*These are my own personal views and opinions and do not reflect those of any company or project that I am affiliated with”
Few things in crypto are as memorable as large project implosions and exploits. In a space that is dominated by a constant barrage of activity, salacious headlines, wild price swings and shiny new things, the implosions are often the most ingrained in our memories because they’re so chaotic (except for DeFi hacks — somehow people seem to forget or ignore these with goldfish like efficiency). Perhaps it’s also because they are so dramatic, or because the characters involved are so unbelievably out of this world, or because there is always so much money involved — probably all of the above. Like all of the major scandals before it (Mt. Gox, Bitconnect, OneCoin, QuadrigaCX and Plustoken) Luna has carved out is own unique cautionary tale about the pitfalls of operating in this tricky space. The events that took place during the week of May 10 2022 ultimately resulted in the single largest destruction of wealth in the crypto ecosystem. An insanely eye popping $59 Billion in market cap was erased from LUNA and UST. This has very quickly and publicly amounted to a collapse for the history books that looks it its going to be our Enron moment. There is so much to unpack in this made-for-Netflix story, but I’ll focus on the elements that I find the most fascinating: Hubris, Due Diligence Failure and the resulting Stablecoin Derangement Syndrome.
Lets begin…
1. Hubris
In greek mythology, one of the most famous stories is that of the fall of Icarus. Icarus was the son of Daedalus, the craftsman who built the Labyrinth on the island of Crete, featured in the story of Theseus and the Minotaur. After a dramatic set of circumstances, King Minos of Crete imprisoned Daedalus and Icarus on the island. Eventually, Deadalus was able to craft some wings out of wax and feathers for him and his son to use in order to escape the island. As they flew away from the island Icarus began to become a little too adventurous and risky with his new flying abilities and was warned by his father not to fly too close to the sun, because it would melt the wax in his wings. Despite his father’s warnings, Icarus flew too close to the sun and the wax holding the feathers to his wings melted. He ultimately fell into the sea and drowned. This story is often interpreted as a warning against the very real dangers of hubris and being weary of not over reaching one’s limits and abilities.
Enter Do Kwon, the charismatic, loud and aggressive founder of Terraform Labs, the parent company behind LUNA and its US dollar Stablecoin, UST. If you’ve followed his interviews, comments and debates over the last year or so, it was very clear from the get go that the animated leader of one of the most hyped L1 chains in the space was both proud and confident about the direction of the project. To his credit, he was at the helm of one of the most successful token value accrual runs in history, with LUNA’s market cap topping out at around $40 Billion at its peak. In addition, UST amassed over $18 Billion and rose to be the third largest stablecoin in the ecosystem.
Over time though, his banter began to skew into egotistical and downright antagonistic sentiment, which at first was definitely entertaining, but quickly morphed into a delusional self image of being untouchable. From making outrageous public bets on twitter about the price of LUNA, to proclaiming that he will destroy his competitors at DAI, to calling his critics poor and bragging about his new billionaire friends — it was clear that he was quickly becoming out of touch with reality and getting high on his own supply. Let’s be clear, crypto is a very competitive and adversarial landscape, especially on twitter, where people routinely engage in all sorts of shit talking, trolling and meme warfare. This type of behavior is to be expected from some who operate in the space, but the difference however is that when you are a leader of a top 10 crypto project in the world, it might be a bad strategy to be make asinine comments and rudely dismiss your critics, who were rightly pointing out the very real and predictable risks of your project. Algorithmic stablecoins are nothing new, and the short history of our ecosystem is littered with a graveyard full of them.
You see, people can be forgiving if you are an asshole, but only if you’re delivering the goods and making them money. People are far less inclined to do so if you talk shit, ignore relevant risks and parade around like your artificial wax wings wont eventually get melted by the sun. The universe has an incredible way of humbling people, especially in the crypto ecosystem. This however, was one of the swiftest karmic retributions we’ve ever seen.
The real crime of course, isn’t the questionable behavior of a high profile founder (there’s plenty of that already in the industry) but the complete disregard of the dangerous mechanics of the project itself. While sometimes legitimate criticisms can be misconstrued for attacks on a project (for any number of reasons — not the least of which is if people are actually short the coin), once in a while these actually turn out to be genuine concerns. The list of credible people in the ecosystem that were outspoken and tried to warn people is not insignificant:
@banklesshq, @AlgodTrading, @GiganticRebirth, @gametheorizing, @cyounessi1, @FreddieRaynolds, @0xHamz, @Galois_Capital, @JackNiewold, @nic_carter and many others.
To summarize it simply, here’s a short explanation from 2018 that Cyrus Younessi put together:
Add to the mix the fact that Terraform Labs began adding other coins to their reserves last year, including AVAX, USDC and of course a very public and massive Bitcoin position, and you have a recipe for disaster when a tail risk event happens. Ultimately, UST was under-collateralized and when disaster struck the death spiral began and there was little than could actually be done to remedy the situation. The inevitable selling off of assets from the Luna Foundation Guard reserves ended up as a futile effort to plug a shotgun wound with a band-aid. As it turns out, the critics were right, and it was unfortunately doomed from the beginning. Unfortunately, only few had the foresight to recognize it, and even fewer to speak out about it.
