LP Letter Excerpt — July 20th, 2022

Jul 29, 2022 | Matt Huang

As long-term investors in crypto, we wanted to provide some additional context on recent market events. Here is an excerpt of what we recently shared with our investors:

2022 has been marked by macroeconomic uncertainty and a global selloff, which has impacted tech, crypto and other markets. Bitcoin and Ethereum have drawn down 49% and 58% YTD, respectively, with other crypto assets impacted more severely such as COIN (down 71% YTD). The selloff has exposed unhealthy leverage throughout the crypto ecosystem, triggering a daisy-chain of distress and bankruptcy. Crypto headlines and sentiment have turned decidedly negative, and although reminiscent of prior so-called bear markets in 2018 and 2015, these events are now playing out with crypto on a much larger stage.

Despite the market thrash, our long-term conviction in crypto as a technology and asset class remains strong. The quality of talent coming into crypto has never been stronger. Meanwhile, the tourist investor class has thankfully decamped. We believe the next 12–24 months will be an exceptionally fruitful time for building and investing in crypto.

What Happened?

A complete account of the ongoing crypto deleveraging will require the benefit of hindsight. For now, based on what we know at this point, it is clear that certain crypto entities grew into unsustainable positions on the implicit assumption that asset prices can only increase. As enthusiasm reigned in 2020–2021, companies and funds felt emboldened, risk limits became a moving target in the chase for scale and yield, and leverage both explicit and implicit was able to accumulate. The exogenous shock of a global selloff was a reality check. While the events are decidedly negative, we are optimistic that lessons learned will translate to a healthier crypto ecosystem long term.

Terra, LUNA, UST

The first domino to fall was the Terra blockchain. In short, Terra was best known for LUNA, its native blockchain asset (akin to ETH on Ethereum), and UST, a USD-pegged stablecoin built on top. The UST peg was maintained via a bidirectional redemption process against LUNA: when UST dropped below $1, you could “burn” $1 of UST to “mint” $1 worth of LUNA, and vice versa when UST grew above $1, you could “burn” $1 worth of LUNA to “mint” $1 of UST. This process would, in theory, keep UST near the $1 peg... so long as confidence in the system remained strong.

Like many prior “algorithmic stablecoins,” the design of UST was subject to a potential negative spiral if faith in the value of UST and LUNA was lost, which would lead to everyone running for the exits. In fact, the issues with algorithmic stablecoin designs are so well-trodden that perhaps the most interesting question is not “why did UST break?” but instead “how did UST get so big before it broke?” This is a question that we had been asking ourselves from the sidelines throughout LUNA/UST’s meteoric rise.

While a root cause is hard to pinpoint precisely, the combination of a charismatic founder (in Do Kwon), many vocal investor proponents (including the now insolvent 3AC), a too-good-to-be-true Anchor protocol offering 20% yield on UST, a flashy attempt to acquire large amounts of BTC as collateral, and many other factors fueled a frenzy of retail and institutional speculation in the underlying LUNA asset and the seemingly low-risk 20% UST yield. Rising LUNA value led to greater confidence in UST’s stability, and more UST deposits led to greater confidence in LUNA.

The positive feedback loop was incredibly strong on the way up, but the negative feedback loop was even stronger on the way down. LUNA has now declined from over $100 per LUNA in April to less than $0.01 today. The UST stablecoin broke its $1 peg and is now worth close to $0. More than $18B in UST deposits and $40B in LUNA market capitalization has vanished.

As the air escaped LUNA and UST, the selloff in crypto prices was likely accelerated and issues started to appear elsewhere in crypto.

3AC and the crypto lenders

Three Arrows Capital (3AC) began as a traditional FX arbitrage fund in 2012 before expanding into crypto via both arbitrage and directional strategies. With their own capital, 3AC’s founders (Su Zhu and Kyle Davies) grew <$1M in starting assets to several $B+ over the course of 10 years – by any measure, an incredible feat. Yet it was this same track record, achieved without much appreciation for risk, that arguably paved the way for 3AC’s demise.

