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Vellir #5 → Crypto's Black Wednesday

This week marked crypto's 'Black Wednesday', leading to significant losses for the sector. But there are silver linings too...
Vellir #5 → Crypto's Black Wednesday
Photo by Simone Viani / Unsplash

There might not be many people in the world of cryptocurrency who recall the day, thirty years ago, when Sterling (£GBP) was forced out of the European Exchange Rate Mechanism (ERM).  That day, which has become known as 'Black Wednesday', made the name (and fortune) of one George Soros, cratered trust in the British Conservative Government, and set in train events that led, ultimately, to Brexit.

While economic observers, and most of us, are pre-occupied by war in Ukraine, volatility in the stock markets, rampant inflation, and a serious cost of living crisis, the world of crypto has just had its own Black Wednesday. On 11 May, the value of Terra (UST), a crypto 'stablecoin' supposedly pegged to the $US, fell almost to zero, wiping $billions off the market cap of Terra, and causing huge losses for investors in Terra and its sister currency Luna.

The parallels with 1992 are stark. As then, a well-capitalised speculator seeing a currency pegged artificially high (then, £GBP to €ERM; now $UST to $USD) exploited its vulnerability to send the currency into free fall, making huge profits from short positions as efforts were made first to defend the currency, and then to exit loss-making positions as fast as possible as the price cratered. In the first instance, George Soros made his fortune. In this one, as yet unidentified actors have made theirs, with the casualties being investors in and holders of the Terra and Luna currencies.

No one should be that surprised. In January, the British entrepreneur, investor, and author Azeem Azhar interviewed Do Kwon, the founder of Terra/Luna and CEO of Terraform Labs, the company behind the currencies, for his 'Exponential View' podcast. That episode is well worth another listen, but it left a whole series of unanswered questions which, even to a layman, screamed 'bank run waiting to happen'. In late March, the 'Bankless' podcast, known for its scepticism about Terra but for its bullishness on crypto in general, hosted a 'Bulls vs Bears' discussion on the topic of Terra/Luna, and whether it might be "a ticking time bomb". Later they talked to Ethereum co-founder and all-round crypto Sage Vitalik Buterin, whose comments left listeners in little doubt about the long tail risks to which under-collateralised stablecoins might be exposed.


Buterin's comments, as is often the case, were perceptive. While encouraging 'further innovation in the sector' he noted that without collateral, stablecoins like Terra/Luna were dangerously exposed to speculative attack. The USP of Terra/Luna, and one which played exceptionally well to those in the crypto world for whom maximum decentralisation is sacred, was its total lack of 'off-chain collateral', i.e. the lack of any fiat currency or other asset to back up the value of its currencies, despite their £USD peg. It was exceptionally 'pure' in crypto terms, unlike other prominent stablecoins like Tether and £USDC, which hold actual $USD or equivalent assets in their treasuries to back up the value of their pegged stablecoins, to varying degrees.  As Do Kwon told Azhar in their conversation, holding £USD is expensive and inefficient. Turns out, however, that it is rather important if your currency is pegged to the $USD.

The signs were there in late March and April as the people behind Terra/Luna began buying Bitcoin, the gold standard of crypto, as a defensive war-chest in the event of an attack such as the one that happened this week. But as Chancellor of the Exchequer Norman Lamont discovered in 1992, throwing £billions into the market to prop up your currency just adds to your losses; Terra/Luna's Bitcoin war-chest didn't last long.

There is much more to be learned about the collapse of Terra/Luna, including the role played by products like the linked 'Anchor Protocol', a savings product offering unbelievable (and clearly unsustainable) 20 percent yields in return for using it to save Terra/Luna, and the role played by motivated sellers of the currencies. However, the collapse brings with it some big clouds, and a possible silver lining for those in, or interested in the world of web3 and crypto.

The biggest cloud is reputational. The crypto and related web3 industries have been making progress in terms of building credibility and shedding some of the negative perceptions which have long dogged cryptocurrencies. In part, this has been achieved thanks to significant increases since 2018 in the value of many crypto assets, and by the rapid adoption and mainstreaming of consumer crypto products like Coinbase (which itself took a big hit this week).  Increasing numbers of thoughtful investors and entrepreneurs have also adopted crypto and advanced real-world use cases which are gaining traction. However, ponzi schemes like Bitconnect and OneCoin are still fresh in many people's memories, and the sudden collapse of the third biggest stablecoin will reinforce negative perceptions of the wider industry. You can hear this fear in the voices of Ryan Sean Adams and David Hoffman in their latest Bankless podcast as they walk listeners through the Terra/Luna meltdown, despite their own long-standing bearishness towards the currency.

Of course, there may be a bigger cloud to come in the shape of significant regulatory action in response to Crypto's Black Wednesday. On the day Terra/Luna collapsed, and completely coincidentally, the US Fed was issuing cautionary guidance about the risks posed by stablecoins, although it made no specific mention of Terra/Luna.  And the UK Government has announced plans to regulate stablecoins this year.  Calls for more regulation are certain to increase as stories of retail investors in crypto losing their life savings flood the mainstream media.

Here, however, there are also silver linings. Truth is, the sector needs more intense scrutiny, precisely because the line between creative innovation and sketchy risk-taking is still so hard to draw in the world of web3 and crypto, and dubious projects like Terra/Luna that look and sound (and are) too good to be true are still widespread. The crash will, hopefully, force more of those projects built on shaky foundations to falter, as did many of the cash-burning companies of the original dot.com boom, leaving the authentically brilliant, genius founders of game-changing web3 technologies and companies to emerge. And they will need to find an accommodation with policy-makers and regulators in order to thrive, as Microsoft, Amazon, Apple, Google and others have before them. We will be tracking these developments closely at Project Vellir.

Jonathan Luff is the co-founder of Epsilon Advisory Partners, and CyLon, advising and investing in outstanding technology companies since 2013. From 1998-2012 he served in the British Diplomatic Service, and as an advisor to the Prime Minister at 10 Downing Street, specialising in national security issues, technology and innovation.