Terra, George Soros and Zugzwang: Crypto’s 1992 Moment

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  1. All that was left to do was to create a panic at the particular point of vulnerability and force LFG into
Stanley Druckenmiller and George Soros, 1992

(This is designed to be a non-technical look at a complex series of trades in cryptocurrency markets that caused one of the most volatile weeks in history. Some facts and concepts have been simplified by necessity.)

Preamble

Two speculative currency attacks, exactly 3 decades apart.

One ‘fiat’ currency system, one digital (crypto) currency system.

30 years ago, the target was one of the oldest central banks in the world.

Last week, it was a cryptocurrency network that had grown too big, too fast.

Both netted an estimated $1Bn for the attackers and made global headlines.

Both caused massive financial losses for those on the other side of the trade.

Both with huge ramifications for the future.

And both ultimately possible due to the faulty design of two monetary systems which buckled under the weight of two different attacks, resulting in a critical loss of market confidence.

As someone who spent over 2 decades trading in traditional markets (and the last 3 years fully immersed in crypto) I’ve had a lot of questions from former colleagues on trading desks and friends in general about the events surrounding the collapse of the Terra ecosystem over the last week.

What actually happened?

Here is my attempt at a (non-technical) explanation..

Last week saw the spectacular failure of the Terra’s native stablecoin (UST) and governance token (LUNA) which sent shockwaves through the cryptocurrency markets and made headlines across the financial world. Almost US$50Bn equivalent of crypto value was wiped out.

Both coins (which are linked) fell over 90% in the course of 48 hours — even by the wildly volatile standards of crypto markets, this was a remarkable turn of events.

Here is how the crypto market entered the month of May:

Source : coinmarketcap

(Note : the $1 price of the currencies ranked 3, 5 and 10, identifying them as ‘stablecoins’ — we will come back to this concept later..)

I will contrast this collapse to an earlier speculative attack, almost exactly 30 years ago, that is well-known to most in finance and even made the news in the small Scottish village where I was growing up at the time.

I’m referring to the the speculative attack on the British Pound by the Quantum Fund, led by George Soros, in 1992. This day became known in the UK and across financial markets as ‘Black Wednesday.’

For perspective, I will explain both trades in 3 parts

  • The Setup
  • The Trade
  • The Aftermath
Are you watching closely?

1. Quantum Fund v The Bank of England (1992)

The Setup

In 1992 the United Kingdom had been fixing their currency, the British Pound (GBP), in a band versus the German Deutschemark (DEM) for 2 years. The system was called the European Exchange Rate Mechanism (ERM.) Most other major European countries had been doing this for some time.

Why?

For a few reasons.

From a political perspective there was a widespread trend towards closer European integration at the time. Harmonizing currencies was a crucial part of moving towards a single currency, the euro, which was eventually launched in 1999.

From a purely economic perspective it was preferred that exchange rate volatility be reduced to facilitate cross border trade in the Eurozone.

So in 1990 the UK government entered the ERM and pegged their currency to the DEM at a rate of 2.95 DEM to 1 GBP. They agreed to a band of +/-6pc that it would be allowed to deviate. At the lower extreme of this range (2.773 DEM) the Bank of England would be forced to intervene to buy GBP and sell foreign currency reserves— at the higher band (3.12) it would be obliged to do the opposite. It had entered into this arrangement with a war chest of foreign currency reserves as ammunition and had the power to set domestic interest rates.

“Just the two of us, building castles in the sky..”

There were three problems with this setup.

First is that the two economies involved (Germany and Britain) were already diverging in the early nineties. Generally not the best time to fix exchange rates.

Second was that the UK’s ruling Conservative party was split between pro-Europeans and ‘Euro-sceptics’ with differing agendas and attitudes toward closer European ties. This influenced how the other member countries of the ERM saw the UK, and this ambiguity of their commitment was not lost on the financial markets.

Third was that the central peg value of 2.95:1 was probably too high (for GBP) versus the historical performance of the two currencies. This last assertion has been the source of heated debate by economists for decades. In addition, this peg had not been negotiated with the Germans as was the precedent with other countries — the UK just announced it.

The Trade

In the early 90s, the Bank of England was cutting interest rates to help the economy due to a recession and weakness in the UK housing market. In contrast, the German economy was experiencing some inflation due to fiscal spending related to the recent fall of the Berlin Wall and German reunification.

And if there is one thing that has terrified German policy makers since the 1920s, it is inflation (see: Weimar Republic.)

