In 2008 the prices of some structured credit products built out of subprime U.S. mortgages went down, and as a result there was a global recession and millions of people lost their jobs. If you had asked a normal person in 2007: “How would it affect your life if it turns out that investors have mispriced the super-senior risk in synthetic collateralized debt obligations built out of subprime mortgage tranches,” that person would have said “I have no idea what you are talking about, but I can’t imagine how that collection of words would affect me.” But it did. Loosely speaking,[1] the mechanism was that the people (often banks or shadow banks) who owned subprime CDOs (1) also owned other stuff and (2) had borrowed money to buy that stuff. When their CDOs collapsed, they had to sell other stuff to pay off their debts, which drove down the prices of other stuff, which led to broad market contagion, which destroyed a lot of wealth, which reduced economic activity, etc. Meanwhile the banks had lost money and were more risk-averse and less able to lend, which also reduced economic activity. And so normal people lost their jobs because of contagion from some weird financial asset that they hadn’t even heard of.
Matt Levine muses on Crypto
If you asked a normal person, you know, two weeks ago: “How would it affect your life if the prices of some monkey JPEGs and algorithmic stablecoins crash,” I think most people would reasonably have said “I do not own a monkey JPEG and do not aspire to own one, so this will not affect me at all.” My guess is that they would have been right. My guess is that the real world is not too affected by the crypto world, and that if crypto prices crash there will not be a ton of contagion in the rest of the financial system. But I think it is, at this point, debatable. Crypto has at least started to work its way into the real financial system. Some traditional investors also own crypto; if their crypto goes down they might have to sell regular stuff. Some public companies are exposed to crypto (because they are crypto exchanges, because they have levered crypto holdings, etc.), so your boring old index fund might go down when crypto goes down.
Ten years ago, if you had waved a magic wand and every cryptocurrency went to zero, not much would have happened. A few oddballs experimenting with a newfangled money called Bitcoin would have seen their experiment fail. “Oh well, that was cool for a while,” they would have said.
Five years ago, if every cryptocurrency went to zero, a lot of people would have lost a lot of money. But they would mostly be crypto people: Some individuals and some hedge funds that bought crypto would lose their money. The contagion to the real financial system would have been small. Lamborghini dealerships would have a rough year. But most people would barely notice.
Five years from now, if every cryptocurrency goes to zero … well, I don’t know what the next five years will be like, but a plausible story (as of last week anyway!) is that there will be continuing integration of crypto into the real economy. More crypto companies will be big and important and intertwined with other companies; their stock will be in the indexes and they will borrow money from banks and use their own money to finance real businesses. More traditional investors will own crypto, and will make levered bets on crypto, and if those bets blow up they will naturally sell more liquid traditional assets, causing contagion from crypto markets to stock and bond markets. Crypto platforms will be used for real economic activity; ordinary people will invest their savings in those platforms, and those investments will be used to finance real, non-crypto business activity. You’ll get your mortgage from a decentralized finance platform or whatever.
This is a very bullish story for crypto; in this story, broad institutional adoption and growing utility will be good for the popularity, and prices, of crypto. And then if there’s a break in crypto — if there’s a run on a stablecoin, if there’s a rug-pull in a popular DeFi project, if all the apes gone — that break will naturally spread to the broader financial system, and that will be a sign of crypto’s success. Ideally there would not be a lot of breaks; that would also be a sign of success. But a sign of failure would be if crypto projects keep blowing up and nobody outside of those projects notices. That would be a sign that crypto isn’t good for anything, that it cannot provide benefits to the real world. If crypto can be good for the real world, then crypto prices going down should be bad for the real world.
Right now we are probably in between? Crypto has been having a horrible time:
A massive sell-off in cryptocurrencies wiped over $200 billion of wealth from the market in just 24 hours, according to estimates from price-tracking website CoinMarketCap.
The broad plunge in the crypto complex, driven by the collapse of the TerraUSD stablecoin, hit major tokens hard. Bitcoin plunged by as much as 10% in the last day to its lowest level since Dec. 2020, while Ethereum dropped as much as 16%.
