5/10/2022 | Domain Money Advisors | Investment Memo |
Over the last three days, Luna fell 73% from $75 to $20 as of writing. Given the magnitude of the move in LUNA, the DM Advisors Investment Team is issuing this update on what occurred and their view on the asset going forward.
Luna is the native cryptocurrency of Terra, a smart contract protocol purpose-built by Terraform Labs to support stablecoins. Given its growth and large market potential, Luna is a holding in select managed portfolios.
UST, the flagship Terra stablecoin, is pegged to the U.S. dollar and is the largest decentralized stablecoin as measured by its market value of $16.5B. While many stablecoins like USDC and USDT are backed by reserves, UST is not fully backed by reserves, and instead maintains its peg to USD through a series of incentives and arbitrage bounds, a mechanism that allows it to be widely referred to as an algorithmic stablecoin.
The sharp decline in Luna was in response to the value of UST falling below $1 and the market weighing the possibility that UST could fail.
On Monday 5/9, amid a widespread selloff in stocks and crypto, UST fell below its $1 peg to USD. The selloff in UST was likely triggered by the aggregate market cap of Luna falling below the aggregate market cap of UST. During the period of selling, UST reached a low of $0.6879 before climbing back above $0.90, where it currently trades.
As an algorithmic stablecoin, UST attempts to maintain a peg to the dollar via a mint-and-burn process. The process incentivizes creating or destroying Luna in transactions that ensure 1 UST is always worth $1.
However, to protect the value of Luna and avoid overprinting, the mint-and-burn mechanism has built-in speed bumps. As UST’s value quickly dropped, these speed-bumps slowed the ability for market participants to perform their usual arbitrage function, which serve to normalize UST’s price to the dollar. As a result, for a number of hours on 5/9, UST traded at a substantial discount to the dollar for a prolonged period of time. Once the buffers were relaxed, UST climbed closer to the $1 peg.
While the price action of UST was unprecedented, the protection mechanism worked as designed during a period of heightened dislocation. While we certainly think that Terraform labs has a lot to learn from this experience, we do not have reason to believe that UST has failed beyond recovery.
That said, this is a dynamic situation and our team continues to monitor as the story unfolds.
Terra is a universal platform for payments, credit and investing, open to anyone in the world and built around UST. Over the last year and a half, Terra grew from a cold start into the second largest crypto ecosystem, a statistic that has been maintained despite the recent setback.
The goal of our crypto strategies is to hold a basket of high quality cryptocurrencies that we believe is positioned to provide substantial returns on a 3-5 year horizon. If Terra succeeds in creating a viable alternative to legacy financial infrastructure, the total addressable market for UST is trillions of dollars of value. Accordingly, at current valuations, we think that Luna provides attractive risk adjusted returns for investors with a long term perspective.
We believe that Terra has the ability to regain the trust of its users and emerge stronger. However, the road back will be long and substantial improvements will need to be made to Terra to shore up confidence. In our view, one of the most important initiatives for Terra is to create more use cases for UST. Diversifying use cases will reduce the likelihood of all users of the protocol trading UST in the same direction at the same time, thereby reducing the possibility that UST becomes unpegged.
We have decided to hold on to Luna in our portfolios, carefully watch the situation, and reassess this decision as we get new information. After the price decline, we now hold Luna with a modest weight in our strategies and think the risk/reward tradeoff of retaining the investment makes sense for our clients.
This information is provided for informational and educational purposes only. Domain Money Advisors, LLC (“DMA”) is an investment adviser registered with the U.S. Securities and Exchange Commission and an affiliate of Domain Money Inc. (“DM”). The information contained herein is not investment advice nor intended for any investor or type of investor and does not constitute an offer to sell, a solicitation of an offer to buy or an offer to purchase or sell any securities or cryptocurrency, or investment product or service. While DMA believes that the information contained herein is reliable and derived from reliable sources, it makes no representation, warranty or undertaking, stated or implied, as to the accuracy or completeness of the information. DMA and DM expressly disclaim any liability or loss incurred by any person who acts on the information or ideas discussed. Investing comes with inherent risks and volatility and you should always invest within your means and risk tolerance. No representation is made that any investor will achieve its objectives or will make any profit or avoid losses. Past performance is not an indication of future returns and you should always consult a financial advisor prior to making investment decisions. Cryptocurrencies involve exposure to higher volatility. Please see important disclosures at https://domainmoney.com/legal
* Domain Money Advisors, LLC, an investment adviser registered with the U.S. Securities and Exchange Commission and an affiliate of Domain Money, is currently recommending the following assets contained in this communication as part of Managed Strategies: LUNA
*Important disclosures: Price and market information is sourced from Yahoo! Finance, Coinmarketcap.com and DM Advisors analysis.