Market update: Macro challenges and Terra’s decline
The crypto market has been on a downward trajectory since Bitcoin and the Nasdaq Crypto Index reached all-time highs in November 2021, even as fundamentals remain strong. The reasons are both specific to the crypto asset class and to global markets more broadly.
The current macro environment is unquestionably challenging. The Ukraine-Russia war, global supply-chain disruptions, and the unprecedented expansion of central bank balance sheets have contributed to a sharp rise in global inflation. This has spurred greater fiscal restraint by governments, an increase in interest rates, and investors moving away from risky assets.
Additionally, rising interest rates have decreased expectations for economic growth and company profits. This has reduced the present value of future cash flows—especially for companies with the greatest potential for generating value over a long-term horizon—and led to lower stock prices. The Nasdaq 100, an index heavily influenced by tech companies, has dropped nearly 30% since the beginning of the year.
Crypto has also been impacted by this macro environment. The value of the vast majority of crypto assets is linked to the probability of their long-term success. In scenarios like the current environment, the effects that lead to the decline of stocks and other traditional risk assets also impact crypto asset prices. In fact, since the beginning of the COVID-19 pandemic, the crypto market has demonstrated a greater correlation with traditional markets—a phenomenon that may be potentiated by the entry of more institutional investors into the crypto market.
Source: Bloomberg. Correlation between the Nasdaq Crypto Index (NCI) and the Nasdaq Composite at all-time highs
While much of the current crypto downturn can be linked to the macroeconomic landscape, crypto-specific factors have also played a role. The most relevant was the collapse of one of the main blockchains in the ecosystem, Terra.
The downfall of Terra
The Terra blockchain lost more than 99% of its market value this week. This drastic market movement is a consequence of the loss of trust in the project resulting from the UST stablecoin losing its peg to the dollar on May 7 and pushing the price of UST and Terra’s token LUNA into a “death spiral.” A scenario like this has been considered within the crypto community for some time, and in recent months we have been doing our own internal analysis. Following is our perspective on what these events mean for Terra and the crypto ecosystem as a whole.
The Terra blockchain was built to be an ecosystem of different stablecoins, serving as the payment rail for fintech applications around the world. The platform creators view stablecoins as the “killer app” for crypto, with the potential to bring millions of new users to the space. To achieve that vision, Terra had to bring in real-world use cases. The first of these use cases was a South Korea-based fintech named CHAI, a payment-service operator that used Terra’s blockchain to achieve billions of dollars in transactions.
However, Terra wanted to grow faster and beyond this partnership. To bootstrap adoption of their largest stablecoin, UST, they incentivized demand through the DeFi protocol Anchor (which was incubated by Terraform Labs, creator of the Terra blockchain). The platform started offering fixed annual yields of 20%, much higher than most conventional market rates and even high by DeFi standards. This allowed Terra to attract more than US$18 billion to UST, with around 14 billion UST (75% of the stablecoin supply) deposited in the Anchor protocol on May 6. Terra had achieved its goal to accelerate UST adoption, but the stablecoin was highly concentrated in a single and ultimately unsustainable use case.
UST is an “algorithmic stablecoin.” In contrast to other widely used stablecoins like USDC— which is backed by dollar reserves and custodied by Circle Ltd.—UST’s peg is maintained through price arbitrage between its value against the dollar and a conversion mechanism that allows it to be swapped into a different crypto asset (i.e., LUNA). The aim is for 1 UST to equal US$1.00. To achieve this, new LUNA tokens are regularly minted to keep pace with the value of UST. For example, if UST trades at US$0.99, arbitrageurs can make a profit by (i) buying 1 UST for US$0.99; (ii) redeeming 1 UST for US$1.00 of LUNA and (iii) selling the redeemed LUNA for US$1.00. The problem is that the more this arbitrage opportunity is executed, the faster the supply of LUNA grows, leading to selling pressure. And if investors eventually lose confidence in the ability of UST to regain its peg, they lose confidence in LUNA as well, which pushes prices down even further. This is precisely what happened this week.
For a stablecoin to be successful, investors must trust that it will keep its peg at all times. If this confidence is broken, there will be no demand and the project will fail. This is why it will be very difficult for the Terra/LUNA ecosystem to recover from this incident, even though UST may regain its peg at some point. The developments of technologies for algorithmic stablecoins will certainly continue, and the UST/LUNA drama will surely be remembered as a major stress test for the arbitrage and collateralization mechanisms that have been established to build this kind of crypto use case. However, even if UST or LUNA are unable to recover, crypto investors and developers have been provided with a lot of food-for-thought on how to improve this emerging technology going forward. Ultimately, this process has been a reminder that we are still early in the evolution of blockchain-based applications.