As many have pointed out, adding Bitcoin into the reserves served almost as an exercise in hostage taking or racketeering. Given Bitcoin’s role as the leader of the pack in the ecosystem, any protocol mechanism design that would result in unavoidable forced selling off of Bitcoin will inevitably drag down everything else in the ecosystem. “Support the peg or we’ll market sell a systemic amount of bitcoin”.
“We don’t need to undertake financial alchemy to create an under collateralized stablecoin with volatile crypto collateral” — Nic Carter
In hindsight, one tell tale sign that something was off was the very toxic and aggressive way that both Do Kwon and many of the community members treated their critics. Both were perpetuating an aggressive cultishness whose natural instinct would be to attack and sometimes even bully their critics in what can generously be described as an “unhealthy response”. When this type of behavior is present we can usually attribute it to a “cult of personality” delusion that quickly morphs into egomania and narcissism. This never ends well. Healthy and rational debates about projects should always be encouraged and when we see an avoidance of this, it ultimately results in a echo chamber that will never be able to identify its own blind spots.
Play stupid games, win stupid prizes. Add hubris to the mix and you have a meltdown of catastrophic proportions on one of the world’s biggest stages.
2. Due Diligence Failure or Delusion?
Watching the collapse of LUNA and UST was jarring. If you were looking at the charts in real time, it was impossible to avert your gaze from the action. That vertical red line dropped into the abyss and there was literally nothing anyone could’ve done about it, despite the best efforts of the LFG to protect the UST peg. Watching a top 10 market cap coin disappear virtually over night was not something many of us thought would be possible.
After the dust had settled one major question remained: “how the hell did some of the ecosystem’s biggest and most important players all fall for this?” or at least miscalculate the real risks associated with the project?”
Did nobody really understand the mechanics? Did they not do the due diligence? or did they assume that they would be able to go on the ride long enough to cash out before it inevitably imploded? Perhaps every fund, prop desk, investor and market maker involved was riding so high on the 2020–2021 bull run that they completely ignored the fact that such a scenario was not only possible, but likely inevitable. It’s easy to see why many of crypto’s biggest players would be seduced by Luna’s promise as it continued to grow in size and influence over the last. It would seem as though the conventional wisdom is that the larger it got the less likely it would be to fail. That assertion is a double edged sword, because the opposite — systemic risk and infection — could and ultimately would also turn out to be true.
The list of names of the industry’s most influential players that were involved is long. And to be clear, it is not my intention to name and shame or to kick anybody when they’re down, but it is impossible to ignore the large and powerful orbit that Luna had amassed around it. In fact, it had a sort of irrational mania to it.
“How did Luna run so far? Bull markets hide structural deficiencies. Bear markets crack them. Maybe could’ve worked if collateral was added earlier in lock step w UST growth. Many knew the risks & that the music would stop. They just didn’t think it would be them left standing.” — Santiago R Santos
Perhaps one of most striking elements of this story is the fact that it appears it was some sort of attack might have taken down the project. An attack that was predicted and warned about by several people over the last year. Let me be clear that there is no definitive proof that this was a malicious, coordinated takedown of LUNA and UST, but there’s certainly evidence both on chain and in various exchange order books to suggest that a targeted Soros-style peg attack may have taken place. There’s even all sorts of assertions and conspiracy theories floating around alleging that this attack may have been orchestrated by Citadel or Blackrock. These rumors got so heated last week that both companies had to issue official statements to dispel any myths of their involvement. The theory goes that one well capitalized player borrowed 100K BTC from Gemini or Genesis, selling a chunk of it to Do Kown for the Luna Foundation Guard reserves in exchange for UST, then dumping the rest of the Bitcoin as well as the UST and triggering forced selling in both. This would ultimately trigger LUNA withdrawals from Anchor Protocol (who were offering a 20% yield at the time) and forcing more selling of LUNA that would ultimately result in the total depegging of UST. The attackers could then buy back the BTC at an incredible discount to pay back the loan and short all sorts of other assets along the way. Impossible to prove one way or the other, if this exact scenario took place, but there’s plenty of on chain evidence from the likes of OnChainWizard and others, who have detailed some legs of the alleged attack that netted somebody at least $800MM. Some are speculating that this may have been a move by any number of well known market makers or crypto hedge funds, because only they would understand the nuances of how to pull off such a complex multi legged takedown. While it’s a fun concept to flirt with, it doesn't hold much water because as the old saying goes “you don’t shit where you eat”. It wouldn’t make much sense to create systemic and existential dangers to the very ecosystem that you operate in.
Regardless of who was behind this and how they did it — the point is that these fundamental vulnerabilities in the structural design of LUNA were well known. Add to that the delusion of unsustainable risk free yields for UST on Anchor protocol and you have a recipe for disaster, just one domino drop away from becoming a reality…
Every market cycle that I’ve observed since 2013 has clear periods of euphoria that blind and distort the perceptions of most market participants— including those who should know better. Luna’s association with the heavy hitters of our industry helped to embolden the “too big to fail” illusion. By the looks of the both the rumored and the reported losses, a lot of the bluechip funds really did buy the hype and very likely rode their positions all the way down to zero. The irony (and sadness) about such a blind support campaign for Luna is that its collapse undoubtedly ended up hurting their other investments. Whether this was a case of a true misunderstanding of an investment or pure disregard of the dangers of propagating such a rickety and dangerous idea, some of the industry’s most prominent leaders and figures are going to have to do some soul searching in the wake up of this collapse to ensure that this does not happen again.
