It was bound to happen. The cryptocurrency industry, plagued with similar degrees of opaqueness and complexity to the subprime mortgage market of yore, finally had its Lehman moment.
On May 9, Terra, a network of interlocking digital tokens, collapsed. Terra had come out of nowhere in 2021, but it rapidly commanded an aggregate market value exceeding $60 billion. It became the standard bearer for decentralized finance, the subsector built around Ethereum instead of Bitcoin. Even as the rest of crypto skidded toward a bear market this year, Terra’s Luna token had defied the malaise and become a magnet for alpha-seeking investors.
Then it plunged to virtually zero in the blink of an eye. Terra’s blockchain went dark, exchanges delisted the tokens, and Terra’s leaders scrambled to salvage what they could.
The fallout was considerable: The crypto market as a whole lost a quarter of its value over the next three days. And Janet Yellen, the U.S. secretary of the Treasury, immediately called for legislation to regulate stablecoins after Terra’s UST offering, a token meant to track the U.S. dollar, proved anything but steady.
Perhaps worst of all, Terra’s savage demise delivered a blow to the credibility of decentralized finance, or DeFi, as a sober and useful proposition amid the rampant speculation in cryptocurrencies. DeFi was meant to be a faster, fairer, and more transparent alternative to traditional finance. Thanks to Terra, the sector appears to be just as unhinged and unreliable as the rest of crypto.
As the dust clears, now comes the reckoning — and a few fundamental questions: Is DeFi dead? Or is this just a cycle like the ones that occur in any other market? And if so, what needs to change?
It helps to remember that for all the madness of crypto — Dogecoin’s hijinks, buying “land” in the metaverse, an NFT sold for $69 million — it’s just a software play. Truly. Blockchain is a new type of database. And as with any software play, the staying power and value of crypto will ultimately be determined by its adoption. In Bitcoin’s case, that means the mass-market embrace of digital money that can change hands electronically without the need of intermediaries such as central or commercial banks. In Ethereum’s case, it means using smart contracts, an innovation in computer science that enables users to code entire financial agreements into tidy digital packages that operate on autopilot.
The problem — and it’s a doozy — is that the entrepreneurs who are building decentralized finance projects have neglected to make their offerings simple and easy to use. Quite the contrary, they tend to fashion insular systems with little connection to the real world. There are exceptions: A venture called MakerDAO recently joined forces with logistics outfits and used its stablecoins to finance beef shipments from Australia to Hong Kong. It may not be sexy, but it works. There are others — NFTs, for all their strangeness, are actually proving to be useful applications for managing fine art, as well as providing new marketing channels in the entertainment and sports industries.
By and large, however, DeFi projects feel like games, not businesses. Their players revel in the esoteric language of these projects like members of secret societies. Crypto liquidity pools, parachains, zero-knowledge proofs, Layer 2 blockchains . . . the list of arcana seems endless, and it brings to mind the same baroque nomenclature that characterized the subprime mortgage boom. Remember CDO-Squared?
It’s little surprise that civilians have no idea what DeFi designers are talking about, let alone how to use their products. So far, the whole proposition remains largely an object of speculation, not adoption.
Terra epitomized this problem. Founded in 2018 in Singapore, Terraform Labs was designed to create the “reserve currency” for DeFi. To that end, co-founder Do Kwon, a Stanford University–educated computer scientist, built a system that revolved around the U.S. dollar. He established a stablecoin called UST that was marketed as being pegged to the greenback. It was kind of, sort of — well, not really — pegged to the greenback. Rather than back the token with reserves, UST was linked to another token, Luna, Terra’s flagship. The idea was that holders could redeem 1 UST for $1 worth of Luna. But the design left UST uncollateralized. This so-called algorithmic stablecoin was a pegged asset with no real peg.
Investors overlooked that design flaw during 2021 as the crypto bull market flexed and Luna’s price multiplied about 20 times between May 2021 and April 5, 2022, when it reached its all-time high. Meanwhile, Terra launched a savings account offering called Anchor Protocol that virtually guaranteed UST holders a 20 percent annual return on their capital.
Of course, providing such guarantees is verboten in traditional finance and is a classic red flag for fraud. Skeptical investors groused that Terra’s structure looked like a pyramid scheme because investors were ramming UST to pocket the 20 percent, and there was no way that was sustainable. An influential DeFi investor who goes by the Twitter handle Sensei Algod publicly called UST and Luna a “Ponzi,” and in March he offered to bet Do Kwon $1 million that Luna would be worth less than $88 a token in 12 months.
Easy bet, in hindsight. When inflation spurred the Federal Reserve to raise rates, crypto dove alongside stocks, especially tech shares. Sure enough, crypto behaved as all markets do in such febrile times — and savvy traders targeted the weak and pounced. Though it’s hard to know exactly what happened to poleax UST, suffice it to say that there was a run on the token, as well on as its sister assets Luna and Anchor. The stablecoin lost its peg and fell to 60 cents on the dollar, and eventually to less than 1 cent.
There’ve been loads of postmortems, but the most important takeaway is actually the most obvious: DeFi will never scale if it isn’t regulated. Unlike Bitcoin, which is content to float through the markets like a bizarro version of gold, Ethereum and DeFi have a purpose: to reinvent finance. How can anyone expect institutional investors or ordinary people to take these platforms seriously if they don’t protect their customers from shoddy business models? How can these platforms ever expect to be adopted and fulfill DeFi’s ostensible aim to improve finance? Hedge fund veteran Bill Ackman captures the moment nicely by praising the “brilliant technology” of blockchain and lamenting the corrosiveness of schemes like Luna.
“Hyping tokens that are not supported by businesses that create value will destroy the entire crypto industry,” Ackman tweeted on May 16, adding that the industry should embrace self-regulation.
That’s not good enough. There are many players in crypto who understand that making the space safe and reliable is key to its long-term success. Accepting regulation as a way to bolster confidence in the entire proposition may be the only way to overcome the damage wrought by Terra and, let’s be honest, the other potential disasters still out there.
Yet regulation goes against everything so many crypto entrepreneurs believe in. The whole point of DeFi is to not need regulation. There’s the rub. But as crypto supporters reckon with the wreckage of their Lehman episode, do they have any other choice?
The masses won’t use DeFi if they don’t trust it.