Adapted by Hashdex from “The possibility of a bank run and $UST de-peg event,” by José Maria Macedo
Despite recent events, the medium- and long-term prospects of the crypto market and its fundamentals remain strong. The adoption of this new technology continues to increase, Ethereum is moving to another stage of its upgrade plan, and segments such as DeFi and NFTs are gaining more users. Additionally, alternative smart contract platforms, such as Solana and Avalanche, are gaining ground by offering users different value propositions. We also see increasing volumes of capital entering the sector, with venture capital funding levels reaching records in the first quarter of this year. We continue to believe that it is only a matter of time before crypto assets become a broadly accepted technology, creating an addressable market significantly larger than the market today.
Source: CB Insights
For long-term investors with exposure to this asset class, this moment can be viewed as opportunistic. Crypto fundamentals remain strong and there is no intrinsic factor that substantially differentiates the current events from past market drawdowns. We remain confident that blockchain technologies will spark huge advances in global productivity and that crypto assets are a unique investment opportunity for everyone.
The information contained herein (“Information”) may not be reproduced or redistributed in whole or in part, in any format, without the express written approval of Hashdex Asset Management Ltd. (“Hashdex”) and its affiliates and subsidiaries (“Hashdex Group”). By accepting this document, you acknowledge and agree that all of the Information contained in this document is proprietary to Hashdex Group. While not explicitly referenced within this piece, Hashdex Group manages the Hashdex Nasdaq Crypto Index ETF, Hashdex Nasdaq Ethereum ETF, Hashdex Nasdaq Bitcoin ETF, Hashdex DeFi Index Fund, Hashdex Smart Contract Platforms Index ETF and other investment vehicles focused on digital assets (collectively the “Fund” and each a “Fund”) which invests in digital tokens. The Information is not an offer to buy or sell, nor is it a solicitation of an offer to buy or sell, interests in the Funds or any advisory services or any other security or to participate in any advisory services or trading strategy. If any offer and sale of securities is made, it will be pursuant to the confidential offering memorandum of the Fund (the Offering Memorandum). Any decision to make an investment in the Fund should be made after reviewing such Offering Memorandum, conducting such investigations as the investor deems necessary and consulting the investor’s own investment, legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of an investment.
Each Fund seeks to track a relevant index. The performance of each Fund will vary from the performance of the relevant index that it seeks to track. The Information is being provided to you solely for discussion purposes and may not be used or relied on for any purpose (including, without limitation, as legal, tax or investment advice) without the express written approval of Hashdex Group. Certain statements reflect Hashdex Group’s views, estimates, opinions or predictions (which may be based on proprietary models and assumptions, including, in particular, Hashdex Group’s views on the current and future market for digital assets), and there is no guarantee that these views, estimates, opinions or predictions are currently accurate or that they will be ultimately realized. To the extent these assumptions or models are not correct or circumstances change, the actual performance of Hashdex Group and the Funds may vary substantially from, and be less than, the estimated performance. None of Hashdex Group, the Funds nor any of their respective affiliates, shareholders, partners, members, directors, officers, management, employees or representatives makes any representation or warranty, express or implied, as to the accuracy or completeness of any of the Information or any other information (whether communicated in written or oral form) transmitted or made available to you.
Each of the aforementioned parties expressly disclaims any and all liability relating to or resulting from the use of the Information or such other information. Except where otherwise indicated, the Information is based on matters as they exist as of the date of preparation and not as of any future date and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after the date hereof. Investing in financial markets, the Funds and digital assets, including Bitcoin, DeFi tokens, and Ethereum, involves a substantial degree of risk. There can be no assurance that the investment objectives described herein will be achieved. Any investment in the Funds may result in a loss of the entire amount invested. Investment losses may occur, and investors could lose some or all of their investment. No guarantee or representation is made that Hashdex’s investment strategy, including, without limitation, its business and investment objectives, diversification strategies or risk monitoring goals, will be successful, and investment results may vary substantially over time. Nothing herein is intended to imply that the Hashdex Group’s investment methodology or that investing any of the protocols or tokens listed in the Information or the Funds may be considered “conservative,” “safe,” “risk free,” or “risk averse.” Neither historical returns nor economic, market or other performance is an indication of future results. Certain information contained herein (including financial information) has been obtained from published and non-published sources. Such information has not been independently verified by Hashdex Group, and Hashdex Group does not assume responsibility for the accuracy of such information. Hashdex Group does not provide tax, accounting or legal advice. Certain information contained herein constitutes forward-looking statements, which can be identified by the use of terms such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe” (or the negatives thereof) or other variations thereof. Due to various risks and uncertainties, including those discussed above, actual events or results, the ultimate business or activities of Hashdex Group or the Funds or the actual performance of Hashdex Group, the Funds, or digital tokens may differ materially from those reflected or contemplated in such forward-looking statements. As a result, investors should not rely on such forward- looking statements in making their investment decisions. None of the Information has been filed with the U.S. Securities and Exchange Commission, any securities administrator under any state securities laws or any other governmental or self-regulatory authority. No governmental authority has opined on the merits of the offering of any securities by the Funds or Hashdex, or the adequacy of the information contained herein.