Crypto and UST: What Happened?

Headshot of Paul Foley, CTEX Markets CEO

Cryptocurrency. That’s the topic today with a repeat guest, Paul Foley. This is Stewart Foley, no relation, your host at the podcast. Paul, welcome.

Paul: Thanks, Stewart. Great to be back.

Stewart: It is great to have you. You did such a great job on our last podcast. And so we’ve changed our format just a little bit with a different question. And so I’m going to throw this one; we’ve got a three-part question for all of our guests, hometown, first job of any kind, fun fact. Hometown.

Paul: Now, or originally?

Stewart: Originally.

Paul: Originally it’s Derby in England.

Stewart: Nice. First job ever.

Paul: Working for IBM as a field service engineer in the ministry of defense computer center.

Stewart: Wow. That’s a lot better than mine. I worked at McDonald’s. Number three, fun fact.

Paul: I enjoy beekeeping.

Stewart: Really? Oh, that is a fun fact. All right, we’ll talk about that offline. Here’s what I want to talk about. Man, there’s a lot going on, a lot of talk in crypto land, and the first question is, I think the hardest, which is UST, this is how much I know. This was a crypto coin that was supposed to be pegged to $1. It’s supposed to have a stable valuation. And they achieved this through an algorithm, and something went wrong. That’s where my knowledge ends, Paul. I need to turn it over to you from there. What happened with UST? First of all, what is it? And then what happened?

Paul: Okay. Well, as you mentioned, USD Terra is, or was, a stablecoin and it was algorithmically backed. Now typically a stablecoin as the name suggests is a coin of cryptocurrency that tries to isolate its holder from volatility in the market and is typically backed by something which effectively guarantees its value. In old-fashioned terms, if you imagine the US dollar, when they were still using the gold standard, you could argue that the US dollar was actually a stablecoin, but clearly isn’t anymore. But so, typically when we think of the stablecoin, we think of three different ways that it can be backed. It can be backed by a fiat currency. It can be backed by another crypto or several, or it can be backed by an algo.

So, a good example of a fiat-backed cryptocurrency is USDC. And the idea of USDC is that $1 equals one USDC. When you come to buy and sell it, you might end up buying it for $1.0001 and selling it for $0.999998 or something like that. But you are typically within that $0.002 margin. And the thing that makes it work is in order for you as an organization to create USDC, you have to be holding one USD in your hand. So the only people that can typically mint USDC are people that’ve got a license to hold USDC to custody for client. And likewise, if one USD walks out of your establishment, you are then supposed to burn one USDC. So that means that realistically speaking, the amount of USDC that is ever in circulation cannot surpass the amount of USD which is in circulation. In real terms it means the market cap of one should not exceed the market cap of the other, it can’t. And that’s how they maintain their peg.

With a crypto-backed stablecoin, it’s like portfolio management. You’ll have a selection of coins which are supposed to even themselves out. And you use that as your peg mechanism. It might be, for instance, in old-fashioned terms, if you are holding a portfolio of NASDAQ, then you would isolate yourself from market volatility by holding a reasonable spread of different assets, and it’s a reasonable way to do it. And the only way it can go wrong is if you have a complete market crash when everything goes down or, God forbid, everything goes up.

Now, so it’s more risky than a fiat-backed stablecoin, but it’s less risky than an algo-backed crypto. So with an algorithmic-backed stablecoin, you typically have a completely automated system. So it automatically mints, automatically burns, potentially will automatically buy and sell so as to maintain supply and demand in an attempt to try and maintain the value of the stablecoin itself. So for instance, if the market suddenly flooded with a stablecoin, which reduced its value, you’d expect the system behind it to start burning coins, to reduce for supply and forcing the value of the available liquidity higher. And likewise, if the value started getting too high, you’d expect it to mint more so as to force the value down by increasing liquidity.

So there are three different types of stablecoins. Now, unfortunately, UST was an algorithmic-backed coin. And it, unlike a lot of other things with it just, or a lot of other stablecoins, with them being backed or pegged to two different sources, it makes the maths a little bit more interesting to start with, because in theory, it was backed not only to the US dollar, but also to another coin called Luna. Now, I don’t know if you are familiar with Luna.

Stewart: I’m not, and I’m assuming that some of our audience isn’t either.

Paul: Okay. So, Luna was a coin whose value was in its utility. So, if you imagine an ecosystem around UST and Luna, where there’s lots of little services or distributed applications where you have to pay your fees to use those services or byproducts in Luna. So the value wasn’t necessarily holding Luna itself, the value was that you could use it in terms of utility elsewhere to buy an exchange for goods and services. And obviously by maintaining the supply and demand of Luna as the ecosystem gets bigger, and there’s more people trying to consume the available liquidity, that pushes the price of Luna up. So, that’s very simply what it was.

