News & Resources

Aquanow Digital Dives: How Much Was Your Lunch? 🍽️ - Vol.16

May 13, 2022

It’s been a heck of a week for risk assets. Equities are lower, credit spreads have widened, and the CBOE’s implied volatility index (VIX) remained elevated each day. The prospect of tighter monetary policy to combat high inflation while economic activity wanes is a good setup for ebullience to fade. However, this week was also marked by a systemic event that caused considerable damage in digital asset markets. The crumbling of Terra’s UST algorithmic stablecoin has been likened to the fall of Lehman Brothers in 2008, which isn’t a perfect analogy, but the project’s failure will leave a profound mark on the ecosystem. 

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Similar to the collapse that catalyzed the Great Financial Crisis (GFC), the UST debacle is an example of financial innovation gone awry combined with hubris and inadequate risk management, driving a system-wide deleveraging. Some notable differences are that Lehman was a 150+ year-old institution whose operations were subject to government oversight and whose regulator stepped in to provide liquidity and other backstops to control the contagion of its insolvency. Terraform Labs was incorporated in 2018 and operates free of central bank control or stimulus. Its model relies on arbitrageurs, algorithms, and independent investors. It’s also worth noting that crypto markets are less of a tangled mess than the banking system, so while it might be hard to imagine, there’s been less counterparty concerns from UST’s collapse than what was feared in ‘08/’09. 

In the words of Michael Batnick and Ben Carlson, “not to brag” but readers of Digital Dives wouldn’t have scrambled to understand what transpired this week because the relevant themes were discussed in our last two notes. In Volume 14, we looked at the stablecoin landscape and considered that the rapid growth in algorithmic stablecoins posed systemic risk to the broader ecosystem given the possibility of a bank run. Volume 15 introduced the Aquanow DeFi Funding Index (ADFI), which is a benchmark composed of lending rates for real-world, asset-backed stablecoins, in well-established lending protocols. The underlying assets/pools of the ADFI were selected specifically because they represented the baseline level of risk/return in decentralized finance. Venturing elsewhere could certainly result in excess returns, but it would also expose investors to additional hazards. Last week, we looked at an example which decomposed the sources of a hypothetical return, including the additional yield associated with pools involving more speculative assets like UST. Don’t get me wrong, the discussions weren’t about me claiming to know that certain events would unfold imminently. I’ll always say that these notes aren’t about predicting but trying to understand. Having said that, David Morris at CoinDesk pretty much nailed it when he published “Built to Fail” on April 22nd.  

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There were many similar cautionary notes and the popular media outfit Bankless even hosted a debate about the merits/perils associated with the Tera/Luna ecosystem. The risks were known and communicated broadly. Investors in the subprime mortgage bonds that fueled the runup into the GFC have alleged that information asymmetries and misleading credit ratings provided them with false confidence and led to their significant losses when the whole thing unwound. However, those who have lost on the UST collapse would have understood the outsized risks if they conducted even cursory research. The Anchor protocol offered 20% yields on the Terra stablecoin, which compares to the ADFI at around 2.8%. Like Paul Mallon’s infamous lunch, the 1,700 basis point spread doesn’t come for free. 

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Any investment which claims to double your money in 3.5 years deserves some scrutiny, but it doesn’t necessarily mean it should be avoided altogether. I’d made a small investment in Luna which is effectively worthless today after having been one of my top performing trades in percentage terms. The key is that, while the loss stings (particularly bad too because I took an L on the similar IRON/TITAN collapse last year) I knew that this risk existed and in fact, I speculated that the music would keep playing long enough that more upside could be reaped. An important risk management tool is position-sizing. Lending UST on Anchor for a chance to compound at 20% is compelling, but the return must be weighed against an understanding that the token is prone to losing its peg. In such instances, there is a cascading effect on its counter-currency (in this case, Luna), which results in a death spiral. The potential for total loss can be borne by some investors, but no one should have been using Anchor like a savings account. There’s no benefit of hindsight here either – the risks were known ex-ante.

There are some positives and negatives to glean from this debacle. 

What concerns me most is that the digital asset industry had begun to engage more positively with lawmakers, and it seems like there was momentum behind the idea that these things have enormous potential for good. UST had just recently made it into the top three stable coins with a market cap of nearly $20B. For its part, Luna’s capitalization had been as high as $41B and entered the week around $20B (it’s maybe worth a couple million today). Ignoring the fact that there really was no cloak-and-dagger here, some politicians will point to the billions in lost savings while demanding heavy-handed regulation or even outright bans. To me, the regulators have contributed to this outcome somewhat. I get that passing regulation takes time, but assets like USDC or even USDT could proliferate further or be iterated upon if there were clearer disclosure rules and no risk that some agency could come and seize their assets. You may argue that part of UST’s promise was its greater level of decentralization, but Do Kwon (the co-founder) certainly seems like a dominant figure there, so I’m not sure that was the case. Regardless, more bad press isn’t helping the mainstream adoption thesis.

