• October 6, 2022

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An important cryptocurrency collapsed last week and the fallout is having far-reaching effects on stocks, bonds and other risk assets. Unfortunately, this is only getting started.

Terra Luna

LUNA
, the digital coin in the Terra ecosystem, crashed last week to near zero, a stunning fall from $67.64 a week ago. Luna was supposed to underpin UST

UST
, a stablecoin algorithmically pegged at one U.S. dollar.

When the UST peg broke, panic ensued. Investors sold risk assets of all stripes.

For many investors this contagion effect feels like déjà vu. The Russia and Asia currency crises of the 1990s roiled markets and wiped out fortunes. The news seemed to come out of nowhere then everything suddenly went off the rails as investors learned about exposure at money center banks in the United States and in Europe.

A cryptocurrency inspired contagion has the potential to be much worse.

Crypto has become a substantial investment category in a short period of time. It’s the perfect trap for performance chasing among leveraged professional money managers.

Let’s start with Terraform Labs. The blockchain project was developed by Do Kwon and Daniel Shin, graduates of Stanford and the University of Pennsylvania, respectively. The pair thought they could disrupt the global payments system with a low cost blockchain alternative. To eliminate cryptocurrency volatility, Terra engineers built a suite of decentralized digital coins pegged to real world fiat currencies like the US dollar, Korean won, and the Eurodollar. The twist was these so-called stable coins were not backed by actual fiat currency holdings.

The peg was maintained by a clever arbitrage relationship with Luna.

The Terra ecosystem permitted unlimited swapping of Luna for UST, and vice-versa. If UST deviated from its $1 USD peg traders would be incentivized to buy or sell Luna outside of the ecosystem, then swap it for UST inside the Terra ecosystem for a low-risk profit. This model, called mint and burn equilibrium, depended on economic incentives to stabilize UST, while dynamically adjusting the supply of the underlying parts.

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The weakness of the system was investors were at the mercy of the external market for Luna coins. If confidence waned or the price fell precipitously, investors would be further incentivized to keep selling Luna to swap into UST, creating a death spiral of sorts.

Anchor was the third rail in the Terra ecosystem. It existed to create demand for Luna and UST. Anchor offered investors huge incentives to park assets in the ecosystem. It was essentially a Terra savings account with a promised 20% annualized yield.

In hindsight, UST, Luna and Anchor were all too good to be true.

UST was supposedly pegged to the US dollar, although the structure held no dollars. UST was interchangeable with Luna, yet neither were supply constrained. And Anchor offered savers a 20% yield. The ecosystem worked as long as Luna coins were increasing in value. In early April the alternative coin soared to $116. A month later it is worthless.

Bloomberg reported on Sunday that Terra investors may have lost $45 billion in the grisly collapse.

The financial disaster revives memories of the Asian and Russian currency crisis. These catastrophic financial events began as isolated regional currency crises created by over-extended governments. They ended as full-blown contagions as professional investors globally were forced to reveal, and later unwind their exposure.

Long Term Capital Management was a wildly successful hedge fund founded in 1993 by John Meriwether, a renowned bond trader, and Myron Scholes, a Nobel Prize winner. LTC

LTC
M used extreme leverage and arbitrage to promise big returns to investors. The strategy hit a snag in 1998 when the Russian bond default threw debt markets into a tailspin. At the time LTCM held approximately 5% of the global fixed income market. The unorderly demise of LTCM would have triggered a worldwide financial crisis.

The Federal Reserve ultimately engineered a $3.65 billion bailout loan, but the S&P 500 succumbed to a 19.3% decline.

This should serve as a lesson to investors: Big blow ups like Terra usually lead to bigger blowbacks in the investment community. It’s time to tread carefully while we await the fallout.

If history is any indication, a time of great reckoning is coming both in crypto and other conventional assets linked to it through margin loans or collateral.

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