypto-hash). Bitcoin “miners” receive bitcoin as a reward for completing "blocks" of verified transactions, which are added to the blockchain. The input costs to mining are electricity and computing cycles.
Having hovered between $18,000 and $20,000 for most of 2022, the aggregate cost of minting a coin has fallen to about $15,000.1
The price of a Bitcoin will fluctuate with supply and demand. To facilitate trade, stable-coins, whose value is directly tier to another asset, most commonly the US dollar, have been developed. An analogy is to a money market fund. The stablecoin issuer will try and maintain the peg either by holding adequate collateral or, until recent failures, through complex contract design (see smart-contracts below).
Other assets can be created by mining crypto-hashes; for instance, non-fungible tokens are crypto-hashes of an artwork (or other digital file) signed with a digital signature. Money art from Bored Ape Yacht Club is an example. You can pay for your NFT with crypto-currency.2
Crypto-hashes can also create “smart contracts” where the performance is guaranteed by software instead of by lawyers and judges. Within the crypto world, lending agreements and collateral management has been a prevalent use, and has led to some of the leverage and leveraged unwinds that have been observed. To facilitate all of this, exchanges and trading firms have arisen.
“Staking” is a way to earn “rewards” on your crypto-currency. Certain firms have offered very high rates of return to those willing to lock up their crypto-currency for a period of time by contributing to a staking-pool. As you will see, these are not segregated deposits, and have no insurance in the event the firm fails; they are instead generally just ordinary claims on the estate.3
The staking provider will then on-lend your crypto-currency to a third party on margin.
On Binance Loans, users can borrow up to 65% of their collateral value, and the maximum loan period is 180 days.4
Crypto-Apocalypse (Leverage & Hubris)
The crypto space has been a lesson in unregulated finance. We can now see why a central bank is necessary, and why regulation is helpful. I’m not qualified to explain everything in this space, but let me highlight a few points: I’ll try and keep it simple:
Bitcoin's value fell by more than half its value since its November 2021 peak, which caused the entire cryptocurrency market to collapse.
[In May,] Terra (LUNA) and [the stablecoin] TerraUSD (UST) both experienced such steep declines that investors may be spooked.
TerraUSD, a stablecoin – a system that was supposed to perform a lot like a conventional bank account but was backed only by a cryptocurrency called Luna – collapsed, losing 97% of its value in just 24 hours
First, as Frances Coppola writes, There's no such thing as a safe stablecoin. Those of you who have followed developments in money market mutual funds know that the regulatory authorities have been struggling with this in traditional finance for years, finally going so far as requiring MMMFs that wish to claim a fixed dollar value hold exclusively US Treasury securities. Frances gives an excellent summary of the issues with stablecoins.
So why did Terra/Luna collapse?
Terra was not a “traditional” stablecoin backed by assets; instead it was an innovative “algorithmic” stablecoin. Terra was linked with another cryptocurrency, Luna, whose value floated. It counted on a kind of arbitrage to maintain the peg.
To peg a TerraUSD (UST), a USD value of Luna is convertible at a 1:1 ratio with UST tokens. If UST’s price is, for example, at US$0.98, arbitrageurs swap 1 UST for $1 of USD and make a profit of US$0.02. This mechanism increases UST demand and also reduces its supply as the UST is burned. The stablecoin then returns to its peg.5
As I understand it, TerraUSD was part of a pool with other stablecoins that allowed for easy switching between the various stablecoins. One party attacked Terra by selling $350mm. The selling of Terra forced down its price relative to the other stablecoins, and required the burning (or issuance) or more Luna coins. This resulted in a “death spiral” as Luna became essentially worthless. @ZeMariaMacedo provides the below graphic.6
This all led to a run on the Anchor Protocol.7
Anchor is a decentralized savings protocol offering low-volatile yields on Terra stablecoin deposits. The Anchor rate is powered by a diversified stream of staking rewards from major proof-of-stake blockchains, and therefore can be expected to be much more stable than money market interest rates.
Shortly thereafter, another stablecoin, DEI, crashed as well.8
Subsequently, Three Arrows Capital (3AC), which experienced large losses on Luna9, defaulted on a margin loan worth more than $670 million. Digital asset brokerage Voyager Digital issued a notice on Monday morning, stating that the fund failed to repay a loan of $350 million in the U.S. dollar-pegged stablecoin, USDC, and another 15,250 bitcoin, worth about $323 million at today’s prices.10
There may have been additional contagion as
3AC was additionally known as one of the largest holders of Grayscale Bitcoin Trust (GBTC), an institutional bitcoin product, as well as staked ether (stETH) tokens, both of which have seen steep declines recently.
Other crypto lending firms are under stress.
The crypto-lender Celcius has paused withdrawals due to ‘extreme market conditions’11
The firm has seen the value of its assets more than halve since October, when it handled $26 billion in client funds. Celsius’ cel token has also erased 97% of its value in the same timeframe.
The firm, which takes users’ crypto and lends it out to make higher returns, is thought to have hundreds of millions of dollars tied up in an illiquid token derivative called stETH.
stETH may be the next issue. stETH isn’t a stablecoin; instead it is meant as an arbitrage between the current Etherium blockchain and the pending upgrade to Etherium 2.0. Still, with firms like 3AC ‘selling what they can’ the price of stETH has fallen to 0.92.
BlockFi, which agreed in February to bring its business into compliance with the Investment Company Act of 1940 and paid a fine to the SEC of $100mm, has raised deposit rates, blocked free withdrawals, cut staff by 20% and fired its head trader.
The crypto space is highly concentrated with a few real ‘whales.’ Bankman-Fried’s FTX crypto exchange, agreed to provide crypto lender BlockFi with a $250 million revolving credit facility, and Alameda, Bankman-Fried’s quantitative trading firm, provided Voyager Digital with a US$200 million cash and USDC revolver and a 15,000 BTC revolver.12
I’ll stop here with the background. In the next post I will highlight a few of the lessons that we know well from traditional banking/finance that the crypto/DeFi crowd is now learning the hard way.
Steer, Fried circuits at the bitcoin miners, FT
For a further discussion see Cowen & Tabarrok, Cryptoeconomics
What is Staking?, Coinbase
How To Borrow Crypto on Binance Margin And Loans, Binance blog
Forbes has a good writeup if you’d like more details, The Death Spiral: How Terra’s Algorithmic Stablecoin Came Crashing Down
Kumar, DEI price crash news: Another crypto stable coin crashes after TerraUSD (UST) – Details Here, Financial Express
Sigalos, Kharpal, One of the most prominent crypto hedge funds just defaulted on a $670 million loan, CNBC
Browne, Kharpal, Crypto lender Celsius pauses withdrawals due to ‘extreme market conditions’, CNBC