How We Got Here: Crypto's 2008

Robert Riva / 29 July 2022

How we got here –Crypto’s 2008

“Lehman Brothers” Moment: The TerraFirma Labs Crash  

In March, whistle blowers warned that a fixture of the digital asset market, TerraUSD(UST), may be secretly insolvent, pointing out that its owners had dumped billions worth of their own coin.

TerraUSD is a cryptocurrency pegged 1-to-1 with the US dollar. There are competing cryptocurrencies that do the same, along with many more pegged to other national currencies. Large-volume sales between BTC and ETH (or other assets) typically make use of these cryptocurrencies, dubbed “stablecoins,” as a means of mitigating price swings during a transaction.

Different “stablecoins” employ different schemes for keeping their prices stable. Most are straightforward. But Terra is not.

For users to receive 1 UST, they need to first buy $1 worth of a second currency made by the same parent company, Terraform Labs, called LUNA, at secondary market value, and then use their LUNA as collateral (again—at market value). This $1 of LUNA (and I cannot stress this enough—valued according to the secondary market) is then burned, at which point 1 TerraUSD (UST) is spontaneously created. As the demand for LUNA increases, its market value increases, and so more TerraUSD (in other words, more “dollars”) can be minted per 1 LUNA.

Just so we’re clear, this is LUNA’s only function. And yet, Terraform Labs publicly advertised this model as a strength.

They had argued that, because TerraUSD can be converted back into LUNA and vice versa at a user’s discretion, this gives users opportunities for arbitrage by exploiting brief periods where the price is not quite one dollar by buying one and selling the other or vice-versa. According to their model, the secondary market would always guarantee that TerraUSD stays as close to $1 as possible.

Adding to the instability was the fact that the Terraform Labs company was promising interest of up to 20% APY on TerraUSD coins loaned back to the company. (If red flags could scream…)

While we wouldn’t go near something like this with a forty-foot dung-scraper, a few people—or, rather, a few extremely large institutional investors—apparently felt differently.

Overleveraged Margin Calls on TerraUSD

What happened next was almost exactly what you would expect. One day, Luna’s price stopped going up and instead went down—sharply, all at once, and without any warning except for the aforementioned screaming red flags.

Without naming names, a pair of investment funds heavily exposed to TerraUSD collectively lost over $10 billion in collateral for leveraged trades when TerraUSD collapsed, triggering massive selloffs of their BTC and ETH reserves. To make matters worse, many of these leveraged trades were themselves using BTC and ETH borrowed from a number of crypto-lending services, these as high as 6.5%APY. As the funds became insolvent, these lenders had nowhere to recoup their losses and were forced to sell as well.

The combined volume of all of these large institutions selling into the market, resulted in the prices of Bitcoin and Ethereum plunging to as low as their previous high of 2018, when Jefferson Capital first launched the Genesys Fund.

How We’ve Handled It:

Just before the crash, our previous PM had invested a large portion of our BTC and ETH reserves into a series of digital assets which we felt strongly would appreciate in value in the long term. To be clear: We did then, and we do now. However, as we watched the entire digital asset market depreciate in value, just as the economy at large suffers heavy contractions due to supply chain shocks, inflation, and the rise in global oil & food prices, we have returned to our foundational philosophy regarding the global demand for a store of value in the form of BTC and ETH and, as a result, successfully minimized our losses and maximally benefited from the subsequent rally.