And there does seem to be some worry about contagion to broader markets, at least through the transmission vector of retail meme traders. Bloomberg’s Lynn Thomasson and Anchalee Worrachate report:
As markets slumped in unison on Thursday, traders pointed to the chaos in crypto as a focal point of their concern. Strategists are increasingly worried that small traders, already nursing losses from the meme stock craze, will be wiped out on their crypto holdings and sell everything else.
“Contagion here is not via linkages between the crypto ecosystem and the traditional financial system, but via retail investors sentiment,” said Nikolaos Panigirtzoglou, global market strategist at JPMorgan Chase & Co. “If the $1 trillion capital loss in crypto markets causes broad-based retrenchment by retail investors in other risk assets such as equities, then that’s where the spillover is.” …
“Today there is a new bear factor that has come into play, namely the collapse in the cryptocurrencies,” wrote Malcolm Freeman, a director at Kingdom Futures.
“Investors are getting wiped out in many cases and the question is: Are those investors also involved in equities? Because if they run for the exit, then metals will take notice and most likely head in the same direction,” he said.
And Katie Martin notes that “Typically, what happens in crypto stays in crypto. But big moves can cut through”:
One banker tells me his hedge fund clients are watching closely now, with several taking seriously the possibility that a big crash in crypto, if it happens, could be supportive for that most crucial of markets, US government bonds, again on the notion that it would spark a rush to safer places to park cash.
Martin also notes that Tether, the popular stablecoin, which briefly lost its peg to the dollar, is another potential channel of contagion:
Last year, rating agency Fitch warned that if tether holders were to fold and seek to flip their tokens into real money, then that could destabilise the short-term credit markets where the company says it holds lots of funds.
“The rapid growth of stablecoin issuance could, in time, have implications for the functioning of short-term credit markets,” Fitch’s analysts said, pointing to “potential asset contagion risks linked to the liquidation of stablecoin reserve holdings”.
Credit markets are already wobbling under the pressure of a shift higher in benchmark interest rates. The notion that Tether could, if push came to shove, offload chunks of its claimed $24bn stash of commercial paper, $35bn hoard of US Treasury bills or $4bn pile of “corporate bonds, funds and precious metals” into these market conditions is potentially unhelpful.
I make fun of Tether a lot around here, but at a high level you could argue that Tether is one of the more important crypto projects in terms of having an effect on the real economy. The argument is:
Crypto users want a stablecoin to support their transactions, gambling, yield farming, etc., and Tether is a popular one.
The way Tether works is that if you buy one Tether for a dollar, Tether parks that dollar in some interest-earning dollar-denominated asset.
In practice this means making billions of dollars of loans to real companies and financial institutions to finance their businesses.[2] You know, like a bank.
Tether thus provides financing to the real economy much like a bank does, and because it is … regulated differently? … it can perhaps be more nimble in financing good but risky projects.
In that model, a run on the Tether bank — that is, a run on the crypto bank, on the safe assets of the crypto world — would be bad in much the same way a run on a real bank would be bad, or the way a run on the 2008 shadow banking system was bad: It would cut back on credit to real businesses and be bad for the economy.
ou could have a different model, though. In other Tether news today (this is from May 12th btw):
Tether has refused to disclose details on its $40bn hoard of US government bonds for fear of revealing its “secret sauce”, even as one of the world’s most important crypto assets comes under strain from heavy selling pressure.
Paolo Ardoino, Tether’s chief technology officer, said on Thursday that the group cannot provide information on which organisation is providing custody of its Treasuries holdings, nor where the assets are stored or which firms handle trading on its behalf.
“This is information that is privileged...we don’t want to give our secret sauce,” he said in an interview with the Financial Times. “Our counterparties are not public. We are not a public company. So we keep that information [to] ourselves, but we are working with many big institutions in the traditional financial space.”
Terrific!
Crypto insider trading
Here is a cryptocurrency insider trading scandal that I would like to see:
There is some crypto project that does something. People work together to build something that adds value to the world, and there are tokens that represent some form of economic interest in that project. If the project succeeds and the underlying product is widely used and beloved, the tokens will be valuable; if the project fails, the tokens will be worthless.
Something good happens at the project. A trial version of the product works really well, some regulatory approval is received, some big business decides to use the project, whatever: Some event occurs that materially increases the probability that the project will succeed and, thus, that the token will be valuable.
