🎙Terra Post Mortem and Future with Kevin Zhou, One of the Few Investors Who Predicted the Crash
Kevin Zhou is the founder of crypto quant fund, Galois Capital and former head of trading at Kraken. Last week, Terra, one of the most prominent ecosystems in crypto, effectively disintegrated in days. Its native token Luna had over $40 B in market cap at ...
Kevin Zhou is the founder of crypto quant fund, Galois Capital and former head of trading at Kraken. Last week, Terra, one of the most prominent ecosystems in crypto, effectively disintegrated in days. Its native token Luna had over $40 B in market cap at its peak, and nearly all of it was wiped out while UST, which was supposed to be a stablecoin worth $1 crashed to. It was a historical moment in crypto as never before had a project that big, crashed so hard, so quickly. Kevin was one of the few who saw it coming and predicted the fall just a couple of months ago. In this interview, he talks about the red flags that helped him get to that conclusion.
We also talk about whether there’s any hope for algorithmic stablecoins and explore potential alternatives for this type of asset. Kevin discusses the ripple effects we’re already seeing in crypto and more broadly, what to expect for the coming bear market.
Podcast audio and video was edited by Daniel Flynn and Gary Leuci. Transcript was edited by Samuel Haig.
🎙Listen to the interview in this week’s podcast episode here:
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👀 Only paid subscribers have access to the full interview transcript below.
Cami Russo: I’m so excited to have Kevin Zhou here, founder of crypto quant fund Galois Capital and former head of trading at Kracken to make sense of the wild past few days that we've seen in crypto. Kevin, welcome to The Defiant podcast, It's great to have you.
Kevin Zhou: Thanks for having me on, really excited to be here.
CR:Awesome. Let's start from the big explosion that set off this whole tsunami in crypto with LUNA and UST. I think we're probably witnessing a historical moment in crypto, I don't remember seeing anything of the… sheer magnitude of loss that we've seen these past couple of days, it’s really astounding to witness. I'd love to maybe start with taking a step back if you can just help guide us through what happened. What spurred this? You were one of the few people that actually saw this coming.
A lot of people said ‘well, it was obvious that this was unsustainable that UST couldn’t hold its peg forever’, but I have this tweet thread from you from back in March. I'll just read out one of the tweets from the thread, but I encourage listeners to go and read it because it's so precise. It says ‘if and when this goes south’ — talking about LUNA — ‘enormous amount of paper wealth will get wiped out, some people will literally kill themselves — as we have heard about — and regulators will come down so hard that the landscape won't even be recognizable anymore, stifling innovation for years to come.’ So that's a very scary prediction and at least the first part of it seems to be coming true. So to start, as I said, just taking a step back, what are some of the signs, the red flags that you saw that led you to believe that the Terra ecosystem was unsustainable?
The collapse of UST and LUNA.
KZ: Yeah, I think I first came across it [and] studied it fairly carefully sometime in 2021, and at the time it wasn't as big as it is today. I didn't think too much of it, I thought ‘oh, it's just one of these stablecoins that probably just will never work out’, but never paid too much attention to it. [I] then started revisiting it a lot more heavily in January of this year, at this point it had already blown up to such a big point that [it was] already a top 10 coin. So at this point, I started getting a little bit scared. I think before we've seen these kinds of algo stablecoins collapse, you have Basis, Based, Basis Cash, Ampleforth, ESD, DSD, Yams — the list goes on.
The latest one before LUNA was Wonderland (TIME). I remember being there for that collapse and there was already quite a bit of financial contagion, it spread across multiple assets. There were these protocols that were composed on top of each other that owned each other's treasury assets either directly or indirectly. Some of it was even farming on Anchor. That one we survived. I mean, we basically were able to get out of that one okay. But this… when I was looking at LUNA, I thought, ‘now that this thing is so big… an order of magnitude bigger than Wonderland, this could be absolutely devastating for the space. And I think some of it was me paying attention was also, of course, for profit too. I think there was a good shorting opportunity and I think there'd be a great play to be made there, but I think some of it also is that this thing is so big, it affects everybody. And I think it's important to sound the alarm and spread the word — so that's when I started very aggressively tweeting about it.
And it's around that time that you have all these fanatics, these ‘Lunatics’ in Terra LUNA ecosystem. They're just like the ‘XRP Army’, they're like the ‘Chainlink Marines’ — everybody's rapidly defending their protocol and attacking anybody who says anything negative about them. So a lot of what I was saying was getting drowned out because everybody was just slinging mud all the time. I had to weather a lot of sticks and stones, slings and arrows during that period of time.
But over time, I think eventually people started to see that what me and I think a couple others — at least a handful of us, maybe five or 10 of us on Twitter who were really aggressively sounding the alarm — I think finally crypto Twitter started listening a little bit more. Opinions started getting changed. Then, finally, that plus basically the changing of the narrative. And then on top of that, the compounding effect of the equity markets completely crashing just a couple of days ago and crypto being super correlated to equities… very strongly triggered this run on the bank.