3. Stablecoin Derangement Syndrome
In the wake of the UST collapse it is amusing to watch the predictable group of anti-stablecoin heretics and Tether truthers pop out of their caves for their 15 minutes of attention in the present market cycle. There will be those that use the demise of UST as an opportunity to attack all stablecoins, and this pattern already started to emerge over the last couple of weeks. From Janet Yellen of the US Treasury Department to pundits on Bloomberg and CNBC and everybody in between. However, the reality is that not all stablecoins are created equal. Tether, USDC, BUSD and others are NOT under collateralized experimental technologies, but are instead fully reserved tokens with over $140 billion in backing (at the time of this piece).
UST was an algorithmic stablecoin that was not a fully reserved. The Luna Foundation guard did not have more than roughly 20% in collateral to back the stablecoin at any given time. It was severely under-collateralized and worse was supported by volatile collateral (BTC, AVAX, etc.) that would inevitable send it into a death spiral as soon as a violent market swing would take place. UST was not like the other top 3 stablecoins on the market and should not be treated as such. Rationality however is usually in short supply during chaotic market periods and people often freak out and make silly, hasty decisions. Take THIS individual for example who panic sold $520M of USDT paying a 400% premium only to receive $130M USDC in return — likely because they feared Tether would be the next to collapse.
The job of a stablecoin issuer is to mint and redeem tokens at par to the fiat dollar they are taking in as collateral. This is how the “peg” is maintained in practice. For every dollar of USDT or USDC that I mint, I receive an equal amount of tokens in return and vice versa. The prices of these stables on the open market, while sometimes trading at a slight premium or a discount do not reflect an issuers ability to mint or redeem stablecoins. If somebody decides that suddenly their USDT is worth 50% less today because an unrelated stablecoin collapsed, that’s their decision and their prerogative to sell it on the open market for whatever price they deem to be fair. It does not mean that the issuer is not honoring the minting and redemption at par. While UST and Luna were collapsing, both Tether and Circle (issuer of USDC) were processing redemptions as usual, with extremely high liquidity and decent spreads on most centralized order books.
Not all stablecoins are created equal. Do not let anyone tell you otherwise.
Both Tether and Circle, the two largest stablecoins on the market publish public attestation reports which can be found here and here. A reminder however, that attestation reports and audits are not the same thing (for more info on this check out Gabor’s breakdown here). The sad truth is that the UST peg mechanism was vulnerable and flawed to begin with, and no amount of subsidized Anchor Protocol yields would help keep this alive in the long run.
Unfortunately the mainstream media coverage was also predictably confusing and incorrect in trying to draw conclusions between the UST implosion and the existence and operation of other stablecoins that did not have anything in common with the former. As Adam Back put it, “it’s annoying that markets are being moved around by basic ignorance, amplified by financial news orgs”
4. Closing thoughts
The magnitude of this collapse cannot be understated. We will not know for months the true repercussions and contagion that has resulted from the events of the last two weeks, although some of the on-chain spill over to other protocols has already been documented here. It is almost an undeniable certainty that this will be used as unlimited ammo by regulators and critics alike to point out both the dangers and risks of not just (algorithmic) stablecoins but crypto in general. And to be honest, you can’t really blame them because there really was a failure in self policing by many of the industry’s biggest players who ignored obvious fragility in favor of pumping their bags during the mania of the last bull market. I think we can all agree on the fact that one thing that is badly needed is a mass de-ponzification in the ecosystem. Time and time again it has been proven that the tantalizing urge to create Rube Goldberg machine style schemes is so strong in a space where it’s so easy to blur the truth with big fancy technical jargon and outlandish promises of profit.
In addition to the very real and growing macro economic headwinds, we now have to contend with systemic contagion throughout the industry that will likely push us into a multi quarter bear market. brace yourselves.
One of the funniest ironies to come out of this whole situation is that just months prior to this whole debacle, a tradfi fund who shall remain nameless made a very public bet against USDT. Incredible how they managed to not only re-hash already debunked Tether FUD from last cycle, but also completely ignore the one stablecoin short that would’ve netted godlike returns. In a stroke of poetic justice, they missed the actual rare golden opportunity right in front of them.
Last but not least, one key truth that reared its head in the last two weeks is that even the smartest and most influential people in this industry don’t really know how to play this game — otherwise they wouldn’t be taking $300 Million losses. I guess, just like everything else in life, most of us are just making this up as we go along, including funds with 9 and 10 figure balance sheets. In light of this fact, it’s more important than ever to stress that you should always do your own research, don’t invest more than you're willing to lose and don’t ape into a project because some big name investors are shilling it on twitter.
— fin
ps: how does Maren Altman keep predicting these market moves?
