The Breakdown - Meltdown Monday and the Great De-Pegging

Starting point is 00:00:00 I'm not really going to get into the can UST survive. Will it come back stronger? Blah, blah, takes just because I think that we're still in the middle of this. I guess the best that I can find is that I think that if anything is good, I'm glad that we're ripping through this cycle now, rather than it dragging on and UST becoming a $100 billion asset first. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the Big Picture Power Shifts remaking our world. The breakdown is sponsored by nexo.io, near an FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Tuesday, May 10th, and today we are talking about Meltdown Monday.

Starting point is 00:00:44 It was one for the history books. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dig deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to Bit dot lee slash breakdown pod. Also a disclosure, as always, in addition to them being a sponsor of the show, I also work with FtX. Now, we occasionally have days in crypto that feel like they're deserving of their own name, and yesterday was certainly among them.

Starting point is 00:01:16 I'm calling it Meltdown Monday. Shout out to Rick on Twitter for that suggestion. Now, of course, the story you've been hearing about and watching is UST, the stable coin of the Terra ecosystem losing its peg. I mean, Treasury Secretary Janet Yellen was already talking about it on the hill this morning if you need a sense of its significance. But to understand this whole story, you need to put it in a larger context. Even without UST's crazy depegging event yesterday, the markets were totally deserving of this moniker of meltdown. Alex Kruger writes May 9th, 2022, a day to remember.

Starting point is 00:01:51 NASDAQ, down 4%, gold down 2%, oil down 7%, natural gas down 12%, uranium, 1.8%, soybeans down 2%, and so on and so forth. Now, it's important to note the commodities on his list. FtX Access tweeted, today was a wild day for markets, but there was an important change. Macro went from commodities up, yields up, equities down, crypto down, has been in place for six months, to commodities, equities, crypto, and yields down. The only thing up is King USD. This is true capitulation.

Starting point is 00:02:26 Now, importantly, this may herald a shift in where we are overall, and what's driving the larger macro trade. Dan Tapiero says, now comes the commodity collapse. Bye-bye, inflation fear. So what does he mean? Obviously, as you know, the dominant macro issue for the last six months or longer has been inflation. But within that context, increasingly, the discussion is, can the Fed tame inflation without prompting a recession? One way to read what's going on in markets right now is a growing. conviction that the answer is no. Raul Paul from Real Vision writes, macro update, the SPX is now very

Starting point is 00:03:02 close to pricing in a near imminent recession. Expect growth to collapse. The next step for the great unwind is oil. This line goes that inflation expectations, which are hugely correlated to oil, will fall. Then we should see yields fall, while equities crypto commodities see a full liquidation over the next few weeks. Then the Fed pivots a la 2018, but it will be too late and job layoffs are coming. House prices are likely to reverse somewhat, and the economy will contract. Now, there are signs of these concerns all over the place. The Fed released a market stability survey, and 68% of participants said one of the risks was that the Fed might over-tighten. Interestingly, there is clearly a liquidity concern growing as well. According to the survey,

Starting point is 00:03:44 41% of participants cited concern around foreign disinvestment. The last time they did this survey six months ago in November, that concern wasn't even mentioned. Basically, now that we've shifted to tightening, market participants are asking, if the Fed isn't buying treasuries, who is? And if no one is buying treasuries, where's the liquidity in the system? Lisa Abramowitz from Bloomberg says the biggest buyers of U.S. treasuries are the Fed, Japanese, and Chinese, who all aren't adding to their holdings right now. Until they start buying, Jim Bianco says everyone that is saying,

Starting point is 00:04:14 buy the dip, are a collective not much bigger than a rounding error. Bianco pointed out that the Fed is unwinding its balance sheet until something breaks. the Japanese aren't buying until the yen stabilizes, and the Chinese aren't buying until the lockdowns are completely over. That same report suggests a, quote, higher than normal chance that trading conditions in the U.S. financial markets will suddenly deteriorate. So in this context, the only thing that people are thinking about is capital preservation, and this is showing up in the dollar. Despite inflation being above 8%, the Bloomberg dollar spot index beat out all other assets this month, hitting a 0.6% advance even as stocks and bonds are cratering. BlackRock

