The consequences of the overuse of leverage and collapse of UST are spreading.
Contagion, under its traditional definition, is the communication of disease from one person to another by close contact. In an ecosystem where a new disease is introduced, this contagion effect creates an exponential spread of the disease throughout all participants. We all experienced this effect recently during the COVID19 pandemic, and whether you agree with the regulations or not, the logic of limiting contact to prevent contagion from being so wide spread that it collapses the system makes sense.
Financial markets also experience contagion. Obviously, this does not occur through the spread of a literal biological disease, but instead occurs through the spread of bad debt and balance sheet blowups where the ‘asset’ of debt becomes worthless as it will not be repaid. As more and more of these bad debts become defaulted on or under-collateralized, the turmoil cascades throughout institutions and individuals and causes irresponsible financial actors to become insolvent.
This downward spiral of defaults and blowups is what caused the financial crisis in 2008. Banks and other institutions were loaded up on highly leveraged financial products backed by an underlying of mortgage debt, and in this case very poor quality mortgage debt. Lenders were issuing NINJA loans (no income, no job, and no assets), which describes a loan extended to a borrower who may have no ability to repay the loan in the future. Once a sizable percentage of these loans went into default, all of the highly leveraged financial products and securities based upon them became worthless. This loss of an ‘asset’ on the balance sheets of major institutions led to them being underwater themselves, and at the risk of not making payments to their creditors in the same way that the original defaulting individual wasn't able to. This chain of falling dominos continued on to anyone with a leveraged position in the banks or companies themselves, and considering that we as a society base most of our pensions, 401k, and other investment accounts on the health of these markets, this massive blowup was looking to be a system-wide unwind of poor financial planning. Unfortunately, the Federal Reserve stepped in and bailed out the institutions that failed, and instead of being able to rebuild from a strong economic base and make better decisions in the future, the risk is now more systemic than ever before.
The cryptocurrency asset class is very new, and involves many fraudulent or at a minimum irresponsible actors. Many companies like Celsius, Gemini, BlockFi, and Coinbase base a large portion of their business model on borrowing and lending crypto assets. They essentially act as a bank, where you can send them or ‘deposit’ your cryptocurrency and earn an interest rate on it. These providers often offer insanely attractive interest rates going well beyond 10% APY. But it doesn’t take a mathematician to see that those rates are very unsustainable.
The stablecoin which became de-pegged, UST, had been the 3rd biggest stablecoin by market cap. It exceeded 15 Billion in market capitalization over the course of its lifetime. That is a whole lot of people who had the promise of being able to redeem it for a U.S. Dollar. When that contract was broken and the wealth was destroyed, a lot of those institutions and individuals, especially ones which used UST as collateral for their lending, became underwater. And based on history and the example of 2008, we can see how fast that contagion can spread.
An important note in this whole conversation is to remind everyone that if you sent your Bitcoin to a lending institution like Celsius to earn a yield, you no longer own it. Legally, they have no liability to you, and you are considered an unsecured creditor. They do not insure your assets, and if they became insolvent and were unable to repay all the assets which had been deposited with them, you would likely be forced to settle for pennies on the dollar. Just like how we experienced many bank runs throughout history when there was more gold lent out in paper than the bank had the ability to repay, the same will be true for these crypto lending institutions. Never store your Bitcoin with a third party which participates in lending it out. Hold your own private keys — the extra 5% APY is not worth the massive risk to the principle that losing custody of it presents.
Many lenders were making loans of UST and borrowing money in UST. We can see that even today on the Celsius website. They still list UST as a stablecoin which can be deposited for interest and borrowed. And at ridiculously high rates.
Blockchain analysis shows Celsius made large deposits to Terra’s Anchor Protocol starting in December of 2021. This is the same Anchor protocol which collapsed UST and Luna, and served as the source of its Ponzi nature. Now it appears some of it has been withdrawn during the past week, but there is no way to know what the current level of collateral is for the loans issued by these companies, or even if there is enough Bitcoin on their balance sheets to repay all of their creditors.
These lending programs required excess collateral to protect their loans. For example, if someone wanted to borrow 10 thousand dollars in UST, they would have to provide 15 thousand dollars of Bitcoin or another credible asset. This works well when prices are stable or rising, but if the price of the collateral falls below the loan value, as it has, the whole system starts to malfunction and rot. Not to mention that anyone who held that 10 thousand dollars of UST and didn't use it to purchase something now only has roughly 2 thousand dollars, which I imagine will make repayment very difficult. The contagion of poor lending practices and defaults of debt will cascade through the crypto ecosystem and likely colapse many more projects to come. Anyone who came into close contact with UST, Luna, or these lending protocols and companies is at massive risk. This will then spiral into decreased prices of even sound projects including Bitcoin. And since many people still use leverage to gain exposure to Bitcoin, it could get very ugly as bad debt gets flushed out.
This is part of the process of a free market. It is not pretty, it hurts those who are irresponsible or uneducated, and there is no Federal Reserve coming to take away risk from the individual and distribute it over the whole system. The great news is that just as it has happened in the past, with every bad blowup and debt meltdown comes a stronger foundation, better understanding of what value really means and which assets will stick around, and a reward for intelligent market participants through cheap prices and the easy ability to accumulate more wealth.
Prices of Bitcoin will likely continue to fall as all of this bad debt and poor lending practices are painfully flushed out of the market. Many more projects which held UST, Luna, or lots of debt, will blow up and go to zero. But this is not a time for panic — unless you are one of the irresponsible financial actors who used massive leverage, lent out your money in poor ways, or invested in projects owned by insiders or backed by debt and UST. If you have no debt, are able to continue to produce real value to society or already have and own a lot of cash, and have made proper lifestyle decisions like maintaining emergency savings and running a budget surplus, you will come out on the other side of this chaos much wealthier than before.
Control your private keys, become debt free, and continue to make yourself a fortress. Become censorship and inflation resistant through Bitcoin, and don’t allow yourself to be a domino that can be shoved over by making responsible and conservative financial decisions which set you up for long term success. Limit contact to prevent contagion. In the long run, we are not all dead. So let's make sure to continue fighting for a better world in the future, not only for ourselves, but for everyone.