After the event happens, but before it is publicly announced, some insider of the project buys a bunch of tokens.
Then the event is announced publicly, the tokens go up, and the insider gets rich from her well-timed token purchases.
There is nothing particularly novel or interesting about this; this is just insider trading. Just normal insider trading. Happens at companies all the time: A company has good quarterly earnings or a good drug trial or lands a big customer or whatever, an insider buys stock, the news comes out, the stock goes up, totally normal stuff. Illegal stuff! But normal.
Here is the crypto insider trading scandal that I actually see, repeatedly:
There is some crypto project. Maybe it does something, but this is irrelevant to the discussion.
What is relevant is market depth: If you can sell the project’s token to more people, then it will be more valuable. In particular, if it is listed on one of the big cryptocurrency exchanges, the price will go up, because more people will buy it, independent of any considerations about what the token actually does or whether the project will ultimately succeed.
The project’s token gets listed on a big exchange.
While the listing is being considered, but before it is publicly announced, somebody — presumably an insider of the project or of the exchange — buys a bunch of tokens.
The token lists on the exchange, the price goes up, and the insider gets rich from her well-timed token purchases.
In a sense this is novel and interesting because crypto tokens are (at least sometimes) not securities, everything happens vaguely offshore, and the law of insider trading in this area is underdeveloped and arguably unclear. It is also interesting because the insider trading tends to occur on public blockchains, which means (1) everyone can see the concentrated well-timed trades right before the listing event but (2) you can’t necessarily tie the wallet doing those trades to the actual person involved (to see if it’s an insider, etc.). But the inside information is always fundamentally about the exchange, not about the project. The core inside information is never “the fundamental value of this token has increased,” always “we can sell this token to more people.” It is a dispiriting sort of insider trading.
Anyway:
Over six days last August, one crypto wallet amassed a stake of $360,000 worth of Gnosis coins, a token tied to an effort to build blockchain-based prediction markets. On the seventh day, Binance—the world’s largest cryptocurrency exchange by volume—said in a blog post that it would list Gnosis, allowing it to be traded among its users.
Token listings add both liquidity and a stamp of legitimacy to the token, and often provide a boost to a token’s trading price. The price of Gnosis rose sharply, from around $300 to $410 within an hour. The value of Gnosis traded that day surged to more than seven times its seven-day average.
Four minutes after Binance’s announcement, the wallet began selling down its stake, liquidating it entirely in just over four hours for slightly more than $500,000—netting a profit of about $140,000 and a return of roughly 40%, according to an analysis performed by Argus Inc., a firm that offers companies software to manage employee trading. The same wallet demonstrated similar patterns of buying tokens before their listings and selling quickly after with at least three other tokens.
Look, this exists in traditional finance. There was a fun 2020 case against an S&P Global Inc. manager who allegedly traded on inside information about what stocks would be added to indexes; information about liquidity and demand can be material, just like information about the actual business. But this is rare; most of the material information about stocks is information about the business. In crypto it is the reverse.
Algo stablecoin!
Two weeks ago an algorithmic stablecoin called TerraUSD (or UST) blew up, incinerating tens of billions of dollars of market value. The idea of an algorithmic stablecoin is that it should always be worth a dollar because of an arbitrage mechanism in which one stablecoin can always be exchanged for a number of units of some other crypto token — for TerraUSD, it was called Luna — with a market value of $1. If that other token (Luna) is worth $100 or $10 or $1 or $0.10, that works fine; if the stablecoin trades below $1, you buy it for $0.97 or whatever and redeem it for some Luna that you can sell for a dollar, making an arbitrage profit and pushing the price of the stablecoin back to $1.
The problem is twofold. One is that, if people want to redeem a lot of the stablecoin, the algorithm will print a lot of the other token (Luna), which will tend to drive down the price of that token, which might undermine confidence in the stablecoin, which might lead to more redemptions, which will lead to more printing, which will drive down the price, etc., in what is called a “death spiral.” This is a very well-known problem that long predates crypto; companies have for years issued bonds that are convertible into fixed dollar amounts of stock, which are called “death-spiral convertibles” and have the same problem. The other problem that is more specific to crypto is that the other token — Luna — is just made up, and its value is tied to confidence in the stablecoin. If a death spiral starts, there is nothing to underpin the value of that token, so it can go to zero fast. Luna was trading in the $80s in early May; it’s at about $0.0002 today. TerraUSD is below 7 cents.