Hyperinflation in the Weimar Republic

So the German Bundesbank began raising rates.

When you have a widening interest rate differential like this, capital often flows to the higher interest rate economy (and their currency) and the value of sterling began to fall vs the DEM through the summer of 1992. Right down to the lower extreme of the band.

At the Quantum Fund, Head Trader Stanley Druckenmiller, noticed all this unfolding throughout 1992 and saw the opportunity for a trade.

By August 1992, he had bet $1.5Bn of the Quantum Fund’s $7Bn assets that the value of GBP would fall against the DEM — an aggressive bet in both absolute and relative terms (or so he thought.)

Fast forward to 15th September 1992.

In an interview with Handelsblatt, Helmut Schlesinger, the Head of the Bundesbank, publicly voiced his doubts that the UK’s government could remain in the ERM at the current level.

This unprecedented expression of doubt by the Bundesbank was the catalyst for the fall of the pound to turn into a full-blown currency crisis.

Upon hearing this, Druckenmiller (so the legend goes) went to see his George Soros, who ran the fund, and asked to upsize his position. He outlined his thesis and asked to put the remaining $5.5Bn of Quantum’s market power behind the same trade — to sell the GBP and bet on the band breaking. They would be ‘all-in’ on the trade.

Soros, already famous for large bets, saw the genius of the trade and the rarity of the opportunity. He told Druckenmiller to think bigger. Instead : sell $14Bn worth of GBP versus DEM (by borrowing an additional $7Bn against the position) and go for the jugular. Instead of 100% of the fund, bet 200% of the fund.

In other words, not only bet the ranch, but borrow another ranch and bet that too..

(Note: this is an insane level of concentration but survivorship bias means that doing this and failing means going broke and fading into obscurity — the few who succeed become trading legends and get Medium articles written about their brilliance.)

By now other traders had realised that the UK government had painted themselves into a corner, there were clear political gaps appearing both within the UK government and importantly within the ERM (between the UK and Germany.)

With blood in the water, market confidence in the GBP/DEM peg began to evaporate.

There were 3 choices available to the Bank of England, acting for the UK government, at this point.

1) Intervene in the markets and defend the peg at 2.776 by spending foreign currency reserves. Sell USD and DEM, buy GBP.

2) Raise interest rates

3) Leave the ERM, devalue and let market forces determine the value of the pound

None of these were particularly attractive.

Why?

1) The BOE had finite foreign currency reserves as ammunition, and the buying they had started to do was having no effect.

2) The UK economy was weakening and needed lower interest rates, not higher ones.

3) Politically, leaving the ERM after only 2 years would be a huge embarrassment

So we come to our word of the day: Zugzwang

Zugzwang is an concept in chess strategy wherein one player is put at a disadvantage because of their obligation to make a move. And yes, it happens to be German.

At first the Bank of England fulfilled their obligation and dutifully intervened to buy the pound — basically Option 1. This was costing tens of millions in reserves per hour as the entire currency market started to focus on the growing crisis.

When this had little effect they moved to Option 2. They raised the base rate once from 10% to 12% and announced it would rise again to 15%.

In. A. Single. Day.

This was an desperate attempt to burn speculators and turn the tide of the market. But the UK economy was weakening and the Bank had already been cutting rates for the last year — the markets knew immediately that this was a an unsustainable move.

The selling intensified.

In the evening of Wednesday 16th September 1992 the UK government finally gave up the fight.

Norman Lamont, capitulating, 16th September 1992

Norman Lamont, the Chancellor of the Exchequer, held a press conference and sheepishly announced to the world that the Bank of England was giving up the fight. The UK would leave the ERM and allow the free market to determine the value of sterling against other countries.

By November that year, Pound Sterling had crashed 15% against the Deutschemark and 22% against the US dollar.

Source : Bloomberg

The Aftermath

Quantum were not the only hedge fund who benefitted from this trade, but they were the most high-profile. They netted $1Bn on the trade and Soros would forever be known by the sobriquet ‘The Man Who Broke The Bank of England.’

The brains behind the trade, Stanley Druckenmiller, would end up working for Soros until they parted ways in 2000 and he continued managing his own funds. He ended his career in 2010 with one of the greatest performance records of any institutional money manager in history.

The Bank of England lost GBP 3.3Bn on the failed defence of the pound.

The UK economy actually ended up as a net beneficiary — export competitiveness increased due to the weaker GBP and it emerged from recession faster than expected.