And that's basically how everything started: equities crashed, the entire market crashed, and then basically when the market crashes, when we're looking at the mechanism of LUNA and UST basically as the market goes down, as the value of LUNA goes down, then basically what backs the UST also goes down — because UST stays at the same market cap, but LUNA's supposed to be backing it. So that's going down, and then all the external collateral that they had bought — the $3B that they had bought in Bitcoin — that also is losing value. So then people start to get scared. And at the same time, a tiny bit of money was starting to come out of Anchor from the reduction of the yield from 19.5 to 18%. It wasn't that much that alone [it] wouldn't have done it — a lot of these things alone, I don't think would've done it, But it's just a cacophony of these events, this coincidence of these kinds of events and the stars aligned and they basically triggered a bank run. And once that started, it only fueled itself. It’s one of those things that just keeps getting bigger and bigger, and spirals out of control. And basically now we're seeing hyperinflation with LUNA, and everything has just been taken down.
I also think some people might say ‘but what about the rest of the markets’? Well, I think a lot of what's going on is that you have these large firms in crypto, some of them funds who are maybe levered long LUNA or leveraged short UST. Somewhere along the way… they're just getting margin called as the price keeps dropping, and then they have to sell off all of their good assets, the non-toxic assets, to then cover their margin. And then some of them wound down their position and maybe they were okay, they only took some damage. But some double-down, and then they just keep selling all the good assets to double-down on their position to support a bad asset. And then some of them are just gonna get wiped out. So that's how I think a lot of that contagion spread to the rest of the market, just from a purely mechanical standpoint.
And then on top of that, there's also psychology — as people are risking off, then people start wondering ‘oh, what other risks am I not seeing? Maybe Tether is going to depeg too. Maybe we should short that thing, we should get out of Tether? Maybe Ethereum was not as sound as I thought, maybe Solana, or Avalanche are not as good?’ So then widespread panic starts to spread, maybe some of it unwarranted. But when people start thinking about [the fact] these massive losses are even possible from a top 10 coin, then people start getting really spooked. Because people have heard about like a CoinGecko page two, top 200 coin maybe going to zero very quickly. But this sharply and for this high of a market cap coin to evaporate, like double digit billions worth of value in a couple of days, now everybody is spooked about everything. That's also how I think fuel fear fuels itself too.
CR: Yeah, it was really so impressive to witness. I also think seeing that market cap flip between UST and LUNA, I remember being like ‘okay, now this will really trigger even further losses because there's nothing there, there's just not enough capital to back this’. And now with the huge hyperinflation of LUNA, it doesn't matter — you can print trillions of this, but if it's worth nothing, it's still never going to be enough.
LUNA was never solvent.
KZ: Yeah, [that] definitely is the case. And what I wanted to say is that the inflation is so bad right now in LUNA that I think it's a step beyond hyperinflation. I think it's the hyperinflation of hyperinflation, as in hyperinflation itself is accelerating. And it's because as you mint LUNA by burning UST — let's say the first clip you have to mint a million LUNA to do, then the next clip you have to mint a billion LUNA. To do the next clip, you have to mint a trillion, next clip you have to mint a quadrillion — soon things really get out of control. So not only is there hyperinflation, but there's accelerating hyperinflation on top of that, so I think it's a very dangerous time.
I also think that when you look at what happens at the very boundaries of all of this, which is that LUNA’s price is so compressed that it is now lower than a single tick above zero on an order book on an exchange. So for example, a tick might be [that] some exchanges use one penny as a tick, so when LUNA's value is below half a penny, technically it rounds down to zero, which means that there is no bid side liquidity whatsoever — it's a one-sided order book, there's only offers and there's no bids. At that point, even the UST, there's no longer even an incentive to inflate it further because none of the UST can even get its own value of a dollar's worth of LUNA. No matter how many trillions or quadrillions of LUNA equals $1, there's no way for them to even monetize that to get back the value that they have in UST. So that's basically one of the other things that I predicted, that in the final death throes of this system, what's gonna happen is that you're gonna get price compression so bad on LUNA that it's below a single tick, bid-side [liquidity] evaporates, and then everything left in UST is just bad debt.
Everybody before that could actually come out and do this arbitrage where the system itself still thinks that UST is worth $1 — the underlying system still thinks it so it'll give you $1 is worth of LUNA. But then, eventually, once all bid-side liquidity evaporates, then all of the rest of UST is just bad debt and it's worthless basically. So that's what I'm seeing. I saw earlier that UST is trading at many multiples of the market cap of LUNA, for sure there's gonna be some bad debt in there. It's almost a game of musical chairs to see who can exit first. And then everybody left holds the bag to zero on UST — this happens when LUNA liquidity evaporates.
I also wanted to just rewind a little bit and talk about something that you brought up which was pretty interesting, which is that you mentioned that there was a point during the crash... where the UST market cap flipped LUNA's market cap, and then it became very obvious that this thing probably was insolvent… If you look at a lot of my earlier predictions in my tweets, the claims that I made were that LUNA was very insolvent already before all of that, even when LUNA's market cap was four, even five times that of UST’s, it was already insolvent, it just [wasn’t] obvious.
CR:In what way?