Starting point is 00:04:53 CIO Rick Reader said, we're holding our cash with both hands. So that's the setup, right? And then we move over into crypto. Even without the Luna Terra USD stuff, it's been gnarly out there. Bitcoin fell nearly 10% over the weekend. We saw more than $1 billion in liquidations. And ultimately, we are subject to the same macro trade that every other asset is right now. However, U.S. just put this into overdrive. By way of just the most minimal possible background, and I have to stress that there is so much to this story, so much technical that's worth getting into, that I can't possibly hope to sum it up.

Starting point is 00:05:29 But just by way of the minimal background, Terra is a blockchain ecosystem built on cosmos that has two key tokens, at least for our story. Luna, which is theoretically the governance token of the ecosystem and UST, which is the stablecoin. Now, there are two types of stable coins, broadly speaking. collateralized stablecoins have reserves of some real asset one-to-one backing the stable coins. So you put a real US dollar in, you get a USDC out. That's the idea of a collateralized stable coin.

Starting point is 00:05:57 Algorithmic stable coins are a little bit different. In general, the idea is to use the relationship between two assets and market incentives to keep the value stable. So in this case, $1 of Luna can be redeemed for $1 of UST, no matter what the actual market price of either asset is. When the assets are swapped or redeemed for one another, the other asset is burned or destroyed in the process. When times are good, this should mean that as the supply of UST grows, the supply of Luna decreases, making it deflationary. And of course, supply, demand, yada yada, Luna supply goes down,

Starting point is 00:06:30 Luna price goes up, you get the idea. Anyway, to this one-to-one swap opportunity that's characteristic of algorithmic stable coins. This creates, in theory, an arbitrage incentive where if UST starts to be worth less than a dollar, arbitrages should step in and buy UST in order to redeem it for Luna because the fixed rate means that they'll make the difference between that $1.1 of Luna and the under-costed UST. The reverse is true on the other side if the peg exceeds $1. But then we get to the question of why someone would want to hold or use UST

Starting point is 00:06:59 when there are other more popular stable coins out there, especially during these early phases. Part of that answer is Anchor, a yield-generating protocol built on the Terra blockchain that has been offering up to 19.5% yield on deposits. Basically, Anchor incentivizes people to mint or buy a shiload of UST in order to reap the 20% yield. So again, when this is working, great stuff, right?

Starting point is 00:07:21 U.S.T. supply goes up, Luna supply goes down, Luna price goes up, people are paid for holding U.S.T, and so on and so forth. But of course, this is a story of what happens when things go wrong. Looking for ways to step up your crypto game? Then go with Nexo. For starters, you get free crypto. for each purchase or swap. How about earning guaranteed yields?

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Starting point is 00:08:40 FDXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCS, you pay no gas fees. Download the FTCX app today and use Referral Code Breakdown to support the show. Over the weekend, more than $5 billion of anchor deposits left.

Starting point is 00:09:16 that's more than one-third of the total that had been there. This put pressure on the peg, with UST falling to 98 cents. Terra had planned for this possibility, though. A few months ago, after another peg-breaking scare in the wake of Luna falling quickly, they built what is effectively a Forex Reserve called the Luna Foundation Guard, or LFG, to backstop UST in the case of this sort of market volatility. The reserves were to include up to $10 billion worth of Bitcoin. Remember, this was a narrative for Bitcoin price appreciation for a while, the Terra-Do-Quan bid buying up all the BTC for the Luna Foundation Guard. Over the weekend, LFG announced that it would lend $1.5 billion in BTC and UST to defend the peg. On Meltdown Monday, however, things got

Starting point is 00:09:59 even crazier. UST started to lose its peg again, and instead of these arbitrages stepping in and getting it back to a dollar through redemptions, a spiral started where the price of Luna and UST were falling in lockstep. UST got as low as 65 cents and Luna dropped more than 50% to $24. As this happened, the Luna Foundation Guard deployed 28,205 Bitcoin in an attempt to defend the peg by buying UST and providing liquidity on exchanges. This, of course, created significant downward pressure on the price of Bitcoin, which fell 10% or more in a day, even creeping for a time under $30,000, to its lowest price point since last July.