I want to emphasize here that:
1.This problem is extremely, extremely well known.
2.Algorithmic stablecoins have death-spiraled in the past in extremely public and predictable ways.
3.Lots of people loudly predicted that TerraUSD would death-spiral in exactly this way.
4.It did.
But I guess we’re gonna keep going until we get it right. Or until we get it wrong a bunch more times:
Among the handful of algo stablecoins that survive is the USDD token launched by controversial crypto entrepreneur Justin Sun on his Tron network just before the collapse of UST. …
USDD went live on the Tron blockchain in early May, according to Sun. It can be used on the Ethereum and Binance Smart Chain blockchains through so-called bridging software. The stablecoin uses an arbitrage mechanism similar to what Terra used to maintain its peg. For example, when 1 USDD drops below $1, traders can make an instant profit by sending 1 USDD to the Tron blockchain in exchange for $1 worth of Tron, the native token of the network, with the arbitrage incentive designed to bring USDD’s price back to $1.
Terra showed that an integration of such algorithmic programming to keep a token stable is easier said than done, largely because the stablecoin is dependent on investors believing that its sister cryptocurrency will continue to appreciate. …
Sun agreed that Terra’s failure shows the flaw of algorithmic stablecoins, but said it also gives an opportunity for new projects to adjust. USDD aims to raise $10 billion through the Tron DAO Reserve -- which it called an “alliance” of market participants including Alameda Research and Amber Group -- to defend USDD’s peg. That’s a similar setup to Terra’s main developer Do Kwon’s Singapore-based non-profit Luna Foundation Guard.
Look I don’t actually think this is impossible. When we first talked about TerraUSD last month, I liked the idea of the Luna Foundation Guard and its pool of money. The point is that you build up a valuable algorithmic stablecoin on a wave of investor confidence, and then you use that value to build a sort of foreign-exchange reserve fund. You can print Luna for free, so if people value Luna you should print a bunch of it and exchange it for things that (1) people also value and (2) are uncorrelated to Luna. You buy $10 billion of Bitcoin or Ethereum or Treasury bills or gold or whatever and, if the stablecoin goes down, you spend some of that reserve fund to buy the stablecoin and prop up the price. If you build a big fund and show a willingness to deploy it, then no one will doubt your stablecoin, so you won’t have to spend the fund, so your other token (Luna, Tron, whatever) will appreciate, so it will all work in a self-sustaining way. “The basic structure of the trade,” I wrote, “is (1) Ponzi, (2) acceptance, (3) diversification, (4) permanence.”
I don’t think this strategy is crazy! I mean, of course it’s crazy, but I do think it could work. (Does it … sort of … describe the history of fiat currency?) It’s just, you know, if you slip up on the way to permanence, you vaporize tens of billions of dollars. And it’s extremely easy to slip up, because in the early going the only thing underpinning the value of your stablecoin is confidence in your system. And people keep slipping up.
Also here's a wild quote:
“An algo stable will exist in the next five-to-seven years,” said Hassan Bassiri, a portfolio manager at Arca, which was an investor in Terra. “And it has to exist or else what are we even doing in this space?”
Losing a lot of money, for one thing. Is this … is now a good time to launch an algorithmic stablecoin? A month ago, all the people who were like “there needs to be an algorithmic stablecoin” put their money in TerraUSD, so it was hard to launch a competitor. Now that TerraUSD has absolutely incinerated all of their money, the field is wide open! People miss TerraUSD — “wasn’t it nice, having a stablecoin that was truly decentralized and algorithmic?” — and so they are willing to ignore how it ended.
Backed stablecoin?
We talked recently about the possibility of contagion from the cryptocurrency markets to the broader financial system. My basic view is that there's not much, really, but there’s more than there used to be, and it will be a good sign for crypto if there is more contagion. If crypto is more tied up with traditional finance — if more investors own both bonds and crypto, if crypto provides financing for traditional businesses, etc. — then that will be a sign that crypto is important, but it will also increase the risks of crypto.