KZ: I'll explain that a little bit… So when the market caps flip, then it becomes obvious. But it turns out, in my opinion, even before that it was already insolvent, even with a very high LUNA market cap. And the reason for this is because when you sell into the bid side of an order book, you incur slippage. So if you sell a million, you're gonna get a certain price a little bit below fair market value. If you sell a billion, you're gonna get much lower than when you sold a million. So with each successive sell of UST into LUNA, as you're unwinding let's say $18 billion worth of UST, each successive sell compresses the LUNA market cap by more than a factor of one… My guess at the time was very generously three to five, medium generously five to eight, and then a bit on the aggressive side, eight to 10 times of this multiplier effect of selling assets down and how much it compressed the market cap. It turns out historically, now that we've seen it play out, the rate was about eight to nine. So it was about the eight to nine ratio, which was on the very more extreme, more dangerous side. But in any case, generally, what that would mean is that you need eight to nine times LUNA's market cap [compared to the capitalization of UST] to sustain whatever UST's market cap is. So really, the whole thing was just an illusion that there was solvency, because they had created a giant supply sink for all the UST in Anchor with the subsidized yields at 19.5%. that's basically what my advocacy was, what I was saying isn't just that LUNA is insolvent, what I'm saying is that it was always insolvent and it was insolvent by a lot, even when LUNA's price was in the high eighties, [low] hundreds — it didn't matter, it was insolvent by a lot. And I think that's something that a lot of people would probably think that I'm a bit more on the extreme side, but that was my opinion at the time.
CR: So right now, I still see USDT has a market cap of about $4B. Is that what holders are now stuck with? Is that the losses that investors have to just write off?
KZ: I would say that LUNA's price right now is still between two and three cents, so they can still get some money out. The amount that they're getting out becomes less and less over time, and eventually there's gonna be some bad debt. How much total bad debt is left in the system? [That’s] hard to say right now. The market cap of UST is $4B, but that's at a price of $0.31. The amount of UST that's in the system is 11.7 billion of circulating supply — if that were [priced at] a dollar [per token], that's $11.7 billion. So out of where it should have been, how much bad debt is there? I would say, at this point, probably $7B to $8B, maybe $8B to $9B of bad debt. I think at most they'll be able to get out maybe another $2B to $3B through the hyperinflation of LUNA before complete buy-side liquidity evaporates.
CR: Oh my God, this is so tragic. I want to get your sense of who exactly [has been] left holding the bag. Are these retail investors who got in thinking that this was a saving instrument, that they were getting into something safe, a stablecoin, that they were pretty much guaranteed a 20% return? Or is it more crypto-savvy investors who maybe knew what they were getting into?
KZ: From what I've seen, at least [from] the rumors that I've heard, it's a mix of all of those folks. So you definitely have folks on Twitter who are just individuals, retail investors who just say they lost everything. Basically they lost their mortgage, they lost other savings — very devastating. And then you also have funds and investors on the professional, institutional side who will probably shut down from this event. There's gonna be some that completely blew up, and there's gonna be some that took on losses so big that they would not be able to continue their activities. So I think we're gonna see how that shakes out pretty soon. But I've at least heard examples… of both retail and institutional investors losing a lot of money.
CR: Wow! It's interesting what you were mentioning before [that] for the system to work, that you'd need to have a volatile token collateralizing the stable token with a market cap that is many times higher than that of the stable token — you were saying eight to nine times. If that had been the case, if LUNA had been worth a lot more so that its market cap was a lot higher, could this thing have worked out? I guess the more general question is do you think there is still hope for algorithmic stablecoins with maybe a modified type of design? Maybe if there was more underlying demand for LUNA, for the collateral asset? Are there things that can be done or would you completely scrap this idea?
Are algorithmic stablecoins destined to fail?
KZ: On your first point, I would say that instead of LUNA’s market cap being a lot higher, what I would say is it would've been way better, just to cap UST issuance. Like if UST only got issued out, instead of to 19 billion, maybe if it was like 10 billion…, or five billion — maybe that would've been a lot more prudent. It's very hard to say how high LUNA could have gotten if the market conditions were right or the feds didn't raise the interest rates… That's not something that the people in charge of TFL can really control, but you could have some soft cap on the issuance itself, either a hard cap or soft cap at five or 10 billion, or something like that. Or even say that the cap is literally what the market cap of the volatile asset is divided by eight or divided by nine, something like that. You could do it that way now.
I don't want that experiment to happen because I'm sure there are other weaknesses. I generally tend to think my opinion is that generally these kinds of algorithmic stablecoins basically are feedback mechanisms… that contract and expand supply through some mechanism. They're all the same, basically, when you reduce it down. At the end of the day, there's some point at which something causes it… to inflate when the price is too high and causes it to contract when the price is too low. It doesn't matter how many bells or whistles you attach to it, it doesn't matter how many feedback loops you go through, how many knobs and dials you turn to make that happen — ultimately, that's basically the idea, and everything reduces down to that idea.
So I just generally think that it can't work because, effectively, what's going on is that these guys are trying to play The Fed. But instead of having humans with economic models, they're using some predetermined algorithm. I don't even think The Fed works, so how can this stuff work when, first of all, it's like The Fed and The Fed doesn't work. And second of all, they can't force people to pay their taxes in their coin, and they can't force OPEC to trade oil in their coin. So they're basically like a fed with fiat money, but a very weak fed with one arm tied behind their back. It doesn't matter if you do open market operations, it doesn't matter if you replicate everything that The Fed does — it's just gonna be worse because you don't have those two pillars. And even then, in the long run, I don't think The Fed works. So that's what my thought is.
CR: Right. The idea there is that with The Fed and the U.S. dollar, at least there is demand for dollars. It's like you said… OPEC trades in U.S. dollars, it's the sovereign currency that backs external debt, and so on. But I wonder if something similar can be achieved with crypto if there was some sort of intrinsic demand for the collateral backing an algorithmic stablecoin. I think that's the core of the issue here, that there was just not enough demand for LUNA — people were selling it off in the market and things snowballed from there. But I wonder if there [could be] a system where there was more intrinsic demand for the underlying sister-asset.