Starting point is 00:10:36 Last month, Lynn Alden had explained how this might happen. Quote, on the other hand, this presents a future risk for the Bitcoin price. If Terra encounters a problem and is forced to sell a lot of Bitcoin to defend its UST peg, it will be detrimental to price in a similar way that their current buying is favorable to the price. Terra's unsustainable anchor protocol with 20% yields results in a lot of UST demand, and with this new reserve practice by Terra, UST demand now results in BTC demand. This can be thought of as a source of indirect, artificial, or unsustainable Bitcoin demand, which should eventually dry up.

Starting point is 00:11:08 Active Bitcoin traders should keep an eye on Terra's Luna and BTC reserves relative to UST market capitalization. Because if it starts to break down and they are forced to defend the UST peg, we could see tens of thousands of coins worth of rapid Bitcoin selling pressure. I'm not saying that will happen, but it's a new factor to monitor going forward. A month later, that is exactly what had happened. Linaldon added today, Terra's multi-billion dollar algorithmic stable coin UST blew up today. Aside from destroying the value of Luna, they use their Bitcoin reserves to try to defend the peg, kind of like a flailing emerging market, using its gold reserves to defend its FX. All right, so this is a lot, but let's check in to

Starting point is 00:11:45 see where we are now. Lunar remains down more than 40% in the last 24 hours, but is up to about $30 from its low around 24. Bitcoin is hovering around 31k, 18% down over the last week. UST hasn't regained its peg, but is trading at around 90 cents now, which is certainly better than the 65 cents it hit last night. Doe Kwan, the hard-charging leader of the Terra Protocol, whose brash attitude about all this has seriously rubbed some folks the wrong way, just tweeted close to announcing a recovery plan for UST, hang tight. That was about an hour ago as I was prepping this episode. And on that note, it's important to keep in mind that this story is still very much alive.

Starting point is 00:12:21 Yes, UST has quieted down from the sheer insanity of yesterday, but that doesn't mean this is over by any stretch. It's also important to note that there are a huge array of theories and speculations going on around the specific catalysts and market actions for the past few days, ranging from this was normal market action to it was a coordinated campaign by Citadel to attack Luna to you name whatever normal theory of who does what in crypto. None of that is clear at this time, so I don't think it makes sense to speculate on. But let's try to capture a few of the categories of reflections and takes from the communities

Starting point is 00:12:51 that I think are more fleshed out right now. Candidly, most of the community is angry and in I told you so mode, although perhaps for different reasons. Holding aside the fact that UST created a price risk for Bitcoin, the Bitcoiners are most mostly in that mode because they had told them so, but also because of the decentralization theater surrounding LFG. Nick Carter wrote, just buying Bitcoin doesn't make your thing decentralized. Bitcoin isn't some magical elixir that turns centralized systems decentralized. You don't inherit decentralization from Bitcoin. The astonishing thing is people are

Starting point is 00:13:24 still asserting U.S.D is decentralized just solely on the basis of the system owning a portion of BTC. By that logic, micro-strategy and Tesla are decentralized. The entire U.S.T. incredibly opaque and untransparent, more so than USDC or USDT for that matter. Who conducts open market operations? What's the status of the Bitcoin Reserve? Why did it get moved? Who controls the multi-sig? Etceter.

Starting point is 00:13:47 No answers. But that's just Bitcoiners being Bitcoiners, right? I don't know about that. Hasu, who is notoriously independent, writes, no matter how this ends, I don't want people to call UST decentralized again. Even the little collateral backing it is untransparent and controlled by a single party, used to perform discretionary open market operations. This is like 10x worse than the Fed. Ryan shot Adams from bankless, who is first and foremost a dot-eath says let's call it what it is.