As for the ruling Conservative government, they lost their reputation for economic competence and would go on lose power in a landslide to Tony Blair’s Labour Party in 1997. They would not form a majority government again for a generation.

British Press reaction to Black Wednesday

Across the UK, anti-Europe sentiment (‘euro-scepticism’) grew within the country. The UK never seriously considered joining the euro in 1999 and voted to leave the EU entirely in 2016.

2. Unknown attacker (aka ‘Stan’) v Terra (2022)

(Note : we are only one week on from the collapse so not all facts are confirmed, what follows is my conclusions from the on-chain data and public announcements)

The Setup

TerraUSD (UST) is an algorithmic stablecoin that sought to track the US dollar on a 1:1 basis. It is one component of the Terra ecosystem of linked crypto projects and applications.

What is a stablecoin, and how are algorithms involved?

Stablecoins (‘stables’) are a specific type of cryptocurrency that seek to track the value of a fiat currency, normally the US dollar, and maintain a 1:1 peg. They are the equivalent of a ‘safe asset’ in cryptocurrencies or are designed to be such.

When crypto traders wish to exit positions in the more volatile coins, they generally can be found on the sidelines ‘hiding in stables’ until the situation becomes clearer or they increase their conviction about the direction of the market.

When critics assert that all cryptocurrencies are useless as a medium of exchange as their value is far too volatile, they are forgetting about stables.

Stablecoins : The Good, The Bad and The Ugly

Clint Eastwood as The Man with No Name

The two most popular stablecoins are run by private entities (‘centralised’ in crypto-speak.) Their acceptance by ‘real world’ businesses have been growing for years, culminating in the news last year that Visa will allow stablecoins to be used to settle transactions on its payment network.

Look again at the market cap summary from May 1st :

Source : coinmarketcap

You can see from the table above that the 3rd and 5th largest cryptocurrencies (Tether and USD Coin, respectively) are stablecoins, with market capitalisations of $82Bn and $49Bn on May 1st. That is, their price is $1 and should not change.

Tether is the oldest and largest but there have been long-running concerns about the quality of the assets on their balance sheet and their backing. They have settled cases with both New York State and the CFTC over alleged refusal to provide transparency of their assets and concerns around both the validity of their 1:1 backing and their separation of client and corporate funds.

Sharing ‘FUD’ (Fear, Uncertainty, Doubt) about Tether on sites like Twitter is a popular hobby among crypto traders.

USD Coin, backed by Coinbase and Circle, has been making up ground in recent years in terms of size and turnover and is the preferred stablecoin by many institutions due to its relative transparency. In March last year it was USDC, not Tether, who Visa famously announced as their stablecoin partner.

Why are they so popular?

Practically: speed and cost.

Stablecoins allow for transfer of huge sums of fiat equivalent across networks and exchanges in the fraction of the time (and cost) for the equivalent amount of currency in the traditional banking system.

They are one of the key ‘on-ramps’ from the traditional finance world to cryptocurrencies and, as such, have drawn the attention of global regulators concerned about their governance and backing.

How do they work?

Pretty simple. To commence your adventure in cryptocurrencies anyone can swap an amount, say, US$1000 in exchange for 1000 USDC or 1000 Tether. With your dollars now ‘digitised’ you can send them almost instantly (and relatively costlessly) across cryptocurrency networks to recipient individuals or exchanges.

They both stand ready to reverse the trade (redeem USDC or Tether 1:1 for US$ cash) if you so wish. Alternatively you can sell your USDC or Tether for US$ on one of the many global exchanges to re-enter the world of fiat currencies.

Stablecoins are, essentially, a bridge between the fiat and crypto worlds.

The Bosphorous Bridge in Istanbul, connecting Europe and Asia

Stablecoins are useful innovations for individuals as diverse as the worker in the developing world looking to avoid outrageous remittance costs when sending money back to their family to the institutional trader looking to shift large amounts of capital quickly across blockchains to the next market opportunity.

For some in the crypto market, however, it is neither optimal nor sustainable to have the largest stablecoins run by a private entity.

Why?

There are issues around how much they can truly scale, how much existing banks will allow them to hold as assets (as well as the transparency of those assets) and the ease with which regulators could sanction them.

They deem it preferable for the bedrock of crypto trading to be truly decentralised ‘algorithmic’ stablecoins. There would be transparency of reserves held on the blockchain which could be verified, greater ability to scale and regulators would be powerless to stop the growth of the decentralised economy.

Figuring out how to do this is immensely complex and one of the biggest Holy Grails in crypto. It has been a tough nut to crack.

