Dear friends
The past month has once again broken records in the wrong direction: The S&P 500 was off to its worst 100-day start in a long time, only 1932 (Great Depression), 1940 (World War II) and 1970 (Vietnam) were worse. Meanwhile the Nasdaq hit its longest weekly losing streak since the dot-com crash. Due to the tech sector’s lower market cap and higher oil prices, Saudi Aramco has now replaced Apple as the world’s highest valued company.
Factors such as business and consumer confidence, market volatility, rising costs of goods and commodities, and uncertainty factors such as the war in Ukraine and U.S.-China relations have all negatively affected investor sentiment.
On top of that, the Federal Reserve raised interest rates by 50 basis points, the largest single rate hike in 20 years. Its chairman, Jerome Powell, reiterated that he would not hesitate to raise rates further until inflation declines, even though “restoring price stability may involve some pain.” With a balance sheet several times larger than before 2008 and still record-low interest rates, there may still be a long way to go to balance the macro economy.
All of this contributed to another bearish month with almost everything in the red: The Nasdaq closed -2.1%, the S&P 500 0.0%, 20-year bonds -2.4%, gold -3.3% and bitcoin -15.7%.
Our strategies unfortunately also suffered further declines with Universal -2.4%, Progressive ‑6.5%, and CryptoMax -1.8%.
But last month will be remembered for a “black swan” event that shook the crypto world like an earthquake: on the second weekend of May the UST stablecoin on the Terra blockchain imploded virtually overnight, wiping out over $30 billion in wealth.
But what is a stablecoin and why did it become so unstable? While regular cryptocurrencies are notoriously volatile, sometimes rising 1,000% and then again losing 80%, most stablecoins are designed to maintain a constant value of $1. This allows investors to keep “cash” in a crypto portfolio without the need to convert into actual dollars or to quickly send exact amounts to a recipient anywhere in the world.
The first stablecoins, such as USDT or USDC, were issued by centralized companies and (at least in theory) are holding $1 in reserve for each coin issued. They basically provide a digital wrapper for a dollar-denominated liability. Later, USDT diversified by holding other tangible assets, primarily U.S. bonds, to improve its bottom line without too much additional risk. To avoid centralized control, other stablecoins such as DAI have emerged that attempt to hedge sharp price fluctuations by 150% collateralization with Ethereum-based assets.
Much like the dollar went off the gold standard in the 1970s, Terra’s (un)stablecoin UST adopted a purely algorithmic approach by automatically reducing the supply of its own sister coin, LUNA, when demand for UST increased so that 1 UST would always stay at $1. In other words, LUNA was supposed to absorb all the volatility to keep UST stable. To “play it safe,” Terra recently also built up a Bitcoin reserve worth $2.3 billion, on the assumption that if UST suddenly dipped below $1, this reserve could be sold to stabilize the system.
But then someone with deep pockets carried out a deliberate and coordinated attack, similar to the infamous “Black Wednesday” in 1992, when legendary hedge fund manager George Soros bet against the Bank of England and made $1 billion.
In Terra’s case, the attacker gradually accumulated about $1 billion in UST and went on to borrow over $4 billion worth of Bitcoins. Then, over the weekend of May 8, he started by selling $350 million worth of UST in one go into a low liquidity market. This caused serious turmoil and pushed the value of UST down to about $0.97. In parallel, he began sending hundreds of disturbing alerts via “fake” Twitter accounts to create further panic and provoke a sell rush on UST.
Terra responded quickly and began selling its $2.3 billion in Bitcoin reserves as planned, hoping to re-stabilize UST. Clearly, such a move on a weekend would also drive down the value of Bitcoin itself. This undermined overall confidence and created selling pressure on all other cryptocurrencies including LUNA, further weakening the value of UST reserves.
The attacker then waited a moment for UST to show signs of recovery, and then sold its remaining $650 million in UST to deal the death blow. With Bitcoin now down over 25%, he was able to comfortably cover his short position and make about $800 million on this trade, net of the calculated UST losses. If he also sold LUNA short, he may have made even much more.
But who was the attacker and what were his motives? Conspiracy theories quickly emerged on social media: Perhaps a government that wanted to publicly make a stand against stablecoins and in favor of central bank digital currencies? Maybe a Terra insider who intentionally pulled the rug and cashed in because he thought further growth was unsustainable? Or simply an unscrupulous hedge fund that found a way to make $800 million over the weekend?
So far, no one knows for sure, but it has certainly sent the crypto, stock, and bond markets into turmoil. As the Tether USDT stablecoin indirectly came under pressure as well, losing over $10 billion in market cap, large-scale liquidations of Tether’s bond reserves occurred to bring USDT back to exactly $1. This in turn impacted bond markets and highlighted how important and intertwined cryptocurrencies have become with other asset classes.
Interestingly, JPMorgan reported that it currently believes Bitcoin to be nearly 30% undervalued and that the bank plans to use the digital currency to replace real estate as the preferred alternative asset class going forward. So for adventurous investors, this could be an interesting buying opportunity….
The year 2022 has definitely been tough on investors so far, but as always, there is a glimmer of hope: after similarly poor 100-day starts, the rest of the year stocks have gone significantly up in each case, by an average of 19.1%. So let’s hold steady and keep our fingers crossed…
Stay happy, healthy and wealthy!
Omar