Heading into 2022, 3AC’s swelling overconfidence combined dangerously with a crypto lending ecosystem that was all too willing to extend unhealthy amounts of leverage to grow loan books in search of higher yields. Incredibly, one crypto lender, Voyager Digital, seems to have loaned as much as $350M USDC and 15,250 BTC (collectively worth $1B+ as of March 30th) to 3AC completely uncollateralized. Such a large loan extended with zero collateral is plainly indicative of bad judgment, but also hints at the intense competition among lenders to grow assets and the relative comfort they felt in working with a large and reputable fund like 3AC.

Not all lenders were quite this cavalier. Celsius and Genesis loans seem to have been partially collateralized, while BlockFi loans seem to have been overcollateralized. Nevertheless, in aggregate, 3AC was able to accumulate billions of debts on top of billions of assets, which were highly levered to the continued growth of crypto asset prices. Once the market selloff and subsequent LUNA/UST collapse came, what happened next was inevitable. 3AC swung from multiple billion in net assets to over $1B in net debt, collapsing into bankruptcy and blowing large holes in the balance sheets of crypto lenders.

While 3AC caused the most damage, crypto lenders also made various other mistakes. Some engaged in risky trading strategies with client assets (e.g. so-called “yield farming” across DeFi protocols). Others locked up capital in seemingly low-risk arbitrage trades (e.g. betting on the price convergence of GBTC and BTC) that implicitly assumed a long-term duration that was mismatched against the short-term nature of client deposits. For the crypto lenders that survive, it seems likely that risk management will gain new prominence internally.

Lessons Learned

The crypto ecosystem is reimagining money, the financial system, and internet applications based on new technical and economic primitives. A process this fundamental and ambitious is bound to be messy. Every failure is an opportunity for learning, and we are optimistic that the crypto ecosystem will emerge smarter and more resilient.

This is not crypto’s first crisis (nor will it be the last). In 2014, MtGox was the largest Bitcoin exchange processing 70+% of global trading volume, and a hack resulted in the loss of over 7% of all BTC in circulation. In 2016, a smart contract application called “The DAO” was holding almost 15% of all ETH supply in custody when it was hacked. At the time, both events seemed existential. Fear was widespread and asset prices followed. Yet, in our experience, such events ultimately do not halt the fundamental driver of progress in crypto: developers and entrepreneurs working on building the future.

These crises also catalyze positive change. The decline of MtGox gave way to more secure and well-run exchanges such as Coinbase and drove the development of fully non-custodial exchanges like Uniswap. The DAO hack gave way to more focus on smart contract security. Hopefully, the LUNA/UST collapse will give way to broader understanding of the risks around algorithmic stablecoins, and the blow-up of 3AC and crypto lenders will give way to better risk management.

One underreported fact has been the relative strength of performance in decentralized finance (DeFi) protocols in contrast to centralized finance (CeFi) lenders and funds. DeFi lenders such as MakerDAO, Compound, and Aave were all able to remain solvent through pre-programmed mechanisms to liquidate collateral as margin limits were reached. These systems are on-chain, transparent, with code that anyone can inspect and little opportunity for unhealthy leverage to accumulate. There is a long way to go for DeFi to match the existing financial system, but some of its fundamental advantages are starting to show.

Beneath the headlines, in our day-to-day work, our optimism remains unchanged by recent events. Not a day passes where we don’t encounter a talented college student or a seasoned tech executive thinking about spending the next 5–10 years of their career building in crypto. Crypto infrastructure and developer tooling are maturing. The opportunity for new DeFi protocols, especially in the aftermath of this CeFi unwind, is immense. And we see many emerging green shoots across consumer areas such as gaming, digital art, and social networking. Progress and opportunity abound, largely unaffected by public asset prices and the ongoing deleveraging.

Looking ahead, we continue to focus on the multi-decade opportunity for crypto. Our team and the entrepreneurs we support are finding it easier to focus amid a quieter environment that is long on substance and short on distraction. The tourists are gone, and valuations are starting to rationalize. Strong companies are finding it easier to hire great talent. Overall, we are optimistic that the next 12-24 months will be an exceptionally fruitful time for building and investing in crypto.

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Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors and is not made on behalf of Paradigm or its affiliates and does not necessarily reflect the opinions of Paradigm, its affiliates or individuals associated with Paradigm. The opinions reflected herein are subject to change without being updated.

Unless otherwise indicated, the information is current as of July 20, 2022. Such information is believed to be reliable and has been obtained from sources believed to be reliable, but no representation or warranty is made, expressed or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of the information and opinions contained in this letter.

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