This Time isn't Different: Part II
Meet the new finance (defi); same as the old finance (tradfi)!
Previously, we heard the story of the Global Financial Crisis.
In Part II, I’m going to tell a different story. At least, it starts as a different story. Whether or not it ends that way? We’ll see…
Fiscal theory of the price level
We begin with Terra, which was a cryptocurrency ecosystem with two key securities: Luna and TerraUSD (UST). Luna was the cryptocurrency for transactions made on the Terra protocol. You can think of it as equity with no fixed value: its price reflected the extent to which people were building useful things on Terra’s blockchain.
Meanwhile, UST was a stablecoin, designed to trade at par with the US dollar. You can think of it as debt: a fixed income asset where you expect to be able to sell it for the amount you paid plus interest on top. Unlike many other stablecoins which had fiat assets backing its value, UST was an algorithmic stablecoin. That meant its peg to the US dollar was defended by an algorithm, which would ensure 1 UST could always be traded for $1 worth of Luna. If UST was worth too much, the Terra protocol would induce inflation selling UST to the market, and induce deflation by selling Luna if it was worth too little.
Algorithmic stablecoins can seem weird, so let’s map it to a more obvious concept from traditional finance.
Consider the US dollar.
One way of thinking about the US dollar is to conceive of it as an algorithmic stablecoin of sorts. Much like UST, it is an asset where you expect to be able to redeem it for the value you paid plus interest, though here the interest rate is negative thanks to inflation. Much like UST, its purchasing power is meant to follow a stable path, though here it is meant to fall by 2% a year. Much like UST, inflationary policy involves issuing more of the stablecoin via monetary expansion. Much like UST, deflationary policy involves swapping the market’s stablecoins for an asset which represents a share of the economic output of the system i.e. government surpluses or deficits. The only difference is that with the US dollar, this can be achieved forcibly, by raising taxes to soak up US dollars, rather than relying on consensual market transactions.
This should make you wonder: if the Terra protocol can’t demand taxes, what defends the value of Luna?
The next tradfi analogy is how countries establish and defend currency pegs.
The Mundell-Fleming trilemma tells us that a country can only pick two out of the following three: free capital mobility, fixed exchange rates and central bank independence. When places like Hong Kong decide to peg their currency to the US dollar, they do two things. Firstly, they ensure they have a large foreign exchange reserve which they can use to defend the peg. Secondly, they accept that if they want free capital mobility, they’ve outsourced monetary policy to the central bank of whatever currency they’re pegged to e.g. the Federal Reserve.
Terra did things a bit differently. They did have a version of forex reserves, the Luna Foundation Guard, which held billions worth of other cryptocurrencies. However, they tried to have their cake and eat it too, refusing to accept the trilemma. In order to lure people into holding UST, they set up the Anchor protocol, which paid sky high yields if people bought UST and lent it to Anchor. In other words, they wanted UST to have a fixed exchange rate with the US dollar, refused to accept any barriers to capital flow and wanted to set their own interest rates.
What happened when they started to lower the unsustainably high interest rate paid on Anchor? Almost immediately, there was a huge exodus of UST deposits. There are two ways to sell UST. The first is to rely on the stablecoin’s protocol of giving you Luna in return for UST. The second is to sell it for other stablecoins on a decentralised exchange (DEX) known as Curve, which offers pools of liquidity between various pairs of cryptocurrencies.
So when people started heading for the doors, the first mechanism meant that the supply of Luna massively increased. This meant Luna’s price fell, incentivising people to sell Luna for something else. In turn, even more people tried to get out of UST and Luna, causing a death spiral. After all, there was nothing keeping up the value of Luna.
As for the second mechanism, the flood of sales meant that there was more UST than other stablecoins on the exchange. To rebalance this, the exchange began to offer UST at a discount, but no one was biting. With the imbalance growing, Curve had to keep on offering steeper and steeper discounts. Thus both of these mechanisms destabilised the peg.
It is at this point that LFG deployed its billions worth of cryptocurrency reserves. It is possible to defend pegs this way. During the 1997 Asian Financial Crisis, the Hong Kong Monetary Authority bought up HK dollars by selling foreign currencies, fending off pressure from George Soros and other speculators who were trying to push down the price of the HK dollar. Rather than mirroring the HKMA however, the LFG turned out to be closer to the Bank of Thailand, which had to accept the depegging of the Thai baht from the US dollar in 1997, after exhausting all of its forex.
It’s yield farming all the way down
While LFG’s defense wasn’t able to stop the UST from collapsing to nothing, what it was able to do was push down the prices of the many cryptocurrencies it was selling. Of course, it wasn’t just them either: everyone else who was overexposed to the collapse of UST and Luna had started to sell their other cryptocurrencies.
In particular, there was another asset which got pushed off its “peg”. This is staked ether (stETH). Ethereum is currently preparing for an upgrade to Ethereum 2.0, and as part of that, people can stake its token, ether (ETH). This means locking up the token on the yet-to-be-unveiled Ethereum 2.0 network, such that it cannot be spent or sold until the new network comes online at which point each ETH staked can be redeemed 1:1 for ETH. Of course, they get cryptocurrency rewards in return.
For those who want to maintain liquidity, Lido Finance protocol offers a token known as staked ether. In return for giving Lido one ETH, you get back one stETH. This is a token, so it can be used like any other cryptocurrency. One popular trade has been to deposit ETH with Lido, get stETH, use it as collateral to borrow ETH on a lending protocol like Aave, and then rinse and repeat.
This recursive yield farming can seem pretty safe. Most of the time, stETH trades 1:1 for ETH. However, this isn’t an actual peg, and until Ethereum 2.0 arrives, there’s no reason why it should be exactly 1:1. In particular, once you hand over your ETH, Lido will have staked it for you, so there are no takebacks. The only way to unwind the trade is by selling stETH on secondary markets, and if there is more demand for liquidity in the market or if people believe that the new network is being delayed, it is quite likely to trade below parity.
The UST depeg led to stETH dropping below parity for two reasons. Firstly, the broad crypto downturn and asset firesales meant liquidity in the market was drying up in general. Secondly, many people had been engaging in another yield farming trade. This involved an asset called bonded ETH (bETH), which was just a representation of stETH on the Terra blockchain. By exchanging ETH for stETH with Lido and then converting that into bETH, they could lend it and earn yield on the Anchor protocol. This had led to a significant demand for stETH. When UST collapsed, people pulled out their money, converting it back and raising the supply of stETH.
This seems very bad, but how do these tiny fractions of the crypto market bring the entire house of cards down? That’s what we’re going to figure out in Part III!