Crypto Just Passed Its “Lehman’s Test”

It was the largest bankruptcy in corporate history…

On 15th September 2008, Lehman Brothers filed for bankruptcy. More than $619 billion in debts went up in smoke. Lehman’s collapse directly contributed to a domino effect that led to the Great Financial Crisis of 2008.

The credit market’s liquidity evaporated… The S&P fell by half. Thirty million US jobs disappeared… U.S. households lost $16 trillion worth of financial wealth… More than a million homes went into foreclosure. Fear and panic spread…Some said the stock market was going to zero… or that it was the end of capitalism. Others said it was the end of human civilization.

Then the U.S. government rushed in with a $700 billion bailout package for banks deemed “too big to fail.” With the stroke of a pen, taxpayers were on the hook for Wall Street’s reckless behaviour. But it didn’t stop at $700 billion…The Federal Reserve injected $3.7 trillion more into the financial system over the next several years… and Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act to prevent another crisis like Lehman.

Here’s why I’m telling you all this…

…Crypto just had its own “Lehman moment”

…And amazingly, it didn’t become the “Great Crypto Financial Crisis” of 2022. It didn’t need a multibillion-dollar government bailout. It didn’t require any congressional hearings. I’d even argue Crypto has emerged stronger because of it.

Last month, Crypto saw its biggest collapse ever when one of the most successful blockchains — the Terra (LUNA) ecosystem — crashed and burned. Terra was a blockchain for issuing stablecoins and creating decentralised financial infrastructure. TerraUSD (UST) was a stablecoin designed to maintain a 1:1 match to the U.S. dollar. LUNA is the asset that backs UST. On the 9th May, UST started to see heavy selling, causing it to trade for less than $1.

I don’t want to get too deep in the weeds here nor to apportion blame on any (likely) bad actors that precipitated this collapse for financial gain. But here’s what happened…

The pressure on UST came from Anchor Protocol, a savings and lending platform in the Terra ecosystem. In a very short time, users withdrew $2 billion worth of UST from a platform on the Terra blockchain. That led to increased selling.

Around the same time, other token holders sold hundreds of millions of dollars of UST on a different decentralised exchange. Once that selling started, Binance and other exchanges saw heavy UST selling as well… and the token’s value fell even further below $1.

That’s when the Luna Foundation Guard — a non-profit that supports the Terra ecosystem — stepped in. It loaned $1.5 billion in Bitcoin and UST to shore up UST prices. It also sold about $3 billion in Bitcoin to try and preserve the 1:1 match. But by then, it was too late. LUNA dropped to well below a penny, and UST traded at just a few cents.

Today, LUNA has a grossly inflated supply and an ecosystem left in shambles. At its height, LUNA had a market cap of $60 billion. Today, it’s worth $639 million.

That said, the LUNA crash illustrates something the mainstream media is missing: the resilience of the Crypto market in general and Bitcoin in particular.

The Crypto Crash: Just The Nature of Capitalism?

It may seem counterintuitive… but I’m encouraged by how Bitcoin and the entire Crypto ecosystem handled the collapse of UST.

Nearly $60 billion in value was vapourised when UST crashed. To put that in perspective, when Lehman Brothers went under, its market cap collapsed from $46 billion to essentially zero.

So in pure market-cap terms, we had a Crypto crash bigger than Lehman’s crash.

You’ll see traditional Wall Street pundits and regulators wag their fingers and admonish Crypto for the Terra crash…

But the collapse of Terra may show that Crypto is actually far less fragile than the traditional financial space.

Here’s what I mean…

If another major financial firm went to zero overnight as Lehman did… it would cause such a level of havoc in the financial markets that the Fed would have no choice but to intervene.

Every lawmaker in the country would be demanding new regulations… And the media headlines would be screaming of a global collapse. Yet, if you look at the spill-over effects from Terra, it’s been relatively muted.

Crypto didn’t need the Fed to come to the rescue. It didn’t need dozens of congressional hearings. It didn’t take taxpayer bailouts. There was no stock market crash… Or millions of foreclosures… Or the loss of 30 million jobs.

If you were affected by the LUNA crash, I don’t want to minimise any losses you may have incurred. But the important thing is this: while the UST-Terra blow-up was an awful experience, it hasn’t destroyed markets like the collapse of Lehman did. To me, that shows the resilience of the Crypto ecosystem already built.

Had something like Terra happened in 2018 — when the Crypto market was much less mature — I believe it would’ve been devastating for the whole sector and would have been very difficult to recover from.

Yet, since the LUNA crash, the Crypto market is only down about 60%. Sure, that’s uncomfortable. But in fact it’s par for the course in Crypto: we’ve seen Bitcoin drop 50% or more four times since 2016 and each time, it has rallied to new highs.

My point is: as difficult as it is to see an erstwhile successful crypto project blow up, that’s the nature of creative destruction that we see in true capitalism at work. Every day, we see new innovative businesses born, and old businesses die and be replaced by something better. No doubt we’ll see the same with Crypto projects. The flaws and risks in the Luna/Terra/Anchor setup were clear to those of us who analyse projects in this space. Furthermore, I believe you can minimise your investment risk by focusing on robust Crypto projects, and by adopting strict risk limits on position sizes.

The fact that Terra failed doesn’t negate the exciting innovations and value of blockchain technology as a whole. Adoption by users and big businesses — arguably the true test of the value of the blockchain — has continued despite this crash.

Overall, I believe this important stress test of the whole Crypto ecosystem provides validation of the strength and resilience of the sector and augurs well for the future of the industry.

PTLIB is co-founder of Dragonfly Asset Management.

DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.