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On the other hand, Janet Yellen commented earlier this week that the Treasury Department would be ready with a report on stablecoins imminently and legislation drafted before year’s end. She’s generally proven herself to be a pragmatist, so there’s reason to believe that she’ll recommend increased but not unruly oversight. It’s my understanding that many incumbent institutions remain on the sidelines because they want a clearer picture of how the U.S. (and other nations) will proceed with regulating digital assets. They’re not perfect either, but the emanation of enterprises with experience educating clients, while adhering to strict KYC and fiduciary rules, should help reduce the likelihood of another blow up like this. Barring onerous legislation, action here could help offset the bad image of the Terra failure.

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It’s not just cryptoassets that are subject to systemic risk though. The IMF explains that between 1970 – 2017, there were 151 banking crises, 75 sovereign debt catastrophes and 236 currency meltdowns. In the first case, that’s an average rate of more than three instances of financial stress requiring significant policy intervention per year. Typically, for matters as important as the monetary system, we wouldn’t allow such high incidence of adverse outcomes. Further, the banking system has been around for centuries, so how come there are still so many calamities? 

I was first introduced to the work of Bernard Lietnaer in this podcast, where the founder of what might be the first DeFi protocol ever (Mark Richardson of Bancor) mentioned him in the context of why we think the current economic system - which happens to be one of the first we stumbled upon - is the optimal solution. Can we improve it? Mr. Lietnaer was an interesting economist because his experience was more practical than academic. He has many fascinating ideas about how local or specialised currencies in conjunction with their central bank counterparts can provide effective incentive mechanisms and render the economy more robust. A core tenet of his is that in any ecology, monocultures, while being efficient, are doomed to fail. Hyper optimization for a given environment might look good on the surface, but it leaves the population vulnerable to change. 

There’s a stablecoin angle to this thinking as well. Dai is the oldest decentralized token that is pegged to the USD. Rather than holding dollars in a bank account or maintaining its peg algorithmically with mint-and-burn mechanics, it holds mostly digital assets as collateral and issues the stable token as a loan (there is an algorithmic component, too). About a year ago, MakerDAO (who operates the venture) began accepting real-world assets in its vaults as well. Because Dai is overcollateralized, its model is sometimes criticized as being capital inefficient, but is that such a bad thing? Throughout the recent rout, Dai has held steady, which adds to the Terra figurehead’s woes since he publicly stated his intention to ruin the project. It seems the folks at Maker are having the last laugh:

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The pursuit of efficiency has led to remarkable innovations, so it’s a logical motivation for humanity to pursue. However, like decentralization, when taken too far it results in volatile systems. Something that's been hyper optimized is left vulnerable to a shifting environment. This was Bernard Lietnaer’s key point for monetary systems and this note from the Harvard Business Review highlights the idea in a business context. Cash on a balance sheet is “inefficient” when times are good, but it can be a blessing during recessions. We’re seeing this play out in real time, too. The supply chain tensions due to COVID-locked-down factories in Asia are a clear example of when systems are built for efficiency, they sacrifice resiliency:

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Albert Hirschman was an economist who might be able to unseat the Dos Equis® guy as Most Interesting Man in the World. Born in Berlin, by his mid-thirties Hirschman had completed a robust academic formation in Paris, London and Italy, fought against fascists in Spain, joined the French ranks in WWII (later helping the resistance movement), moved to the U.S. mid-war to take a fellowship at Berkley, did a stint with the Office of Strategic Services in North Africa, got married and had two children, served on the Federal Reserve Board and worked on the Marshal Plan. You might think that all this would require a focus on efficiency. However, Albert’s work is centered around the idea that impediments and failures are important drivers of progress – an idea he calls the Hiding Hand Principle:

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The Luna/UST failure is still playing out and its impact will be felt for many years to come. In fact, it’s looking like a catalyst for regulation, which has been long awaited by institutions wanting to get involved in the space, but poses risks of its own. The web3 lobbying effort has just become significantly more difficult. However, looking past the fortunes evaporated, trust lost, and reputations ruined, there were some really cool developments in digital assets this week. S&P Global provided Compound Treasury with the ecosystem’s first credit rating (it’s only B-, but still a big step towards broader adoption), Maker inked a deal with ConsolFreight and MasterCard to finance the shipment of Australian beef from Brisbane to Hong Kong and FTX U.S. announced a pilot program to provide supplemental income, banking services and a Visa debit card to residents of less affluent communities in Chicago. The wounds left by the systemic collapse today will inform the community of survivors going forward, helping to build something more resilient.

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