One popular theory of contagion is about stablecoins. Not algorithmic stablecoins, which try to be worth a dollar without holding any dollars, and which can crash to zero with surprisingly little impact on anything else, but “backed” stablecoins like Tether and USD Coin, which try to be worth a dollar by holding roughly $1 of dollar-denominated financial assets (commercial paper, Treasuries, bank deposits, etc.) for each $1 of stablecoins they issue. If there is a run on one of those stablecoins, then they will need to sell their underlying assets, which, if the coins are big enough, could cause the prices of those assets to go down.
When we discussed this, I wrote that “at a high level you could argue that Tether is one of the more important crypto projects in terms of having an effect on the real economy,” just because it purportedly buys so much commercial paper, meaning that it effectively lends billions of dollars to (presumably non-crypto) companies to fund their operations. On the other hand, lots of people have their doubts about Tether, in part because it bizarrely refuses to disclose much about its holdings, and because there is curiously little evidence about what Tether — which seems to be one of the world’s biggest buyers of commercial paper — actually buys.
In that vein, here is a new paper by Sang Rae Kim at Yale on “How the Cryptocurrency Market is Connected to the Financial Market”:
The cryptocurrency market is connected to the traditional financial market through reserve-backed stablecoins. A one standard deviation ($320 million) increase in the issuance of major stablecoins (Tether and USD Coin) on a given day results in a 10.7% increase in the commercial paper issuance quantity, a 20 basis point decrease in the commercial paper yield, and a 15 basis point decrease in the Treasury yield the following day. This shows that the exponential growth of stablecoins created an excess demand for short-term money-like safe assets such as commercial paper and Treasury. I also explore the fiat cryptocurrency market's effect on the commercial paper market. A one standard deviation increase in the market capitalization growth of major fiat cryptocurrencies (Bitcoin, Binance Coin, and Ethereum) on a given day results in an 11.9% decrease in the commercial paper issuance quantity, a 20 basis point increase in the commercial paper yield, and a 18 basis point increase in the Treasury yield the following day. This result suggests that investors exchange stablecoins for fiat cryptocurrency when the fiat cryptocurrency market is doing well, lowering the demand for stablecoins and thus commercial paper.
Huh! A correlation between stablecoin issuance and commercial-paper issuance does suggest that, you know, the stablecoins hold commercial paper. Kim also “conduct[ed] an event study that studies the impact of Tether’s shift in their reserve management strategy away from holding commercial paper to holding Treasuries,” finding that “stablecoin issuers’ impact on the commercial paper market was significantly subdued following this strategy shift,” suggesting that the strategy shift was real.
On the other hand a 15 basis point effect on US Treasury yields seems like it might prove too much? Treasuries trade more than half a trillion dollars a day, and I don’t really believe that the demand for Tether has a big effect on the demand for Treasuries. (There may be some correlation: A flight to safety in crypto markets might mean more demand for stablecoins, while a flight to safety in traditional markets might mean more demand for Treasuries.) I guess when demand for stablecoins drives demand for US Treasuries, that’s when you’ll know that crypto has really arrived.
Terra2
Hey Terra is doing stuff:
A proposal by the founder of the troubled Terra ecosystem to salvage the project was approved, averting a total collapse of one of the most-watched experiments in decentralized finance.
Under Do Kwon’s newly approved structure, the original blockchain will be known as Terra Classic, while its native token Luna, which plunged close to zero this month, will be renamed Luna Classic with the ticker LUNC. The new Terra blockchain will start running a coin under the existing Luna name and ticker, and won’t include the TerraUSD stablecoin
Terra’s unraveling, which started earlier this month with the implosion of the algorithmic stablecoin Kwon had touted relentlessly, marked one of the biggest busts in the crypto industry’s history. While the outcome of Wednesday’s vote represents a victory of sorts for Kwon and his supporters, doubts persist about whether Terra can ultimately be revived.
The process means Terraform Labs is effectively abandoning the stablecoin TerraUSD, or UST, which from now on will only trade on the Terra Classic blockchain. Designed to maintain a 1-to-1 peg to the dollar, it traded at around 10 cents on Wednesday.