So, that comes to the question, what went wrong? Now, at some point, UST lost its peg to the US dollar. It started by only going down a few cents then down to about $0.80 then $0.70, then $0.60. And it’s just a, on-the-price job, looked like a stairway down. And so this resulted in them losing, I think it was somewhere around 60 billion. And to give you an idea of what a profound effect this had, before this event started Luna was trading at about $83 a coin. At the moment it’s trading at $0.000056 a coin. And UST was trading at between $0.99 and $0.999. And is currently trading at $0.0008. But, it’s all well and good understanding that there was a crash and that the Luna organization tried valiantly to try and maintain the peg by putting all of its Bitcoin onto the market to raise dollars, to prop it up and it failed. But I guess the more interesting question is why did it happen? And, the reason that this is interesting is because this really illustrates the risk associated with algorithmically-backed stablecoins. So by the way, stop me if this is getting too-.

Stewart: I love it. It’s great. I’m learning like crazy here. And I suspect that our audience is as well. So why did it happen? This is my view, it’s like somebody decided, well, let’s see if we can break this thing. And is that the start of something like this, or is it not as nefarious?

Paul: There is a smoking gun at the start of this story. The interesting thing is, there’s been mention of a couple of the equity, private equity funds and things like that, the different hedge funds, but unfortunately at the moment, no one’s able to put the actual finger on them and say, you did this. So it’s the kind of BlackRock-type people.

Stewart: We got to edit that part out. Somebody’s going to get sued on that one.

Paul: Yeah.

Stewart: Yeah, go ahead. Sorry.

Paul: So I guess the important place to start is to understand that there are two different ways of swapping your UST for Luna and also to trade it for dollars. You can either buy and sell on an exchange, or you can mint and burn via their protocol. Now, obviously, if you go the mint and burn route, you get exactly a one-to-one ratio. So, $1’s worth of Luna, $1’s worth of Terra. And that’s how it’s supposed to work. But obviously, when you go and buy and sell on the exchanges, that’s when you get the arbitrage market. So you get the deviation away from the dollar, positive or negative. So obviously if you’re selling it’s great if the price goes above a dollar, and if you’re buying it’s great if the price is below a dollar, because that way you’re getting it for less, then you can get it on the platform and potentially you can go and swap it for Luna and you end up making a profit.

So, the mechanism that the algorithmic coin used was effectively this arbitrage and liquidity. So, as I mentioned, if UST becomes overvalued, they’ll mint more, which increases liquidity and reduces the associated value. And obviously, if UST loses value, then they start burning tokens. And that reduces liquidity, which should increase the value. So they’re effectively juggling supply and demand. And people outside of that ecosystem are effectively using the exchanges to take advantage of any slight arm equation. So this actually, I guess the problem really started when somebody took something like 500 million of Luna and dumped it on the market. And so obviously this increased the supply massively, which forced the value down. Now this obviously then creates a situation where people panic and they start trying to ditch whatever assets they’ve got so they can get out of Luna.

So, they were burning their Luna. There’s also people trying to desperately sell their UST. They effectively created a bit of a run on the bank in traditional terms. So, as more and more people are trying to sell their Luna, liquidity increases massively, and the price goes down, which makes it hard, if not impossible, for the UST guys to maintain that peg. This makes things worse. It’s literally a spiral and the price continues to drop because people think something’s going wrong. So, then we go back to the start where people are more and more inclined to sell their Luna, which forces the price even further down. So it’s that spiral-.

Stewart: Yeah. It’s the death spiral. Yeah.

Paul: Yeah. So, that whole run on the bank.

Stewart: And so that can happen to an algorithmically-based coin, but that is not something that can happen to Bitcoin, for example, completely different things. From my perspective, how do I look at a coin and go, oh, that’s an algorithmically-based coin, or how do I find that out? How do I determine that?

Paul: Actually, this scenario could happen with any asset. So this is the typical panic sell of an asset. So for example, when Swiss airlines was going out of business years ago, there was this death spiral of selling, which took their value down to something like $0.001 per share, where it had previously been over $100 a share. So it could happen to any asset.

Stewart: Well, like the Icelandic banks. It was a similar deal where people, somebody said, uh-oh, there’s a problem. I need my money out. And it’s exactly that, it’s a run on the bank.

Paul: The problem comes in the fact that something else is pegged to it. So, it artificially drags that down with it. So, you basically get to the point where the guys at UST, the UST Guard Foundation, the people responsible for maintaining that peg were trying to do whatever they could then to try and bring up the value of UST, to try and prop up Luna, but it just wasn’t working. And what you actually end up doing is go into an incrementally, or iteratively, inflationary situation where one death spiral is actually forcing the inflationary spiral at the other. So, that’s basically what happened. Now in terms of ‘how do you identify a stablecoin’, this is where Google comes in. You’ve got to just go and have a look because there’s no way of you knowing it’s not what it’s-.

Stewart: But it’s like, as you said, every other asset that you would buy, know what you’re buying, know what it is that you own. And so your day job aside from being a two-time crypto podcast superstar is that you are the CEO of CTX, which is a crypto exchange. What impact of the unraveling of UST and Luna had on the wider crypto market?