Starting point is 00:14:15 Luna was reckless and now they're going to bring the wrath of the regulators on this industry. They'll demand stablecoin issuers be regulated like banks. They won't differentiate between a dye, fracks, or UST. Who can blame them after this shi-show? More on the regulator's side in a minute, but we've got bitcoins and Ethereum's now both pissed off. So the question is, is there anyone defending Terra? Sort of. Eric Forhees writes, all this vapid condemnation of Terra is unbecoming. A decentralized stablecoin is one of crypto's most important instruments. I'm glad people are experimenting relentlessly and enduring the crises that challenge and harden all great projects. Now, where Eric might be coming from is the notion that in the K-YC world that we are in and

Starting point is 00:14:53 will likely get even deeper into, where concerns around anti-money laundering will constrain how people interact with crypto and digital assets. Some see these sorts of algorithmic stable coins as potentially the last refuge for non-Kyc private transactions. Still, as per the discussion above, a lot of people have a hard time seeing this particular example as decentralized. In one of the most articulate threads about all of this, John Wu wrote, UST is stabilized by one, contracts, and two, the gigantic gravity well created by the size of Do Kwan's nuts. That's both semi-flattering, but also semi-terified. Kwan also just hasn't won himself a lot of friends.

Starting point is 00:15:31 Mike Dutus, formerly of the block and from Linksdown says, everyone's like, stop being mean to UST, don't kick a founder while he's down. Brough, the guy literally nuked any human who is like, hey, this thing might not be totally economically sound, off the earth with an army of tens of thousands. Cry somewhere else. What's more, some have pointed out that this screws up the stablecoin space for everyone else. Arthur Bratman, the co-founder of Tezos, writes,

Starting point is 00:15:54 implying that luna is just some stablecoin that happens to have been shaken by the market move, obscures a very fundamental difference between models like Tether, only blows up if there is fraud, die, similar to the perp sold on FTX, and Luna, which is fundamentally unsound. Nick Carter, who by the way has gone deep on dollarization and found himself years ago, surprised by how interested in stablecoins he was, wrote on April 21st, of all the bad ideas the crypto industry has come up with, Algo Stablecoins are among the worst. When these things inevitably fail, regulators will use the failure as a stick to bash the rest of the industry with, most likely causing reprisals against useful and functional stable

Starting point is 00:16:30 coins. This morning, he retweeted an article about Janet Yellen talking about UST on the Hill and said, when the decent stable coins get suffocated by the vice-like grip of regulation and forced into ill-fitting bank charter models, and the stablecoin space becomes uncompetitive and sterile, be sure to thank your local Algo stable founder. Indeed, all of this concern around the regulatory implications was completely validated when Janet Yellen was already discussing it this morning. In response to a question from Senator Pat Toomey on stablecoin, she said, a stable coin known as TerraUSD experienced a run and declined in value. I think that this simply illustrates that this is a rapidly growing product and there are

Starting point is 00:17:06 rapidly growing risks. She also said we should have legislation by the end of the year on stable coins. Now, of course, we shouldn't immediately assume that lawmakers won't be able to understand the difference here. In response to me noted, quote, an important distinction with algorithmic stable coins. And you have folks like Jake Trevinsky from the Blockchain Association defiantly saying they'll work to ensure that regulators don't pay them with the same brush. But this shit certainly doesn't make that. job easier. So is there anything redemptive here? I'm not really going to get into the can UST survive, will it come back stronger, blah, blah takes, just because I think that we're still in the

Starting point is 00:17:40 middle of this. I guess the best that I can find is that I think that if anything is good, I'm glad that we're ripping through this cycle now, rather than it dragging on in UST becoming a $100 billion asset first. But that's kind of cold comfort in this context. So there you have it. That's the first take. I'm sure we'll be talking about this a lot this week. I'm sure everyone's going to be talking about this week. Hopefully that helps give you a little sense of what happened on Meltdown Monday and how people are thinking about it. For now, I want to say thanks again to my sponsors, nexo.io,

Starting point is 00:18:11 Neer and FDX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. Hey, breakdown listeners. Come join CoinDesk's Consensus 2020, the festival for the decentralized world this June 9,000. through the 12th in Austin, Texas.

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The Breakdown - Meltdown Monday and the Great De-Pegging

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