When they’ve become just numbers on a screen, there’s no prefix or qualifier on the type of asset.
2022 is the year when digital assets joined the club of stocks and bonds, and became big enough to cause real problems. I’d imagine this is how my parents felt giving me the car keys at 16.
The seemingly endless sea of red in the NASDAQ and S&P 500 feels like a continued barrage where every rally gets mercilessly pummeled. Digital asset markets are faring no better, which is especially interesting given their alleged robustness to inflation, the boogeyman haunting equities and selling off treasuries.
As the ecosystem of coins and tokens grows, it inevitably becomes linked with the world of stock and bond certificates. It is no longer just the crypto native institutions that have accumulated massive “bags” and concentration in this asset class; even the most staid traditional investors have been dipping their toes in with single digit percentage allocations.
Nearly 40% of millennials and 30% of GenX’ers own some cryptocurrencies. These allocations aren’t bifurcated based on the asset type, but they represent a part of an entire portfolio that goes up and down in concert - ideally a diversified harmony. A sneeze in one can cause a cold in the other.
It’s often the same type of investor that believes in the world changing power of Tesla Motors or ARKK’s Innovation Fund that also has faith in a decentralized future of blockchains and permissionless securities. Likely to their own respective chagrins, it’s far less than six degrees of separation between the alt coin speculator and the sovereign bond investor.
If one bucket springs a leak, it’s very likely that another bucket gets emptied either as a rebalancing measure or a risk-off consideration. Water ebbs and flows.
It is a great sign for the maturity of these new markets that they are in fact well enough integrated in the broader financial ecosystem to cause some degree of contagion. Unfortunately they are not well developed enough to be totally self-sustaining and are susceptible to the violent gyrations of emerging markets.
Over the past week we’ve witnessed the spectacular collapse of the alleged stablecoin UST. This monetary collapse has led to a waterfall of effects, slashing Bitcoin and NASDAQ prices. It had quickly risen over the past six months to be the third largest stablecoin behind USDC and USDT.
What differentiated UST from its larger competitors, was that it was algorithmic - there were no dollars or commercial paper backing its value. The mechanism that UST used to maintain its 1:1 ratio to the US dollar was a collateralization in the form of another token LUNA, whereby UST could always be redeemed for $1 worth of LUNA. Assuming LUNA maintained some value as the native token of the burgeoning blockchain Terra, this seigniorage supported the stablecoin.
The demand for UST was very strong, primarily due to the high yields offered by Terra’s savings protocol Anchor. While it was openly known that the rate of 19.5% on deposits was “promotional” and only a temporary subsidy over the true borrow/lend balance, this type of marketing is very common and often effective in crypto assets. UST market cap ballooned as a result.
What UST was hoping to achieve was significant enough network effects to allow its value to become self-evident - much in the way the US dollar has been since Nixon took America off the gold standard. If something isn’t fully collateralized, it’s only faith or the power of the US military and taxing authority that holds it together.
The group responsible for open market operations of the coin had made many steps towards achieving this in a decentralized manner. Increasing their reserves in other assets like Bitcoin and Avalanche helped bring in new partners to the ecosystem. Importantly, they were also creating liquidity pools that would allow for the free and robust exchange of UST for other stablecoins.
Ultimately what brought all of this down was a well timed liquidity play. It’s hard to call it an “attack” because ultimately markets are a system of rules, and exploiting fragilities is what makes the entire system stronger. They must be Darwinian for capital to be efficiently allocated.
There was $19B worth of faith in UST at its peak and both retail and institutional money relied on and supported it. There were believers - myself included - that creating truly decentralized stablecoins was not only important for the overall crypto ecosystem, but that it was a solvable problem and UST had the best chance of doing that.
Financial markets have a way of humbling even the greatest traders. George Soros famously broke the Bank of England with his bet against the pound in 1992 - eerily similar to the profits earned by the liquidity crunch initiated against UST. Two years later he lost twice that amount on his Russia bets when the ruble devalued.
Market participants take particular schadenfreude in humbling the arrogant. The founder of Terra is an especially cocky figure named Do Kwon. Despite all his diplomacy over the last several months to bring in other partners, he mocked his critics mercilessly and ridiculed their legitimate challenges to his system. This makes it particularly interesting for those with enough capital to exploit them, find his protocol’s weaknesses.
The number of retail investors that lost life changing amounts of money in this implosion is heartbreaking. Influencers peddled this as a high yield savings account, and individual depositors enthusiastically placed their college funds and startup capital there. Crypto DAOs used it as a treasury, and institutional investors traded assets against UST as if they were dollars.
The regulators are already circling what remains of this stablecoin, and it certainly leaves a black mark on the digital asset ecosystem. The pathway towards integrating the power and benefits of decentralized digital assets into the global financial markets will continue to be rocky, as the razor sharp double edged sword of brilliant innovation is catastrophic failure.
Investing in high risk emerging technologies is not for the faint hearted. Technology has made this easily accessible, and with regulation inevitably a step behind, individuals must be prepared to self regulate, and not overdose on hopium.
While enthusiasm is necessary, it will also create divided camps. Whether it's Twitter or a DeFi protocol, the screens between us have a tendency of making things a little bit less nice. Mercenary capital can hide behind anonymous wallets in a way that a vicious merchant or pit trader never could. There’s a strong socializing force in meat space.
One of the mantras of The Till is that money is for funding goals. The most commonly cited goal people have is to spend their free time or retirement with friends and family. We want to be around nice people that like us.
Perhaps UST would have failed regardless of the actions of Do Kwon, as the incentives for initiating a bank run would prove too great. But it certainly doesn’t hurt to be nice, and there’s no need to poke the bear. It’s important to tread the fine line between support for your product, and using your power as a bully pulpit.
Equity investors can no longer look across the divide and ridicule the punk kids and their DeFi mullets. We have seen that what happens in one bucket can easily spread to the other. Vol traders might be intellectual (and often wine) snobs, but broadly there is respect amongst practitioners no matter what asset class you trade. Digital assets are now a part of that club.
The post pandemic evolution of financial markets has brought traditional and digital asset markets increasingly close together. No matter how advanced technology gets, the most important rules are simple. Treat your critics with respect, and be nice to the new kid - she might be your boss one day.