14th May 2022 > > The Terra fiasco.

tl;dr

More insight into the Terra/LUNA/UST fiasco and its implications for crypto regulation.

Market Snap (at time of writing)

Market Wrap

Those round numbers are so psychologically important, with an ongoing battle around $30k.

Stocks have stabilised for now, and the Terra fiasco will either peter out or as a very long shot there might possibly be a positive resolution.

Curious Cryptos’ Commentary – More Terra/LUNA/UST stuff

It safe to say that Do Kwon, CEO of Terra, has had a difficult week. There can be no doubt that he is a smart cookie, but I suspect the revelation (to him at least) that there are problems inherent in algorithmic stablecoins has been a bit of a blow to his sense of self-worth, as well as his bank account.

In some ways the mistake Terra made was similar to that made by Long Term Capital Management (LTCM) back in the late 90s.

I am sure you all remember the details, but just in case, here is a very brief summary.

LTCM was an algorithmic hedge fund, run by some extraordinarily smart people, including John Meriwether, the god of bond trading. On the board of directors were Myron Scholes and Robert Merton who jointly won the Nobel Prize in 1997 for developing the Black-Scholes model which is the standard model for pricing options and other derivatives.

The core strategy was to identify pairs of financial instruments whose basis had moved inexplicably away from what was to be expected. These arbitrage opportunities would be executed using a combination of physical assets and derivatives, but crucially with extremely high leverage.

As an example, Shell had a split listing between London and Amsterdam. In theory the equity prices should be very similar or the same, but that rule does not always apply. At one point there was a 15% discrepancy. By going long the cheap version, and shorting the expensive version, assuming that prices move back into line, then there will be realised arbitrage profit to be had.

Which is all well and good, until one remembers the maxim that “markets can remain irrational longer than you can remain solvent”. And let’s not forget “markets will cause the maximum amount of pain to the maximum number of players”.

In general, across the entire portfolio, LTCM was short liquid instruments and long illiquid ones.

When the Russian crisis hit in August 1998, liquid instruments significantly outperformed illiquid ones, a phenomenon which is seen during all periods of financial stress. It isn’t difficult to understand how that caused LTCM a lot of pain.

With margin calls left, right and centre, LTCM was forced to liquidate positions that were loss-making (for example the Shell arbitrage was closed for a $250mm loss I believe) and it was eventually bailed out by a group of banks.

Virtually all their trades later ended up in-the-money (particularly the Shell one), but by then it was too late.

LTCM had made two basic mistakes – it had failed to recognise that reality trumps theory every time, and it was over-leveraged.

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Which is what Do Kwon and Terra have done.

The UST algorithm intended to maintain its peg by allowing owners of UST to redeem 1 UST for $1 worth of LUNA.

The key idea here is that if UST is trading at say 98c, one can exchange 1 UST for an amount of LUNA that can then be sold for $1, giving a realised arbitrage profit of 2c. This creates demand for UST bringing the price back to $1 (why sell it someone else giving them 2c?). In theory this works fine, and to be fair, for most of the time UST has been in existence it has worked reasonably well.

The problem arises when it stops working (reality trumps theory). As the arbitrage opportunity grows, more and more LUNA is printed and immediately sold. The amount of LUNA in existence has ballooned from hundreds of millions to billions, hence the reason why the Terra blockchain has been suspended.

Meanwhile the total market cap of UST and LUNA was many multiples of the treasury assets (over-leverage of a sort).

As confidence in LUNA diminishes so it does in UST, enlarging the arbitrage, minting more LUNA and creating more LUNA sellers, without enough assets to support the coin price. Assets which themselves were directly correlated to crypto markets and the ecosystem.

This tail-risk confluence of events has led to a spiral of doom and death, a situation that John Meriweather became personally acquainted with over two decades ago.

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Do Kwon was interviewed just recently about the prospects for most crypto companies. He had this to say:

“95% are going to die. But there’s also entertainment in watching companies die too.”

Spot of schadenfreude anyone?

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Anyway, I hope that helps to give a little more context.