KZ: What I would say is that there is something to be said about the demand side. As for the U.S. government, they're very powerful, they can throw their weight around, they can drive demand [towards] dollar hegemony. With these coins, they don't quite have the military strength in order to do that.
This is a little bit bleak, but if you'll bear with me on a thought experiment, suppose at some point one of these coins also founded a village in the physical world, and they had complete military control as war-lords over this community and they forced everybody to use their coin. Then yeah, that would be sustained demand. And in that sense, they at least have [one] hand not behind their back… The other half is that you need it to be accepted in international commerce. So you need to be able to get other villages to accept your token and your coin for something in which everybody demands, something like oil, for example, that everybody would need. Right. If you could do that within this community of villages and in your village, then your village probably could make an algo stablecoin work for some time, maybe a hundred years or so.
Can DeFi flourish without decentralized stablecoins?
CR: Okay, for all of that to happen, it’s probably so far-fetched that it's probably not gonna happen. So what about other more decentralized stablecoins, because some of the fall-out that we've seen from this is a complete loss of trust in, obviously, all algorithmic stablecoins, but as you mentioned before, even in Tether — which is at least partly backed by fiat. I've seen DAI maintain its peg, but I also saw DAI’s supply really plunge in the past couple of days. So people are getting out of DAI, and DAI is collateralized and backed by digital assets. So, to you, is there hope for a more censorship-resistant stablecoin? Or is really the only model that will work over-collateralized… or backed one-to-one with fiat? Is that the only way? And if yes, that would mean that there's not much hope for a truly decentralized DeFi if one of the core components is stablecoins? If we rely on fiat currency to back our stablecoins, then the system is not very decentralized at its core.
KZ: So before I say anything there, I just want to say that I'm a big fan of decentralization. So I would very much like for there to be a truly decentralized stablecoin. But at the same time, I want to be realistic, and I don't want to… try to believe… just through hopium… that a malconceived contraption will work. And in trying to be realistic about it, I just don't think that is possible. I think it's basically the analogy [to] The Fed. You can mimic open-market operations, you can mimic control over interest rates, you can mimic all this stuff, [but] I think it's just a bit too difficult.
That being said, I think that even without a decentralized stablecoin, there are still some elements of DeFi which can work, and they can work in tandem with centralized stablecoins like Tether and USDC. You can also work with other types of decentralized stablecoins like the Maker or DAI model if it wasn't already so centralized in [that] the backing is already so much USDC, but something like that. Now, that's not very capital efficient because anytime you have to over-collateralize you're actually doing a lot of balance sheet contraction. You can't grow as fast, but it is more sound. And I think, of course, there are still risks there and it wouldn't just say ‘oh, that's the perfect model’ either because you still have ‘black-swan’ risk where if the price gaps you could just be underwater on your collateral and you could just walk away from your collateral. So then there are situations where if the price drops too quickly, people will walk away from their bad debt and then the bad debt stays within the system. Then there's ways of recovering it, but then you have to print MKR — there's all sorts of stuff there. But then we start to enter into a world where a system has bad debt and needs to inflate a volatile asset in order to shore it up. But at least this is much more sound than a pure algorithmic stablecoin because you have that collateral there. And it really requires a real three sigma, four sigma event, maybe even five sigma event for something really bad to happen, and I think that probably should suffice given that the holding period for holding stablecoins for a lot of use cases may not be super high in that it's an intermediary liquid and intermediary between other assets that you want to hold.
So I definitely think that there is still a lot of hope for DeFi and some collateralized stablecoins, even slightly under-collateralized stablecoins I think maybe are okay. But not even close to the level that we've seen with LUNA and UST — the ratios were just way too off.
Does Tether pose systemic risk to crypto?
CR: What about Tether? We did see it depeg a little bit, and I think from the NYAG investigation and other documents… it's at about 70% collateralized, like actually backed by fiat and I think other [commercial] paper, and so on. Do you think that's enough? It seems like people were losing trust in the level of collateralization that Tether has. Do you think, going forward, that'll be an issue?
KZ: I think that it's mostly fine for now, but I want to caveat that and say that there's a lot of nuance… First of all, if they're holding some stuff like corporate bonds or commercial paper, or dollar-like instruments that are not perfectly liquid like the dollar, then it may be taking on a little bit too much risk and maybe it shouldn't be done that way. But what I would say is that that's still a lot safer than just backing it with a completely volatile asset. At least these are more dollar-like instruments.
Now, that being said… we don't have to call it a stablecoin, we could just say that it's a basket of its underlying. So we could say that this is basically worth 60% cash, 20% corporate bonds, 20% commercial paper, and that's basically what you're actually holding. And roughly, most of the time, it functions like it's a dollar, but intrinsically we understand that it's a basket of these three different assets. So that seems perfectly fine, as long as it's transparent, that's what this thing is right now. If you want to call it a pure cash backed stablecoin, well then you gotta back it with cash. But if you wanna call it like a ‘stable-ish coin’, that's 99.99% gonna function like cash, but sometimes may just completely just get wrecked, then you call it a basket.
I think as long as there's transparency and the market has the option, then different people are gonna choose different things. Maybe earn a little bit more interest when you have some commercial paper in there, I think that's fine. So it's just whatever people want now. In Tether’s case specifically, what I want to say is that I think they did a lot of shady stuff in the past, but that being said, I actually do think that they're fully backed.