“We seek the Grail…” Monty Python and the Holy Grail, 1975

But back to Clint Eastwood.

So up until now we have, very simplistically,

The Good (USD Coin),

The Bad (Tether)

..which only leaves

Market Capitalisations as at 17th May (TradingView)

The Ugly (well, it certainly was in the end..)

TerraUSD (UST) was effectively trying to disrupt this stablecoin duopoly and overtake competitors like Dai and Frax. They were gambling on a ‘blitzscaling’ growth strategy which is popular in tech startups in order to get big. Quickly.

Blitzscaling can be a spectacular strategy in business under the right conditions. Burn cash fast but expand your footprint massively.

When it goes right you have Amazon or YouTube.

When it goes wrong… WeWork.

But why even bother to consider holding UST when there is already the choice of Tether or USDC for those that need to hold, invest or send fiat equivalent amounts across crypto networks?

Answer : Anchor protocol and its market-beating 20% interest rate on UST deposits.

Anchor acted as the high-yield money market for the whole Terra ecosystem and for the last year has been paying 20% for UST depositors. Traders could also pledge collateral and borrow against your holdings at a lower variable rate.

Last year when crypto yields were high, this was not remarkable. Many crypto yield offerings in the DeFi (‘decentralised finance’) space were offering juicy yields to attract capital for their projects. Token prices were rising, led by Bitcoin and Ethereum, and the bull market was in full swing.

That move ended in Nov 2021 (also when the tech rally peaked) and prices have been retracing every since. Yields on crypto projects fell to 5–10pc APR except for one — the yield on Anchor.

With Anchor still paying 20% the demand for UST creation exploded, with most of it going straight into Anchor.

(Reminder: ‘UST’ and ‘TerraUSD’ are interchangable terms)

UST swelled from 2.5Bn to 18Bn in 6 months, starting at the crypto market top on Nov 11th

Here we can see Anchor deposits swelling from $2Bn on Nov 10th..

..to $14.09Bn on May 6th.

A seven-fold increase in 6 months.

The problem was, the pace of growth was unsustainable, given the Anchor reserve was losing money on its activities (but gaining market share, eyeballs, brand and trying to broaden its utility.)

“Just blitzscale, baby”

Al Davis of the Oakland Raiders

Who was paying for all this?

The Luna Foundation Guard (LFG) was setup to protect the Terra ecosystem and was backed by some massive names in crypto (Jump Capital, Three Arrows Capital.) They had a warchest of $3Bn in bitcoin to defend the peg if need be. In this comparison, they are equivalent to the ‘crypto Bank of England.’

In March this year, the wider Terra community acknowledged the unsustainability of the Anchor rate and voted to pass a resolution (Proposal 20) where the 20% rate would have to come down gradually if the Anchor reserves (which were funding it) started to fall by more than 5%. This was inevitable and would continue to happen monthly.

In short : the party was coming to a close.

Lastly we need to list the 3 ways that investors could sell their UST.

This, as with the Quantum trade, is key.

1. Curve Finance, an exchange (roughly $550m of UST liquidity in their ‘3-pool’)

2. LUNA /UST swap mechanism at Terra (estimated at $300m liquidity per day)

3. Regular exchange liquidity on FTX and Binance (least liquidity of the 3)

By Friday, May 6 there was roughly $14 billion UST in Anchor. By Sunday 8th, this figure was $11.7 billion as people started to leave in droves.

$2.3Bn in deposits left over a weekend.

Something was up.

What caused this? Speculation is that the first stage of the run was actually our attacker placing, then pulling, large deposits at Anchor combined with media FUD to start the run. I haven’t seen evidence of this yet but it could be out there.

This was the first vulnerability — Anchor was starting to see withdrawals..

Next, crucially, was the fact that that Curve Finance ‘3-pool’ liquidity in UST was going to be on hold on Sunday May 8th for a technical reason — it was moving to a bigger ‘4-pool’ : better for UST liquidity in the medium term but leaving a vulnerability in the short term.

Second vulnerability — short-term removal of a UST exit via Option 1 (the largest way out)

All that was left to do was to create a panic at the particular point of vulnerability and force LFG into zugzwang.

The Attack

There are various tweet threads from crypto researchers that have pieced together the steps in the attack — I read most of them but have drawn largely from this one.

