Even if you are not one that closely follows the crypto space, you might have heard of at least something relating to the blow up of Luna/UST or of the insolvency crisis surrounding big CeFi lending companies like BlockFi and Celsius which take deposits from retail investors and use risky decentralized finance strategies to generate large yields. Maybe you’ve heard of the implosion of Three Arrows Capital as well. Given the severity of these events combined with the general bias of TradFi/mainstream media against crypto, lots of news quickly spread. My goal for this article is to cover the landscape of the so-called contagion including the players involved, the causes, and what might come of all this going forward.
Other than a worsening macro-economic outlook, the first piece to trigger the cascading contagion effect was the fall of stable coin TerraUSD and Luna. Let’s see how this happened. Firstly, it’s important to note that TerraUSD is a stablecoin meaning that it should always hold a peg to 1 US Dollar. TerraUSD is an algorithmic stablecoin meaning that it is not collateralized by anything, but rather relies on an arbitrage mechanism to keep its price stable. Luna is the native governance token, is used in staking on the Terra blockchain, and most relevant to the scenario here, is used in the arbitrage mechanism to keep the price of TerraUSD aka UST stable.
The mechanism is based on the principle that 1 UST can burned and $1 of Luna can be minted as well as the other way around. So it works as follows:
- If the price of UST is under $1, 1 UST can be exchanged for a $1 of Luna and the Luna can be sold for a profit on the difference
- If the price of UST is over a dollar, you can trade $1 of Luna for one UST and sell the UST
Much of the incentive to hold UST came from a protocol on Terra called Anchor. The savings protocol promised users yields of 20% which lead to it being one of the most popular decentralized finance protocols at the time. However, most of that yield was bootstrapped from the Luna Foundation leading it to be unsustainable as you might expect from a 20% yield.
On May 7th, the depegging of UST began and UST quickly began to trade for less than $1. The first event to trigger the depeg was withdrawal of $150M UST from a Curve token swapping pool called Wormhole to be put into another pool called the 4pool that was set to launch. Another sale of $350M UST followed soon after which lead to huge selling pressure. Those involved in the Anchor protocol began to withdraw their stake and dump their UST for Luna and sell the Luna. UST began to de-peg and the mechanism for swapping UST to Luna to defend the peg could not keep up. UST was redeemed for Luna and the Luna was sold which lead to a loop of hyper-inflation crashing the prices of both Luna and UST. As of today, Luna has lost virtually all of its value sending rippling effects through the crypto space.
The Effects of The Luna/UST Disaster
The most obvious effect that came from the Luna death spiral is that billions of dollars of value were wiped away from the crypto ecosystem, further increasing the bearish outlook that market particpants had. Many big funds and VCs had exposure to Luna and took great losses. Among them were Three Arrows Capital (3AC) and Celsius. It was reported that 3AC lost nearly $600M in the collapse of Luna. I’ll touch more on this a bit later in the article as its key in the mapping of the crypto contagion effect.
Algorithmic stablecoins as a whole have been put under great scrutiny with many convinced that they are not the route to take when looking at stablecoin solutions going forward. And it’s not only the crypto community that has been critical of algo stablecoins. The situation surround Luna has brought increased attention from regulators and stablecoins are among the most popular topics needing to be addressed in upcoming crypto regulation.
There was another trade that actually preceded the entire Luna situation. Those who took part in it were Bitcoin miners and most notably Three Arrows Capital and BlockFi.
The Grayscale Bitcoin Trust (GBTC) is a way for investors to gain exposure to Bitcoin without actually having to hold it in their custody. The reason one might want to hold GTBC instead of just Bitcoin is that it mitigates the risk that holding Bitcoin in a wallet brings as well as the fact that it has advantages in terms of taxes.
The way that 3AC and other accredited investors were making money arbitraging GBTC was by depositing Bitcoin for shares of GTBC. For example if you deposited 1% of the Bitcoin in the fund, you could wait out the 6 month lockup period and get back 1% of the shares of the fund. The reason that this was profitable was because the shares of GTBC traded at a premium relative to the Bitcoin in the fund. So 3AC deposited Bitcoin using leverage and was able to later sell the shares of the fund for a profit. 3AC actually held 6% of the trust. The problems arose when GBTC stopped trading at a premium. The trade was no longer profitable and $6B of Bitcoin was essentially trapped while the institutions hoped that they could break even eventually. This lack of liquidity would come to have serious implications as we’ve seen with the collapse of Luna.
