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May 13, 2022

Market update: Macro challenges and Terra’s decline

The crypto market has been on a downward trajectory since Bitcoin and the Nasdaq Crypto Index reached all-time highs in November 2021, even as fundamentals remain strong. The reasons are both specific to the crypto asset class and to global markets more broadly.

The current macro environment is unquestionably challenging. The Ukraine-Russia war, global supply-chain disruptions, and the unprecedented expansion of central bank balance sheets have contributed to a sharp rise in global inflation. This has spurred greater fiscal restraint by governments, an increase in interest rates, and investors moving away from risky assets.

Additionally, rising interest rates have decreased expectations for economic growth and company profits. This has reduced the present value of future cash flows—especially for companies with the greatest potential for generating value over a long-term horizon—and led to lower stock prices. The Nasdaq 100, an index heavily influenced by tech companies, has dropped nearly 30% since the beginning of the year.

Crypto has also been impacted by this macro environment. The value of the vast majority of crypto assets is linked to the probability of their long-term success. In scenarios like the current environment, the effects that lead to the decline of stocks and other traditional risk assets also impact crypto asset prices. In fact, since the beginning of the COVID-19 pandemic, the crypto market has demonstrated a greater correlation with traditional markets—a phenomenon that may be potentiated by the entry of more institutional investors into the crypto market.




Source: Bloomberg. Correlation between the Nasdaq Crypto Index (NCI) and the Nasdaq Composite at all-time highs

While much of the current crypto downturn can be linked to the macroeconomic landscape, crypto-specific factors have also played a role. The most relevant was the collapse of one of the main blockchains in the ecosystem, Terra.

The downfall of Terra

The Terra blockchain lost more than 99% of its market value this week. This drastic market movement is a consequence of the loss of trust in the project resulting from the UST stablecoin losing its peg to the dollar on May 7 and pushing the price of UST and Terra’s token LUNA into a “death spiral.” A scenario like this has been considered within the crypto community for some time, and in recent months we have been doing our own internal analysis. Following is our perspective on what these events mean for Terra and the crypto ecosystem as a whole. 

The Terra blockchain was built to be an ecosystem of different stablecoins, serving as the payment rail for fintech applications around the world. The platform creators view stablecoins as the “killer app” for crypto, with the potential to bring millions of new users to the space. To achieve that vision, Terra had to bring in real-world use cases. The first of these use cases was a South Korea-based fintech named CHAI, a payment-service operator that used Terra’s blockchain to achieve billions of dollars in transactions.

However, Terra wanted to grow faster and beyond this partnership. To bootstrap adoption of their largest stablecoin, UST, they incentivized demand through the DeFi protocol Anchor (which was incubated by Terraform Labs, creator of the Terra blockchain). The platform started offering fixed annual yields of 20%, much higher than most conventional market rates and even high by DeFi standards. This allowed Terra to attract more than US$18 billion to UST, with around 14 billion UST (75% of the stablecoin supply) deposited in the Anchor protocol on May 6. Terra had achieved its goal to accelerate UST adoption, but the stablecoin was highly concentrated in a single and ultimately unsustainable use case.

UST is an “algorithmic stablecoin.” In contrast to other widely used stablecoins like USDC— which is backed by dollar reserves and custodied by Circle Ltd.—UST’s peg is maintained through price arbitrage between its value against the dollar and a conversion mechanism that allows it to be swapped into a different crypto asset (i.e., LUNA). The aim is for 1 UST to equal US$1.00. To achieve this, new LUNA tokens are regularly minted to keep pace with the value of UST. For example, if UST trades at US$0.99, arbitrageurs can make a profit by (i) buying 1 UST for US$0.99; (ii) redeeming 1 UST for US$1.00 of LUNA and (iii) selling the redeemed LUNA for US$1.00. The problem is that the more this arbitrage opportunity is executed, the faster the supply of LUNA grows, leading to selling pressure. And if investors eventually lose confidence in the ability of UST to regain its peg, they lose confidence in LUNA as well, which pushes prices down even further. This is precisely what happened this week.

For a stablecoin to be successful, investors must trust that it will keep its peg at all times. If this confidence is broken, there will be no demand and the project will fail. This is why it will be very difficult for the Terra/LUNA ecosystem to recover from this incident, even though UST may regain its peg at some point. The developments of technologies for algorithmic stablecoins will certainly continue, and the UST/LUNA drama will surely be remembered as a major stress test for the arbitrage and collateralization mechanisms that have been established to build this kind of crypto use case. However, even if UST or LUNA are unable to recover, crypto investors and developers have been provided with a lot of food-for-thought on how to improve this emerging technology going forward. Ultimately, this process has been a reminder that we are still early in the evolution of blockchain-based applications.

Adapted by Hashdex from “The possibility of a bank run and $UST de-peg event,” by José Maria Macedo

Looking ahead

Despite recent events, the medium- and long-term prospects of the crypto market and its fundamentals remain strong. The adoption of this new technology continues to increase, Ethereum is moving to another stage of its upgrade plan, and segments such as DeFi and NFTs are gaining more users. Additionally, alternative smart contract platforms, such as Solana and Avalanche, are gaining ground by offering users different value propositions. We also see increasing volumes of capital entering the sector, with venture capital funding levels reaching records in the first quarter of this year. We continue to believe that it is only a matter of time before crypto assets become a broadly accepted technology, creating an addressable market significantly larger than the market today.

Source: CB Insights

For long-term investors with exposure to this asset class, this moment can be viewed as opportunistic. Crypto fundamentals remain strong and there is no intrinsic factor that substantially differentiates the current events from past market drawdowns. We remain confident that blockchain technologies will spark huge advances in global productivity and that crypto assets are a unique investment opportunity for everyone.









 


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