The start of May was characterized by turbulent times for the financial market. While the market originally seemed to recover after the expected interest rate hike by the Fed, this was quickly followed by a sharp capitulation. This downward movement was largely driven by the announced interest rate policy and monetary tightening by the US. In the cryptocurrency market, this move was accelerated when stablecoin UST lost its peg with the US Dollar.
On May 4th, the Fed’s FOMC meeting took place. As we pointed out last month, most of the market had already prepared for the interest rate increase. When it fell in line with expectations, a 0.5% increase, the market reacted with some relief. This move was further incentivized when Jerome Powell, Chairman of the Fed, stated that he does not consider increases of 0.75% for this year.
However, the Fed formally announced its plans for monetary tightening and indicated that it expected several rate hikes during the rest of the year. As a result, the Fed’s stance and the most rigorous tightening since 2000 quickly undid the upwards move and caused the market to continue in the downward trend. Although there are some indications that inflation in the U.S. is slowing down, a less hawkish stance by the Fed isn’t around the corner yet.
The drop in the cryptocurrency market was accelerated when stablecoin UST lost its peg to the US Dollar. This also led to the downfall of Luna, the cryptocurrency used as collateral for UST.
UST is an algorithmic stablecoin that, as the name indicates, uses an algorithm to maintain the value of 1 dollar. When the price of UST falls below 1 dollar, 1 UST can be exchanged for 1 US dollar in Luna. This mechanism continues until the price of 1 UST equals 1 dollar. For Luna, this causes an increase in supply and therefore a price decrease. If there is a strong increase in demand for UST, the value of UST rises above 1 dollar and the mechanism works the other way around.
UST and Luna both experienced strong growth in their early days. However, their growth accelerated when Anchor Protocol, a savings platform that promises a stable 18-20% return on UST, was launched. The demand for UST grew exponentially and Luna’s price grew along with it.
Over the past few months, we have seen question marks rise surrounding the sustainability of this model. The interest reserves from Anchor were structurally declining and it was still unclear whether this new technology was able to maintain the $1 value of UST.
This week, the latter became painfully obvious. At the beginning of the weekend, exceptionally large sales of UST took place. As a result, its value fell below 1 US dollar for several hours. In order to get UST back to its peg, the increase in supply was countered by the exchange of UST for Luna. Therefore, the supply of Luna increased leading the price to fall.
The decline of both currencies led to further panic which eventually caused a downward spiral and a true bank run. In just a few days, the funds stored in Anchor dropped from over 14 billion dollars to well under 2 billion dollars. In a matter of 4 days, the price of Luna dropped from $60 to $0.004, whereafter Luna’s blockchain was halted and exchanges suspended trading. Below you will find the price change of both assets visualized in percentages.
Over the past few months, trust among users has been declining. To counter this, Luna has been building Bitcoin reserves. While this initially led to positive reactions, it also raised legitimate concerns. To maintain the 1 dollar peg, Luna started selling their Bitcoin reserves.
This additional selling pressure on Bitcoin led to a lower price of Bitcoin which eventually took the entire cryptocurrency market with it. As previously mentioned in our Anchor Protocol report, this downward spiral was a known risk. This was one of the reasons why the Hodl funds did not invest in Luna and UST.
Investors who have been part of the Hodl funds for a while have experienced a moment of market capitulation before. Almost a year ago, the ban on Bitcoin mining in China caused a lot of panic in the market. At that time, we repeated a well-known quote from Warren Buffet:
“Be fearful when others are greedy, and greedy when others are fearful.”
According to the Fear & Greed Index, “Extreme Fear” prevails in the market. In our opinion, this is an interesting opportunity to start investing in cryptocurrency. Learn more about becoming an investor in the Hodl funds on our Becoming an Investor page.
In this blog series on investing in cryptocurrency, we dive deeper into topics such as the evolution of our money, the origins of cryptocurrencies, the various applications of this new technology and the underlying differences.
In the second chapter, we talked about the rise of Bitcoin and how it has been able to develop over the years. By now, the market has grown far beyond Bitcoin which has greatly increased its applications. In this third part, we take a closer look at the different cryptocurrencies and how they affect traditional industries.
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