I think they're actually over-collateralized at this point, because one of the things that they did that they shouldn't have done is they actually went long Bitcoin using the funds that were supposed to be sitting in dollars. But they did it at a time when it was a bull market, so they accidentally made money and accidentally made it more than over-collateralized. Now, maybe they pocketed most of the profits themselves. Maybe the Tether company pocketed most of the profits themselves. But I imagine that they would leave some extra buffer there just to make it a little bit extra collateralized. Or maybe they just left all of it in there. So that's one thing they really shouldn't have done. That was very shady of them, I think. But they ended up getting lucky, these guys just keep getting lucky all the time.
The other thing they shouldn't have done… — so both Tether and Bitfinex are both owned by Ifinex, which is the holding company — they shouldn't have given Bitfinex a loan for $800M, or something like that, way back in the day, because Ifinex got their money stuck in a scam called Crypto Capital. So they were short on customer deposits and they needed to shore that up, so they borrowed money from their sister-company. This is completely taboo, is completely incorrect, [they] definitely should not have done that. And then when they got caught, they dug themselves out of that hole. They got lucky again, because then they're like ‘okay, we're gonna do fundraising for LEO token, we're gonna raise a billion dollars, plug that hole, and then give the money that we took from Tether back. So technically, I think Tether should actually be whole right now, unless they've also done other crazy things that we haven't discovered yet. For the most part, I actually think they're pretty well backed. But that being said, they need to cut out all the shady stuff. They need to stop doing the shady stuff that doesn't inspire confidence.
There's two trades that people really love. The first one is to short Tether, that's like the first thing they do when they come into this space. Second thing they do, and this is back when the Grayscale trade was still alive, they like to do the Grayscale play. So those are the first two things anybody ever does from TradFi coming into crypto. I don't want to be the bearer of bad news, [but] I don't think it's that great of a time to short Tether. I mean, should it be trading at $1? Well, maybe not, maybe like $0.99, maybe $0.999, I don't know. But I think, for the most part, I'm pretty comfortable with it right now. I'm not looking to short Tether right now.
CR: That's hilarious. I think first you're totally right on the idea that it should trade more like a basket, and I think the key there is transparency. If we all knew exactly the things that Tether was holding, then the market would be a lot more efficient in pricing it, and it wouldn't just be based on speculation like it was in the past few hours. And maybe you're right, maybe they are fully backed. But the real issue is that we can't know because there's not enough transparency, and we need to rely on these reports that they publish every few months. It’s just not the right way of inspiring confidence in something that is really core to crypto. It's by far the largest stablecoin in the market, everything trades against it. And it's funny, you're right, it's been anticipated and predicted that Tether would be crypto’s black-swan event, and that it would be the stablecoin that would drag everything down, and maybe crypto would end after Tether’s collapse. But it just keeps reviving and going. And then we have this real black-swan with LUNA, and it really did collapse and actually almost got to zero in a couple of hours or days. So yeah, that ought to [indicate] that it's incredibly hard to predict these things. Like, you think Tether is the obvious black-swan event, but then this other thing comes out of nowhere. Speaking of shorting… were you short LUNA when all this happened?
KZ: I can't comment on the specific positions of the trading desk right now because some of it is still active, so happy to share that later on once the dust settles. But I will say this, which is that we have definitely been short through most of the crash, and not too big in size, but not too small in size.
CR: Interesting, okay. Well at least it paid off to predict and see these red flags in LUNA. I'll definitely want to follow up… on more details on that trade… once the dust settles... So now that we're in the middle of this, what are some of the interesting ripple effects that you're already seeing in the market?
Can a pluralism of centralized stablecoins offer the benefits of decentralization?
KZ: I think mostly it's just [that] you're seeing a lot of this like contagion spread to other assets. But I also wanted to say, one thing that you mentioned… which is interesting about Tether, I want to draw the comparison of Tether to like USDC, for example. As of right now, I personally trust USDC a little bit more than Tether… It's a little bit more, it's not a lot more, but maybe USDC should be at $1 [and] Tether should be at $0.999, or something like that.
And I think that the market trend has generally been in this direction. Way back in the day, Tether was completely dominant and USDC was just starting, a new fledgling stablecoin. And now USDC is more than half of Tether’s market cap. So clearly the market is also responding to the risk, but they're not responding through the price of Tether, they're responding through the supply of Tether relatively going down and the supply of USDC relatively going up. So what I imagine might happen at some point is that if almost all of the value starts migrating to USDC, there's some balancing equilibrium point in which you want to not have all of your stablecoins in one basket. But if Tether was only one tenth the market cap of USDC, I feel like more people would then want to hold Tether just to diversify their risk because there are some risks that are implicit to SDC that are not implicit to USDT, which is about being in the U.S. regulatory environment. So there might be more fear that Tether is backed, but there might be more regulatory fear of USDC getting frozen at some point. So I think there's a natural balancing point between the two, and it forms a little bit of a duopoly. Maybe there's room for a third, but it forms, at least for now, a duopoly, and there's some natural balancing point. It may not be 50/50, maybe it could be 60/40, or 40/60, or any ratio, but there's a natural equilibrium for that in which they both survive and do fairly well. And that's, um, basically where I think things are gonna go…
On the topic of having a decentralized stablecoin, another alternative is just to have many different kinds of centralized stablecoins. By the time you have hundreds of USDC-type stablecoins located in all various jurisdictions across the world, every country has their own version of Tether or USDC, then at that point, you can be fairly sure that there's some solvency there. Buyers and sellers get to pick and choose who they want the issuer to be, there's competition between them. The local governments don't always agree with each other, so not everybody's gonna coordinate and freeze everything at once. So you get a little bit of the value of decentralization just from having more of these things.
