Real people suffered real hurt and are facing real consequences from the fallout of the TerraUSD failure . . . but no, this is not crypto’s Lehman moment, it is its Bernie Madoff one.
Although the jury is out on whether TerraUSD was ever intended as a Ponzi scheme from the start, or simply became one through sheer hubris, the parallels between Madoff’s US$65 billion fraud and TerraUSD are uncanny. Investors were lured to Anchor Protocol for its annual yields of close to 20% the same way they were drawn to Madoff’s promises of steady, outsized annual returns, averaging 8% to 12% in bull and bear markets alike.
Given years of loose monetary policy and faced with the specter of high inflation, investors starved of yield were hopeful that cryptocurrencies may have found a way to do the impossible — pay out well more than inflation on deposits. In Madoff’s case, he hinted at an investment technique known as a “split-strike conversion strategy” which employs trades in stock options, options on futures and stock purchases that was allegedly so effective, he never failed to pay out.
Most Ponzi schemes typically pay returns of 20% or higher and collapse quickly, whereas one Madoff fund which claimed to focus on the S&P 100, reported 10.5% annualized returns in the 17 years to 2008. Even at the end of November 2008, in the aftermath of the Lehman Brothers collapse, that same Madoff fund reported that it was up 5.6% in a year when the S&P 500 had fallen by 38%.
More importantly, whenever clients wanted their money, Madoff would pay out, with one investor not at the time that checks were received within “days.” Anchor Protocol also paid out on its annual yield of 19.75% but unlike Madoff’s funds, where that money was coming from was transparent — the Anchor Protocol Reserve, that by March was being depleted faster than it could be replenished.
To understand how we got here, it’s important to go back to the start. Until such time that there’s a widely available and accepted central bank digital currency that’s backed by a government, private enterprise was always going to fill that gap through its own innovations such as stablecoins.
In the early days of cryptocurrency, stablecoins that maintained a peg to something like the U.S. dollar, did so by placing deposits in a bank account and issuing their cryptocurrency equivalents for use on the blockchain. But the idea of having centralized entities issue stablecoins was anathema to blockchain purists who believed that stablecoins should be decentralized to ensure immutability, censor-resistance and trustless-ness.
Enter the algorithmic stablecoin.
Unlike stablecoins such as USDC and USDT, which are issued by companies and are backed by deposits in a bank or in the case of Tether, through a complex range of holdings, algorithmic stablecoins are backed only by the laws of supply and demand.
In the case of TerraUSD or UST, it would maintain its fixed peg with the dollar through its relationship with LUNA, with both tokens issued by Terraform Labs. The premise was that 1 UST would always be readily convertible to $1 worth of LUNA, so if 1 UST became worth more than $1, LUNA would be converted to UST, to increase the supply of UST and bring parity back to TerraUSD’s dollar peg.
In the event that 1 UST was worth less than $1, UST would be converted to LUNA, reducing the supply of UST and therefore pushing TerraUSD’s peg back up to the dollar. At its core, TerraUSD was about supply and demand and LUNA was its “cushion” to automatically adjust for fluctuations in TerraUSD’s peg with the dollar.
The idea was that if UST fell below its peg, arbitrageurs would hold on to UST knowing that the supply of UST would be decreased to regain the peg providing risk-free profits.
But why would anyone want TerraUSD anyway?
Enter the Anchor Protocol, also owned by Terraform Labs and which promised 19.75% annual yields if investors would deposit TerraUSD, just shy of the 20% that a regular Ponzi scheme would offer that would lead to its speedy demise.
In the same way few questioned how Madoff made consistent returns in good and bad times, never recording a loss, few wondered how Anchor Protocol was able to deliver 19.75% annual yields when the rest of the decentralized finance world only paid out single digits on stablecoins. Considering that the Anchor Protocol, a decentralized finance or DeFi lending protocol charged less on its UST loans than it paid out on deposits, it was remarkable that they were still able to keep going.
Investors who put in with Anchor forgot the cardinal rule of banking, the 3–6–3 rule, where bankers pay 3% on deposits, charge 6% on loans and are on the golfing green by 3 in the afternoon.
Although banking has grown far more complicated since the early days of the 3–6–3 rule, banks still don’t pay out more on deposits than they charge on loans, and while DeFi may have taken the bank out of banking, it hasn’t removed this cardinal rule.
Anchor’s high yields on stablecoins lured many, even the non-crypto natives into the DeFi space, who quickly became schooled in how to use Metamask wallets, but nobody was asking how Anchor sustained these yields as long as they were there. As more investors were lured to Anchor, the amount available in the Anchor Protocol Reserve to pay out those yields started to rapidly run down which became noticeable in mid-March this year.
But so long as the price of LUNA kept on rising, the show could go on — because $1 worth of LUNA was always convertible to 1 UST, which is supposed to be as good as the dollar. As long as the price of LUNA kept rising, there would always be enough to pay out on Anchor Protocol.
In fact, when the Anchor Protocol Reserve started to run down, US$450 million worth of UST showed up to shore up the reserve, and where did that come from?
By converting more LUNA of course.
Terraform Labs founder Do Kwon himself revealed in an interview with Bloomberg that for UST to keep growing, the price of LUNA had to keep going up indefinitely (something which should have immediately raised red flags),
“If UST were to keep growing, LUNA price has to (sic) higher than now.”
But how would LUNA keep its price riding high?
Through relentless marketing of course, by some of the biggest names in the cryptocurrency business.