There was one more event that added to the liquidations already happening and the crypto contagion as a whole. That was the depegging of Lido staked Ethereum aka stETH.
To understand what staked ETH does, you have to know that Ethereum, which is currently a proof of work blockchain, is going to be transitioning to proof of stake after the merge of the Beacon chain. It’s not entirely certain when the merge will happen, since it’s been pushed back a dozen times, but it is rumored to happen in September. Proof of stake requires validators to lock up Ethereum to ensure the security of the system. As a reward they are paid a yield. This stake will be released in an upgrade after the Ethereum merge. However, in order to stake you need certain hardware as well as minimum of 32 ETH which drives away the average investor.
Lido allows users to trade in their ETH and have it staked on their behalf. For this they receive stETH which is essentially a receipt that allows them to redeem the staked ETH when it is available after the lock up period. Users can still user their stETH while it is earning interest from staking. 1 stETH trades for just under 1 ETH and is essentially at parity with ETH.
Celsius and 3AC had significant positions in stETH, and when they had to sell their stETH they triggered another chain of liquidations which pushed the price down further and further as it depegged from ETH.
Three Arrows Capital was rumoured to have sold $33M of stETH. Celsius had an even bigger position in stETH of around $475M.
The collapse of Luna sent many CeFi lenders like Celsius as well as 3AC reeling. This came as a result of using too much leverage in positions as well as providing risky unsecured loans.
Three Arrows Capital
As mentioned before, the main catalyst for 3AC’s insolvency came from the collapse of UST as well as the depeg of stETH. Three Arrows Capital was operating on a lot of leverage through loans from many lenders including BlockFi, Celsius, Nexo, and Voyager. Three Arrows Capital began to default on many of the loans that it had taken. The sheer size of these loans had disastrous consequences for the lenders as they could simply not afford to tank these unsecured loans. Many paused withdrawals and some are currently battling bankruptcy. Since the assets of Three Arrows Capital have been ordered to be liquidated, the whereabouts of founders, Kyle Davies and Su Zhu are unclear.
Just like 3AC, Celsius had exposure to both Luna and stETH suffering greatly from both which lead to the rumors of the lender going insolvent. Celsius was a lender to 3AC which certainly did not help either. Around June 12, Celsius paused withdrawals from their platform.
Recently, Celsius has filed for bankruptcy after paying off all their DeFi loans to protocols like Aave and Compound from which they reclaimed around $1B in collateral. Even after reclaiming this money, the company still has a deficit of $1.2B on their balance sheet.
BlockFi was another one of the many CeFi lenders that was affected by the whole contagion effect, but it has come it has come out in a position not as bad as some of the others. The two main things that led BlockFi’s problems were being a major player in the GBTC trade and lending an unsecured loan to Three Arrows. BlockFi has since been bailed out by Sam Bankman-Fried and FTX, being offered a credit line of $400M with an option for FTX to buy the company.
Voyager was yet another company that was seriously hurt by Three Arrows Capital. Voyager had given 3AC a $660M loan, not expecting a firm like 3AC with a rumored $10B in assets under management to find themselves in such a terrible situation. Voyager froze customer withdrawals and his since filed for bankruptcy. Voyager has receive some help in the form from of a $500M uncollateralized loan from Sam Bankman-Fried’s company Alameda Research, though it is still unclear if Voyager will survive.
There are a handful of themes that have stood out throughout what has been discussed above:
- CeFi lenders ran an unsustainable business model with little to no transparency and risk management.
2. Over-leveraging seriously hurt Three Arrows Capital and caused huge cascading effects to both retail investors and institutional players.
3. Decentralized finance retained its integrity and operated as it should have, providing transparency and accountability through code.
4. SBF and FTX are in prime position for more acquisitions going forward and can take an even greater influence over the crypto space.