CR: That's a great point. I guess the question there, or the issue there, would be on liquidity and volume. If you have a fragmented market, that's also dangerous and not very useful for big traders, right?
KZ: Yeah, I completely agree… Maybe what I was saying about having a hundred actually doesn't make sense. Maybe it really should just be like two, three or four. There's some point at which more gives marginal value, and there's some point in which more creates too much stress on the fragmentation. So maybe the natural point is like three or four, something like that. But that would still be a good trade-off between safety and concentration of liquidity. There's some natural equilibrium point.
Could Terra’s collapse impact the broader economy?
CR: And then on the topic of ripple effects [from UST], someone called this crypto’s Lehman moment, and in the 2008 financial crisis, there was huge contagion everywhere in markets. So I'm wondering, what areas in crypto do you see [as being] the most susceptible to being affected by this? And further, do you think that there's a chance that this spills over to the real economy? Maybe because of what you were saying before that some of the people affected from the Terra collapse are retail investors who put their savings in, does that have a big enough impact to actually affect the real economy? Or is crypto too small?
KZ: I would say crypto is still too small for that. And thankfully UST didn't get up to a trillion in market cap, because then things start really getting affected, so [it’s] good that it wound down now. I mean, preferably even sooner than now. But yeah… I don't see that happening.
What I would say is that in terms of contagion, I don't particularly want to cast dispersions on any individual projects for the most part. If you look at my Twitter, I've only ever said negative things about basically just LUNA and UST. For everything else, I try to be diplomatic within the space, and I understand that there's experiments to be done.
I think, for the most part, I'm even okay with people building casinos too, because I think a lot of people just like to gamble and if people want to play their dumb money games, then they should be able to play their dumb money games. I just thought that this one in particular was just too big. So as much as there are projects that I actually don’t particularly like, that's just a personal dislike and I at least respect that. Some people do like them and don't want to particularly flood their bags or anything like that. So to each their own. Hopefully we don't get something as systemic, as bad, as uniquely dangerous as LUNA UST.
CR: Do you see anything else that could potentially match it?
KZ: No, I would say it hasn't really emerged. What I would say is that if… most of the backing [for] Tether or USDC was… gone, that would be also extremely devastating. But I put the chances of that happening much, much lower than LUNA UST. I think for LUNA and UST, it was just apparent that eventually… this would happen. For the others, it's more opaque, so it's harder to say it's not an inevitability.
Will macroeconomic forces dictate performance of the crypto markets?
CR: Got it. Right now, the market is just a complete bloodbath. It's just crazy going to any market tracker, everything is red. Do you think we are at the beginning of a prolonged crypto-winter like we saw in 2018 - 2019? Or do we bounce back? I mean, there just seems to be so many macro headwinds… playing into this… as well, so it's looking very bleak out there. I'm wondering what your thoughts are?
KZ: So I basically have two things to say about that. The first is about crypto specifically. So let's say this was back to a very normalized 0% interest rate policy, back to the good old days of The Fed, but no extra money printing — just a very normalized 0% interest rate environment… A lot of these cryptos’... market caps have come down quite a ways now. For the most part I think [we’re] in a pretty good spot now. That being said, the narrative is so bad and the fear is so bad that it'll take some time to adjust… I was originally thinking that LUNA would blow up later, so I was thinking like nine months from now. I [would] think maybe like six months of just going sideways before a bull market. But that's under a normalized macro environment.
We're not in a normalized macro environment. As you can I'm sure you've seen, the equities and crypto are very highly correlated these days. And there's also a feedback cycle there because as the correlation is very strong, then basically all these quant shops develop these models showing ‘hey, look in the past, correlation has been really strong, so we should run this correlation algo’. And their correlation algo [trading] between equities and crypto forces the correlation even tighter, which causes the signal to be even stronger for other people to discover, causing them to build correlation algos, and so on and so forth, until things get really tightly coupled, and then finally something snaps because they're actually not the same. Then there's a huge decoupling… I went on tangent, but until that [decoupling] happens, crypto is still fairly correlated to equities. Maybe this LUNA thing is the depegging event or the decoupling event. Unfortunately it's not as crypto people wanted and it decoupled upward, [maybe it] decoupled downward. But we'll see if it actually was the decoupling event. But until that happens, I think macro still is the most important thing.
I want to just caveat [and] say that I'm not an expert at macro, so these are just my opinions. But I think basically given where the CPI is printing at like 8.5% percent, real rates are still negative, and The Fed is basically saying that they're gonna maintain the course of doing that double rate hike, and then probably another one afterwards, and so on and so forth…
What I would say is that [The Fed has] to go a long ways to abate this core inflation. I don't think they make it there, I think at some point they just give up because generally, if you look at the historical Fed chairmans like Greenspan, Bernanke, folks like that, there's always like a put right on the market when the market drops by 20%, 25%. There's enough turmoil that The Fed then steps in and then eases up and becomes dovish. This time around, because inflation is so bad, I think politically, they would have to wait until maybe 25, 30% before doing something like that… I think, so far, it's been just shy of maybe 20%, something like that. So there's a little bit, another 5% to 10% of a drop to go in the market before The Fed exercises that put… I think they're basically gonna keep raising rates until something like that happens or something just catastrophically bad breaks in the economy, and then they reverse course. But I don't think they make it all the way up to the point at which inflation is actually abated.