Crypto royalty like billionaire hedge fund manager Mike Novogratz revealed a LUNA tattoo to his millions of Twitter followers in January this year and some of crypto’s biggest players including Defiance, Jump Crypto and Three Arrows led the purchase of US$1 billion worth of Bitcoin earlier this year to act as a backstop for UST, the Anchor Protocol and LUNA. Similarly, Madoff wasn’t short on high-profile promoters either, including some of the world’s most prominent actors and directors as well as some of the biggest banks and charitable foundations, who all formed part of an echo chamber that perpetuated Bernie’s business.
Despite many complaints that raised significant red flags about Madoff over the years, the U.S. Securities and Exchange Commission was possibly blinded by his sterling reputation on Wall Street. Madoff had served three times as the chairman of the Nasdaq stock exchange and maintained the façade of a legitimate trading firm occupying three floors of well-appointed offices in midtown Manhattan.
An investigation by the SEC’s inspector general would later reveal that over the years, the SEC had received sufficiently “detailed and substantive complaints” to at least “warrant a thorough and comprehensive examination and/or investigation.”
While the SEC did subpoena Terraform Labs and Do Kwon, for the Mirror Protocol launched in 2020, where users could create and trade digital assets that “mirror” the price of U.S. securities warnings about TerraUSD, Anchor Protocol or Luna went uninvestigated.
And while investors in Madoff’s funds were able to get back as much as 80 cents in the dollar, an amazing recovery when you consider that most Ponzi scheme victims get back nothing, TerraUSD, Anchor Protocol and Luna investors are more likely to get nothing back. After the Madoff debacle, the SEC moved to shore up its enforcement efforts, establishing specialized units and staff with expertise and experience in ferreting out fraud, as well as lobbying for resources.
It’s likely that the SEC will do the same in the aftermath of TerraUSD’s collapse and stake greater jurisdictional claim over cryptocurrencies, as the crypto-savvy SEC Chairman Gary Gensler confirms himself as the new sheriff in crypto town.
Madoff’s Ponzi scheme unraveled because the 2008 Financial Crisis prompted withdrawals of some US$7 billion from clients of his various funds, and as little new money was flowing in by November 2008, he couldn’t cover the volume of redemptions. Similarly, were it not for the decline in cryptocurrency prices since last November, the Ponzi scheme that was TerraUSD, Anchor Protocol and LUNA, could have remained undiscovered for some time if the price of LUNA kept on increasing.
Is this the end for cryptocurrencies then?
The demise of TerraUSD, LUNA and the Anchor Protocol couldn’t have happened overnight, it was the result of two years of cheap credit and excessively loose monetary conditions in the aftermath of the coronavirus pandemic.
The U.S. Federal Reserve’s pandemic-era monetary policy and quantitative easing sent yield-hungry investors looking for returns practically anywhere, just as was the case in the aftermath of the Dotcom Bubble in 2001 and the run-up to the 2008 Financial crisis. In 2008 when interest rates started to rise and subprime borrowers were no longer able to afford their homes, their defaults created a domino effect in the market, causing global credit markets to freeze up and the stock market to crash.
Fortunately, the failure of TerraUSD was relatively localized.
Although other DeFi projects and protocols which created synthetic derivatives atop of UST in Anchor Protocol were affected — many of which were liquidated as well, it’s been estimated that as much as 75% of UST was locked in Anchor Protocol. In other words, TerraUSD’s failure has yet to become systemic and hasn’t affected the financial markets, a failure of Tether’s USDT (an asset-backed dollar-based stablecoin) on the other hand might, but that’s another story.
Unfortunately, many of those drawn to Anchor Protocol’s near-20% annual yields weren’t your typical “degen” crypto-types, they were just regular investors trying to get ahead in a world starved of yield and where the value of savings is being rapidly eroded. And while interest rates look set to rise (the U.S. Federal Reserve has promised two more rounds of rate hikes of 0.50% in June and July), they are nowhere near the levels that would deliver real yields which would effectively discourage this sort of behavior.
With inflation at 8.3% in the U.S., real interest rates are still deeply negative, even with the Fed raising borrowing costs by another 1.0% over the next two months.
Every U.S. recession over the past five decades has been preceded by a positive real Fed funds rate — where interest rates are high enough to slow nominal growth.
When measured using the U.S. Labor Department’s Consumer Price Index, the real Fed Funds rate is currently -7.5% versus the 50-year average of 1%. By way of comparison, the real Fed funds rate was over 10% when the central bank was fighting inflation at its peak in the 1980s. In other words, tightening U.S. Federal Reserve policy is more a case of marketing than any real effort to remove the punchbowl — the Fed’s a dove in hawk’s feathers.
And that means there will be more Anchor Protocols and Do Kwons out there who will continue to profit from yield-hungry investors, with shiny new attempts at financial alchemy to smelt copper into gold.
Far from beating back inflation, there are signs that the market believes the Fed is losing the battle against increasing price pressures.
The 3-month to 10-year U.S. Treasury yield curve is the steepest it’s been in 7 years. In other words, investors are demanding more returns for holding longer-term debt, because they believe that inflation will eat away at their returns — such a steepening during a period of tighter monetary policy suggests that the Fed may be losing its inflation-fighting credibility.
This combination of a timid Fed, prolonged inflation and investors being underweight on traditional pro-inflation assets could mean that the macro climate which fomented the rise of cryptocurrencies and DeFi projects like Anchor Protocol is still very much alive.
To quote Bernie Madoff,
“In today’s regulatory environment, it’s virtually impossible to violate rules, but it’s impossible for a violation to go undetected, certainly not for a considerable period of time.”
Eventually, investors will forget Do Kwon’s sins and some other charlatan will replace him with promises of steady, risk-free returns.
As long as real yields remain low or negative, a new “Do Kwon” will find no shortage of fresh investors and that’s why TerraUSD was crypto’s Bernie Madoff moment, not its Lehman Brothers one.