Paul: On the wider crypto market, I think the secondary effect has been the most important. So, the primary effect was a lot of people losing money, but the secondary effect was causing people to question crypto in the first place. And also to question the need for additional regulation. So, if you like, it throws the cat in amongst the pigeons. So it’s that old analogy, one bad apple in a barrel of apples destroys the entire barrel. So we notice that there’s more of an inclination for people to sell than hold. And we can see that in terms of the large investors, the banks, it’s nudged them back towards a wait-and-see attitude. They were previously a little bit bullish. I think the Swiss Stock Exchange has published something over the last few days where they said due to current market conditions, they’re going to wait and see before they really jump into the market with both feet. So it really, it illustrates that there is that underlying uncertainty or fear in the market, which ironically enough makes it a great time to buy.

Stewart: Yeah. As a recovering bond, fixed income guy, that’s when fixed income guys love, value guys love stuff like this. And it’s just interesting, I think that your point’s well taken, which is ‘know what you own’. And I think people are, correctly, taking another look, but that tends to be when there’s an opportunity. The question, I guess, and the questions for you are interesting because your knowledge is so thorough, it’s thorough and complete. And the details that you’re talking about interests me. I’m sure there’s people who have clicked off this thing by now going “Boy,” but so global headlines inflation, inflation. You’re based in Zurich. Is that right?

Paul: Yeah. I’m in Switzerland floating between Zurich and Geneva.

Stewart: So you’re in Europe, I’m in Chicago. Inflation, big story here, inflation, big story there. That erodes the purchasing power of fiat currencies. What does it do, or is there enough data to know how inflation impacts crypto given that crypto is not tied to a particular economy? Is that a dumb question or a really good one?

Paul: Let’s say it’s a fantastic question.

Stewart: Okay. I’ll just go with that. My audience is like, oh yeah, whatever.

Paul: So I guess the effective inflation on the crypto market is really that you are, typically you’re buying with fiat. So as inflation increases, you’ve got less purchasing power, but given the fear that’s in the market at the moment to directly counter that, we’ve got the prices of a lot of crypto are a lot lower than you typically expect. So we are not really seeing the direct correlation between inflation and purchasing power, or cause and effect if you like. At the moment we’re seeing the direct correlation between fear and the crypto market. And at the moment it’s separate from the fiat concerns.

Stewart: That’s interesting. If I’m looking around and I say, just the contrarian in me looks at the run that crypto’s had and just goes, there’s no way, I’ve missed this thing. And then you get a correction and your thoughts are that there’s a buying opportunity maybe. And by the way, as we always, there’s no advice being offered here whatsoever. But if I’m a person who’s looking at the crypto market and I want to step my way in, if I wanted to become or start, buy some crypto, what do I do? Do I go open a Coinbase account? What’s step one for me, and two and three? How do I get it done?

Paul: Well, to be honest, if you’re completely new to this, your best bet is to go to a Coinbase or Binance and just open a regular account with them. You can buy via your credit card or your bank account. They’ve got a perfectly safe infrastructure. If you are an institutional client or a high net worth, then your best bet would be to go to somewhere like Cigna Private Bank, where you’ve effectively got a bank account, which is denominated in crypto. And you are subject to something like Swiss banking regulation, and also the safeguards that it offers.

Stewart: Interesting. And that’s how it’s done. I will confess, I have opened a Coinbase account. I don’t know, I feel like I’ve given a four-year-old a pocket knife. I just, I don’t know, I’m not sure it’s safe for me to have this account. So in general, when we talked to you last, you were talking about supply of crypto and we were talking about how coins are made and so forth. Has your outlook changed fundamentally at all on crypto generally after this UST/Luna event? Has anything changed in your mind from a, as the CEO of a crypto exchange? What would your message be to crypto investors?

Paul: I think the analogy for this is just because you see one airplane crash on the news, does it mean that all aircraft are faulty and you’re going to die if you walk near an airport? No. This is exactly the same. The guy behind TerraUSD, Do Kwon I think his name was, perhaps not the most reputable person. If you look at his background and the projects he’s previously tried to launch, in hindsight perhaps not a good sign for the future, but what people are trying to do with crypto, the freedom that it should still bring is still there. All the promise and alert that is the crypto ecosystem is still there. And this is just one unfortunate situation. I think in hindsight, algorithmic stablecoins are perhaps more vulnerable to hedge funds abuse, the non-stablecoin cryptocurrencies, but overall, it’s not a terrible place to be. And I think it’s still a positive market and a positive, if you like, a positive thing happening in our lifetime.

Stewart: It’s great to have you on. I always learned a lot, Paul. I really appreciate it. I called you up out of the blue and asked you to do a podcast, just given everything that’s going on and you were kind enough to agree to do it. And I just want to say thank you very much. Thanks for being on.

Paul: My pleasure.

Stewart: Thanks for listening. If you have ideas for podcast, please shoot me an email. You can send it to My name’s Stewart Foley, and this is the Insurance AUM Journal podcast.

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