So what my thought is that maybe around like 1.5%, 2%, or something around there, the markets tank too much, it's too much pain [and] The Fed gives up and reverses course. And then we just slowly die by paper cuts through inflation, because whether you die through the market destroying value or whether you die through your money inflating away, at the end of the day, most people prefer the gentler approach there. And it's more invisible too, so it's easier to hide it, or to obfuscate it, or to blame it on foreign powers, or whatever. I mean, I don't know, [they will] just do whatever they're going do, what they need to do, and they're going to call it the best of names… That's what I think happens.
CR: That's so interesting. So you think that The Fed is not going to go through with hiking rates enough to really push inflation down. I mean, maybe they do it until inflation comes down to maybe 2% - 3%, but by that time you think that the fallout in the market will be too big, like maybe a 25% drop in equities that politically is too difficult for The Fed to actually continue on its course. And by that point, they stop hiking rates and then just [allow] inflation at whatever rate… at that point.
KZ: Yeah, that's basically my thought. And I think they're really caught in a hard place because politically inflation is very hard to bear, and politically huge market drops and wiping out like retirement savings is also hard to bear. So if they're going to have to choose one of the two, I think they're gonna take the easy way out and they… choose inflation. That's what my thought is.
CR: If that happens, though, it would seem that's a better outcome for crypto because narrative-wise crypto is meant to be a protection against inflation in fiat. So if we see this situation picking up again where the U.S. dollar is inflating, the crypto investors and advocates can say ‘okay, go get out of your fiat and buy Bitcoin or buy ETH, or whatever.’
KZ: Yes, I completely agree, I'm extremely bullish on crypto in the long term. And that's also part of the reason that I literally dedicated almost my entire career to crypto.
CR: Do you think this plays out this year [and] we started seeing the return of this ‘inflation-hedge’ narrative?
KZ: I want to say yes. I mean, who knows really, but if I had to guess, I think it would.
Crypto’s market cycles.
CR: Okay. So to you, looking at this bear market and 2018, what are some of the bigger differences? [Does] the whole ecosystem look like a completely different market and industry? What are the aspects of the crypto market in this bear market that will really make things different this time around?
KZ: I think most of it is actually the same after seeing five cycles already. Every time it's basically the same, at some point there's just too much euphoria [and] mania, people get greedy. Basically too much capital chases too few good opportunities because all the investors need to put the money to work, and as things start working, they get even more capital [at] even greater orders of magnitude… So then supply comes to meet demand and basically all these projects start coming up with all sorts of random, crazy ideas, and they can still get funding because the investors need to fund somebody. And then, finally, there's a collapse because obviously if you have just random, terrible projects, that's not gonna push the space forward. Eventually the emperor's revealed to have no clothes [and] the market crashes.
Then there's a cycle of digestion as capital dries up. Then, finally, during the bottom of the bear market, now you only have true believers who are actually building in the space, and they make really, really good projects. Project quality goes really, really high, almost nobody wants to fund them because there's no capital sloshing around, but it's actually the best time to invest [when] most people are not interested in investing. And then that builds out and leads into the next bull run. So it basically always happens the same way.
Now, that being said, I think there are maybe a few small differences. What I would say is that in the ICO crash of 2017 to 2018, for the most part, most projects were not as intertangled with each other. So you have some good ICOs, you have some bad ICOs — mostly they were bad, but they failed on their own. And then whoever held, they lost money. This time around, because of the advent of DeFi, now everything is super composed with each other, everything is intertangled with each other. There's a lot more systemic risk. So one blow up could start affecting multiple protocols. the token prices of a lot of different tokens start to become correlated with each other because of this intertwining and entanglement. So I would say that's one difference.
I would say that another difference would be that things are a lot more mainstream now than they were, and even then, that was more mainstream than 2013. So as more and more people come in, the kinds of things that they want to see and the products that they want to use will start to be very different from what the early adopters wanted to use and what they enjoyed. So I think every cycle in a way creates new products, which blows the ocean further out to the general population, [the] quote unquote normy audience. I think that this is a natural course for crypto, I don't think this is a bad thing at all. I mean, this is basically the road to mass adoption, and this is just going to happen. But what I would say is that you can notice… differences between the types of projects and who they were marketed to, what they do, the product design and everything. And you can see that in each of the cycles. As it becomes more and more mainstream, the products themselves become… more mainstream [in flavor... And I see that trend continuing through the next cycle[s] until it's just fully adopted.
CR: So interesting. I definitely saw this sea-change in the past year where crypto finally felt pretty mainstream, or at least not niche anymore. It was something that you could tell anyone on the street [about and] they will have heard of it, especially with NFTs. Clubs in Miami were distributing them out to regular people, big brands [were] adopting it to the point where it was not news anymore — something that in 2017 would've blown people's minds, like Nike selling NFTs... So I agree that this cycle was just spectacular in terms of mainstream adoption. But yeah, maybe we're at this point where there was too much hype and euphoria, and now it's that part of the cycle where the good projects stick around [and] the rest go. And I think it's a healthy shift in the market for sure.
