It had to happen. The cryptocurrency industry, plagued by a similar level of opacity and complexity as the subprime mortgage market of yore, finally had its Lehman moment.
On May 9th, Terra, a network of interlocking digital tokens, collapsed. Terra had appeared out of nowhere in 2021, but quickly reached a combined market value of over $60 billion. It became the standard bearer for decentralized finance, the sub-sector built around Ethereum rather than Bitcoin. Even as the rest of cryptocurrencies headed for a bear market this year, Terra’s Luna token had defied the malaise and become a magnet for alpha-seeking investors.
Then it crashed to practically zero in the blink of an eye. Terra’s blockchain went dark, exchanges delisted tokens, and Terra’s leaders scrambled to salvage what they could.
The consequences were significant: the entire crypto market lost a quarter of its value in the next three days. And Janet Yellen, the US Treasury Secretary, immediately called for legislation to regulate stablecoins after Terra’s UST offering, a token that tracks the US dollar, proved far from stable.
Perhaps worst of all, Terra’s atrocious demise dealt a blow to the credibility of decentralized finance, or DeFi, as a sober and useful proposition amid rampant cryptocurrency speculation. DeFi should be a faster, fairer and more transparent alternative to traditional finance. Thanks to Terra, the sector seems just as unhinged and unreliable as the rest of crypto.
When the dust clears, here comes the reckoning — and a few basic questions: Is DeFi dead? Or is this just a cycle like any other market? And if so, what needs to change?
It helps to remember that in all the madness of crypto – Dogecoin’s machinations, purchase of “land” in the Metaverse, NFT sold for $69 million – it’s just a software game. For real. Blockchain is a new type of database. And as with any software game, crypto’s endurance and value will ultimately be determined by its adoption. In the case of Bitcoin, this means the mass market embrace of digital money that can change hands electronically without the need for intermediaries such as central or commercial banks. In the case of Ethereum, this means using smart contracts, an innovation in computer science that allows users to encode entire financial agreements into neat digital packages that work on autopilot.
The problem – and it’s a sucker – is that the entrepreneurs building decentralized finance projects have failed to make their offerings simple and user-friendly. On the contrary, they tend to create island systems with little connection to the real world. There are exceptions: a company called MakerDAO recently partnered with logistics companies and used its stablecoins to fund shipments of beef from Australia to Hong Kong. It may not be sexy, but it works. There are others – NFTs, for all their oddities, are actually proving to be useful applications for managing arts and offering new marketing channels in the entertainment and sports industries.
By and large, however, DeFi projects feel like games, not corporations. Your players indulge in the esoteric language of these projects like members of secret societies. Crypto liquidity pools, parachains, zero-knowledge proofs, layer 2 blockchains. . . The list of mysteries seems endless, reminiscent of the same baroque nomenclature that characterized the subprime mortgage boom. Do you remember CDO-Squared?
Unsurprisingly, civilians have no idea what DeFi designers are talking about, let alone how to use their products. So far, the whole proposal remains largely a subject of speculation, not assumption.
Terra embodied this problem. Founded in Singapore in 2018, Terraform Labs was designed to create the “reserve currency” for DeFi. To that end, co-founder Do Kwon, a computer scientist educated at Stanford University, built a system centered around the US dollar. He established a stablecoin called UST, which was marketed as being pegged to the greenback. It was kind of, kind of – well, not really – pegged to the greenback. Instead of backing the token with reserves, UST was linked to another token, Luna, Terra’s flagship. The idea was that holders could redeem 1 UST for $1 worth of Luna. But the design left UST unsecured. This so-called algorithmic stablecoin was a tied asset with no real bond.
Investors overlooked this design flaw in 2021, when the crypto bull market gave way and Luna’s price multiplied roughly 20x between May 2021 and April 5, 2022, when it hit its all-time high. Meanwhile, Terra launched a savings account called Anchor Protocol that virtually guaranteed UST holders a 20 percent annual return on their capital.
Of course, providing such guarantees is forbidden in traditional finance and is a classic red flag for fraud. Skeptical investors complained that Terra’s structure looked like a pyramid scheme because investors were ramming UST to pocket the 20 percent, and that was by no means sustainable. An influential DeFi investor who goes by the Twitter handle Sensei Algod publicly called UST and Luna a “Ponzi,” and in March he offered to wager Do Kwon $1 million that Luna would be less than 88 in 12 months dollars per token would be worth.
Easy bet, in hindsight. As inflation prompted the Federal Reserve to raise interest rates, crypto dived alongside stocks, particularly tech stocks. Sure enough, crypto behaved like all markets in such fevered times – and savvy traders targeted and pounced on the weak. While it’s hard to know exactly what happened to Poleax UST, suffice it to say that there has been a run on the token, as well as its sister assets Luna and Anchor. The stablecoin lost its peg, falling to 60 cents to the dollar and eventually to less than 1 cent.
There have been many postmortems, but the key takeaway is actually the most obvious: DeFi will never scale unless regulated. Unlike Bitcoin, which is content to float through the markets like a bizarre version of gold, Ethereum and DeFi have one purpose: to reinvent finance. How can anyone expect institutional investors or ordinary people to take these platforms seriously if they don’t protect their clients from shoddy business models? How can these platforms ever expect to be adopted and fulfill DeFi’s purported goal of improving finances? Hedge fund veteran Bill Ackman captures the moment well by praising blockchain’s “brilliant technology” and lamenting the corrosive effect of schemes like Luna.
“Hyping tokens not backed by value-added companies will destroy the entire crypto industry,” Ackman tweeted on May 16, adding that the industry should embrace self-regulation.
That’s not good enough. There are many crypto players who understand that space’s safety and reliability is key to its long-term success. Accepting regulations to increase confidence in the whole venture may be the only way to overcome the damage Terra has done and, let’s face it, the other potential disasters that are still out there.
But the regulation goes against everything that so many crypto entrepreneurs believe. The whole point of DeFi is not needing regulation. There’s the catch. But as crypto followers reckon with the wreckage of their Lehman episode, do they have any other choice?
The masses won’t use DeFi if they don’t trust it.
Read more crypto columns:
Bitcoin’s lockstep march with stocks raises thorny questions about its usefulness
Is Bitcoin Too Big To Fail?
Does crypto have value? A bitcoin pioneer put it years ago.
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