Our attacker (‘Stan’) setup the attack as follows:

1. He borrowed 100,000 BTC for 42,000 each. A $4.2Bn war chest.

2. He also build a $1Bn UST holding.

(obvious comment— you needed deep pockets for this)

(Also - we can assume that ‘Stan’ also initiated massive LUNA and BTC short futures positions that would benefit from the coming chaos — unconfirmed at this time.)

Just as LFG were withdrawing several $100m of UST from the Curve 3-pool (to go into the 4-pool) the attackers sold $350m of UST for USDC, draining the pool of its reserves.

BAM. Option 1 taken out.

This massive sell pressure starts to ‘depeg’ UST from its 1:1 relationship (remember, Anchor deposits have already been dropping for days now as people try to leave the party before the music stops.)

At this point, the panic increased and anchor withdrawals accelerated. With the Curve Finance exit blocked, some turned to Luna itself to use their Luna/UST swap mechanism (Option 2.)

Problem — only $300m liquidity per day there, remember?

As this was happening, ‘Stan’ was making sure to close Option No3 — dumping $500m of UST on FTX and Binance to drain the exit liquidity there and further fuel the panic.

Result : Zugzwang (2022 variant)

With capital looking to exit faster than traditional exits could handle, LFG were now obliged to sell billions of dollars of Bitcoin they held on the open market to support the UST and try to repeg at 1:1. This succeeded in the short term but the stampede would not stop and the death spiral resumed.

Bitcoin fell 25% from May 8th to the low of May 12th as LFG unloaded their 80,000 bitcoin on the market to save the peg.

Spoiler alert : it did not work.

Exchanges started to pause withdrawals due to an exponential increase in traffic, the Terra network became congested with transactions and there were now only sellers of UST and Luna.

LFG were, like the Bank of England 30 years ago, the only buyer in a market full of sellers.

Aftermath

It is hard to say for sure what the repercussions will be, but this is clearly a milestone moment for crypto in general and DeFi in particular.

We will likely only find out in the coming weeks what investment funds globally were exposed to LUNA and/or UST as May’s monthly reports are released to investors in early June.

For many retail traders, the effect has been devastating and I know of people who have lost a meaningful part of their crypto investments in this collapse.

We all know the rules in an asset class as speculative as cryptocurrency, but the fact is that the Terra ecosystem had the backing of some of the biggest and most established names in the game. The demise of a project this large in this short a timeframe is unheard of and must be hard to stomach.

There were discussions within Terra to use the remaining balances in LFG to distribute to existing UST holders but it looks that the reserve is almost empty. Good for the general market (no more forced selling), bad for UST holders.

The obvious repercussions I see are an accelerated focus from regulators, especially in the US, regarding stablecoins. This was already on the cards but calls for a strong stance will only intensify.

Second, there will and should be soul-seeking within the crypto community about how this all came to pass. There should also be an increased focus by the crypto community on the actual use cases of DeFi projects, their sustainability and their realistic path to generating real value and revenue.

Having been working on Wall Street in 2000 (I made it out of the Scottish village, in case you were wondering) I remember the dotcom crash vividly and the weeding-out of weaker companies and business models. It was a painful yet necessary chapter in the global growth of the internet.

Comparison

Both Quantum and ‘Stan’ targeted unsustainable monetary systems with targeted attacks at a time when they were most vulnerable.

Both attacks were only available to those with vast amounts of capital, clearly, but ultimately the fragility of the systems were the cause for the underlying failures in the GBP/DEM peg and the UST/Luna project.

With the Bank of England, they effectively agreed to a boxing match (with the market) where it quickly became clear that, due to the economic divergence with Germany, they would have to fight with one hand (interest rates) tied behind its back. To make matters worse, they had not consulted the Germans about the level of the peg, they just announced it (against convention.)

So their potential cornerman had little interest in helping them with the fight.

Rocky and Mickey : it’s easier to win a fight with a cornerman

With Terra you can think in terms of attending a concert at, say, the Royal Albert Hall in London (capacity 5,200.)

Royal Albert Hall

As the concert is drawing to a close and the band are about to stop playing you realise that, magically, the crowd has increased sevenfold. There is now a crowd as large as nearby Stamford Bridge in the same venue.

Stamford Bridge

Only the exits aren’t 7x bigger.

All the attacker did was wait until the end of the show when people started to leave and jam the exits.

Then yell ‘FIRE!’

Final Comment

To those effected by the UST collapse, you have my sympathies as someone who has taken their fair share of pain when the market dishes it out. So to finish with a Monty Python quote, I’ll leave you with my sincere hope that your losses are ‘but a flesh wound’ and not a mortal one.

Thanks for reading.