KZ: Absolutely. We're basically going through a process of digesting misallocated capital.
Surviving a bear market.
CR: In this process, what's a good place for investors to take cover? I mean, is it going to the safest stablecoins? Earning a little bit of interest holding Bitcoin and ETH, or like a basket of blue-chip cryptos? What would you recommend?
KZ: I think you just buy whatever you want at the end of the day. I don't want to shill long or short any particular coins because I think that would be a little bit irresponsible. But what I would say is that I'll basically sort of repeat what I heard from [Stanley] Drunkenmiller as he was talking about the stock market. What he was saying is that he wanted to buy assets which were boring companies, but which had good cash flows and a lot of pricing power. So, for example, I think he bought into this door company, they make doors right — a very boring business, but they have a huge market share. I don't know if they're a full monopoly or they have one of two duopolies, but basically they have immense pricing power. So they can pass on a lot of the price inflation to the consumer. And then on top of that it's not like some thousand XPE multiple for tech stocks or something like that, it's value is not coming from expectations of growth. Its value is coming from a very modest multiple as a discount to the cash flows that it generates. So I think that is a prudent and sound way of thinking about things. I think some people would agree, some people disagree, but I think the reasoning, at least if you believe that paradigm, is sound. And I think in crypto, there may be some projects which are more like that, and some projects which are more the opposite of that.
CR:So projects with actual revenue, or protocol fees, or whatever you wanna call it — actual users and activity happening [and] sustaining its value more than just expectations of some other thing being built?
KZ: Yeah. And I would say particularly where the revenue eventually goes to the token holders through some buy-and-burn mechanism, or some other type of mechanism — it goes to them so that they're able to capture the value of it. Now, I don't want to preclude pure governance tokens because I think there's still an expectation in pure governance tokens that they will, at some point, be able to vote themselves the fees generated by the protocol. So I think there is still some future expectation of cash flows, but I would say that… it’s just not a great time [for] protocols which derive their value from future expected growth.
CR: What about staking tokens and Proof of Stake protocols? Is that something that you're bullish on?
KZ: What I would say is that with Proof of Stake and with staking, what exactly is going on financially when you stake? So if everybody stakes, then everybody gets the seigniorage, and then everybody still has the same share of the network. So effectively then the amount that you get in staking combats the inflation exactly, that happens on the supply side. So nominal yields are positive, but real yields are actually zero right now. Let's say nobody staked except for one person, then that person collects all of the yield and gets zero inflation — he faces zero inflation because the only inflation he faces is the new money that he gets, he captures all of the seigniorage. So then the real yield for him is what the nominal yield is right now in practice. Not everybody's gonna stake and not just one person is gonna stake, but it's gonna be some mix of the two, and effectively what is going on here is that you're gonna get some real yield between the nominal yield and zero.
Where does this real yield come from? It comes from the non-stakers. So it's effectively a transfer of value from the non-stakers to the stakers. Now you might ask ‘why would someone be willing to be a non-staker and just transfer this value on to all the stakers’? Well, maybe they have other productive uses for the capital not being staked. Maybe they have this yield farming strategy, this trading strategy, or this and that — they have some productive uses for it. So, in my opinion, the market basically figures out an equilibrium where some people will stake, some people won't, and both will get exactly what they're looking for. That’s what my thought is on staking [and] the financial aspect of it.
CR: That's a super interesting way of looking at it. So I guess it depends on the amount of risk that you want to take. Do you maybe want that lower yield from staking, or do you want to use that capital in some other productive protocol, token that might get you a higher return?
KZ: Yeah. I mean, it's obvious in the extreme case, because if everybody staked and there was no liquid moving supply of this token, then at the end of the day that the network is not very valuable. So the marginal person who can figure out some use of it can basically benefit greatly, and there's basically an incentive for at least somebody to not be a staker. And then if nobody's a staker, then there's an incentive for one person to be the staker because they collect all of the seigniorage. So the whole thing balances out at some point in the middle.
CR: Cool. And then just for an overview of your position on the market going forward, are you long crypto at the moment? Or just like taking chips off the table? Are you in cash? If you can give a little breakdown of where you stand?
KZ: So there's two reasons that I don't want to give my opinion on this. The first reason is that our fund positions are private and generally I like to keep it that way. And the second reason is that I don't like the idea of influencers going on podcasts or shows… and shilling things that they're holding, shilling their bags, or shilling their short positions. So I don't want to be in a position where we already have a position on and then I'm letting people know so that they can come behind me and make my position profitable. So I just don't want to be in that position where there's that conflict of interest.
CR: Okay, that's totally fair and understandable, it's a great point. Okay, and then to wrap up, I'd love to ask you, Kevin, how or what makes you defiant?
KZ: What I would say is my hair. At some point in my life, I just started growing it out long… and I just didn't give a fuck anymore. So that's what makes me defiant, I guess.
CR: Awesome. I guess that does say something about your personality, I think a hairstyle is a reflection of that. This was so interesting, Kevin, thank you so much for helping me make sense of the past couple of days. I know that we'll look back at this time and have our minds blown at what happened and how much crypto changed from this. I guess we'll still need the dust to settle to take lots of valuable lessons from what just transpired. So thank you so much again for coming on the show, it was a pleasure.
KZ: Likewise, it was a pleasure. Thanks for having me.