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Monthly Market Review - May 2022

May was another brutal month for the digital asset space. We will briefly touch on 'The War on Terra’.

Luna was the first digital asset in the top ten to collapse since Bitconnect, a blatant Ponzi scheme that collapsed in January 2018. Given the size of the collapse and how thoroughly the mainstream media covered it, I won't detail the mechanics of the crash here beyond saying that it was akin to a bank run and death spiral. If you are interested, Jump Crypto, which had a multi-billion position in Luna / Terra, wrote a more detailed diagnosis of how the crash played out here.

More interestingly for us is the likely medium-term impact of the crash. The combined market capitalisation of Terra (UST) and Luna at the crash was c. $50 billion, roughly the same market capitalisation as Enron when it collapsed in 2001. However, unlike Enron, there was no broader market impact as other asset classes remained unaffected.

There was still actual harm done though. Investors lost approximately $18 billion of UST. Some retail investors had invested their lifesavings into UST, and as a result, many have lost everything. There have been at least eight reported suicides related to the crash. These investors chose Terra because of its 'stable' promise and its promise of a high yield. The investors stored capital in Anchor, which paid 18% p.a. in UST, subsidised by the organisation and its backers.

On the back of this blow-up, regulators have rushed to regulate 'stablecoins'. Given the size of the loss, we believe there will be enough political appetite to pass serious regulation changes. Recently Japan and the UK have introduced frameworks and rules to define what can be known as a 'stablecoin'.

In the abstract, proactive regulation makes sense. Much of the harm was caused by retail investors misunderstanding the risks of an algorithmic coin losing its peg. Most investors wouldn't know that no algorithmic stablecoins have survived over time. Instead, they unknowingly invested in something they believed was akin to the US Dollar.

However, exactly how regulators achieve this is more difficult. There still needs to be room for innovation, while vulnerable retail investors are better protected. This is a difficult balance, and most regulators tend to be over-cautious. It's easy for investors to blame them if another blow-up happens, but it's harder to quantify the loss in economic productivity due to poor innovation.

The second outcome is that Tether has been under renewed scrutiny. Tether also broke its peg briefly during the Terra crash before recovering to near parity with the US dollar. However, it has been trading at less than $1 since its recovery.

Its offset is telling as it indicates that the market is suspicious of Tether's stability. Tether crashing is not a typical reaction to a crypto market crash; usually, Tether spikes in market downturn as investors see it as a safe haven asset (akin to USD). This helps Tether as the spike in a falling market gives it cash (supplied by arbitrageurs) to fulfil any redemptions when the market is most uncertain. The market cap has also begun to plummet as investors withdraw their capital. The lengthening withdrawal times indicate that Tether may be delaying redemption requests, although the team has denied this.

Tether won't be able to redeem on demand at some stage as much of the reserves sit in commercial paper. If this happens, there will be a severe loss of faith. For now, it appears they have managed to bleed much of the redemptions, but the risk remains very much present.

Tether is now in danger of losing its status as the premium stablecoin to USDC (a fully regulated stablecoin). USDC's market cap has drastically increased since Terra's collapse, and it's now at an all-time high ($54B), indicating that the market prefers the certainty that USDC provides.

We suspect that at some stage this year, USDC will overtake USDT, and the latter will hopefully experience a gradual decline. USDC replacing USDT could be the best outcome of the Terra debacle. Investors will finally be comfortable that the stablecoin they hold is backed by USD. Additionally, it will show regulators that the market will move to quality and certainty over time, which may prevent the most draconian policies from being passed.


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