"Stepping down from the altar": What reflections did the top institutions that invested heavily in Terra have afterwards?

Introduction: Luna’s market value dropped from tens of billions to zero in an instant, and just a few months ago, it completed a $1 billion round of financing led by Jump Crypto and Three Arrows Capital, with participation from Republic Capital, GSR, Tribe Capital, DeFiance Capital and others.

The world's top quantitative institution Jump, the crypto-new capital Three Arrows, South Korea's top crypto VC Hashed, and Delphi, known for designing economic models, are jokingly called Terra's four guardians. Galaxy CEO Mike's tattoo of Luna has become a joke.

Currently, Galaxy Delphi DeFiance has published an article to elaborate and reflect on this matter in detail.

A letter from Galaxy CEO Mike Novogratz :

My tattoo will serve as a constant reminder that venture capital requires humility.

To our shareholders, friends, partners, and the cryptocurrency community:

Over the past week, I have been reflecting on the economy and macro markets, our industry, and Galaxy's place within them.

There is no good news in the markets or the Terra ecosystem right now. Between Luna and UST alone, $40 billion in market value was destroyed in a very short period of time. Investors big and small saw profits and wealth wiped out. This crash has eroded confidence in crypto and DeFi. Whenever money is lost in such an abrupt manner, people want answers. I will try to provide some insight into the ongoing discussion.

First, it is important to know that cryptocurrencies are open source. Information about most protocols is transparent and auditable in real time. Cryptography has always been about the free exchange of ideas, with unrestricted access to data and real-time information. Regarding Terra/Luna, it is important to understand that the mechanisms designed to keep UST stable are public, transparent, and hotly debated in many forums. UST was a bold attempt to create an algorithmic stablecoin that could live in the digital world, except it failed.

Our lead investment team invested in Luna using balance sheet capital in Q4 2020. Our team’s initial thesis for investing in Luna was around the expansion of blockchain-native payment systems. At the time, we learned that the Chai app, built on Terra, had over 1.8 million users and was a top 5 financial app in South Korea, and we saw it as having huge growth potential.

We are interested in this project because it is an example of a cryptocurrency finding use cases in the real world. The ecosystem has changed significantly since our initial investment in 2020. When we invest in an ecosystem, we look for a founding team with a unique idea and track the use of the project. Among other things, we analyze developer participation, investor support, and network activity. Ultimately, we found that Terra has hundreds of ecosystem projects and a world-class list of investors. The original idea is gaining positive validation.

So what happened next?

First, the global macro backdrop has been brutal for all risk assets this year. Growth stocks with negative cash flows have fallen 50-70% this year. Cryptocurrencies have been under pressure, with core assets such as BTC and ETH both down about 58% from their all-time highs, and altcoins down an average of 80% from their all-time highs.

Central bankers are in the early stages of unwinding a massive liquidity bubble, driven by unprecedented fiscal and monetary policy injections into global economies, including the United States, that has supported all risk assets, including cryptocurrencies. The last decade of continuous money printing has left us facing the worst inflation since the 1970s. Many assets have seen significant gains since the COVID-19 pandemic, but are now experiencing a correction.

This macro backdrop puts pressure on Luna and the reserves backing UST. UST’s growth comes primarily from the 18% yield in the Anchor protocol, which is far more attractive than other uses of the Terra blockchain. The downward pressure on reserve assets combined with UST withdrawals triggered a stress scenario similar to a “bank run”. These reserves were not enough to prevent UST from collapsing. Things are always clearer in hindsight. My tattoo will continue to remind me that venture capital requires humility.

The LUNA/UST flash crash also reinforced some core principles of investing (especially cryptocurrency investing):

1. Maintain portfolio diversity

2. Reasonable profit stop

3. Building a risk management framework

4. Understand that all investments are constrained by a macro framework

Galaxy did all of this with our investment in LUNA.

It is heartbreaking to read stories of retail investors losing their savings on a single investment. A core tenet in the cryptocurrency belief system is equal access to the market. But it is important that inexperienced market participants only risk what they can afford to lose. I often say that people should allocate 1%-5% of their assets to this space.

Also, it is important to understand that volatility is likely to continue and the macro picture will continue to be challenging. There is no cavalry to drive a V-shaped recovery. The Fed cannot “save” the market until inflation falls. So, liquidity is important. It is important to be realistic.

What does all this mean for the future of cryptocurrency?

The crypto industry is not going away. The amount of human capital entering the space is not slowing down. The focus on building decentralized infrastructure that allows value and ownership to flow as freely as information on the internet is not slowing down. The GDP of the Metaverse is also on its way up. Our community is resilient, has a shared belief in a new way of doing things, and warrants that these are very early days.

This does not mean that the cryptocurrency market will hit bottom and go straight back up. It will require a restructuring, a redemption cycle, a rectification, and a renewed confidence in cryptocurrencies. Cryptocurrencies are cyclical, and we just witnessed a big one.

Galaxy remains strongly capitalized and liquid with diversified business lines. We are well positioned for long-term growth. Last week, we provided an update on our liquidity, capital, and operating performance as of May 11, including confirmation that Galaxy's treasury does not use algorithmic stablecoins. Galaxy will continue to manage its balance sheet appropriately based on the macroeconomic backdrop. Galaxy continues to believe in the growth of this industry and our platform.

Most importantly, Galaxy and I are fully focused on continuing to support the cryptocurrency ecosystem because the need for innovations that democratize ownership and enhance trust and transparency is greater than ever.

The mission of the crypto community and Galaxy has not changed. I am more convinced now than ever that the crypto revolution is here to stay. Together we will weather this storm and emerge stronger.

Delphi: Ironically, what we believe causes the opposite to happen

Last week’s death spiral of LUNA & UST was arguably the most catastrophic event to happen to the crypto industry since Mt Gox.

Delphi’s core mission has always been to make cryptocurrency happen better and faster, which is why the events of the last week had such a frustrating effect on all of us. It’s ironic that what we believed in led to the opposite happening.

We have always known about the risks and have always stressed them, but the fact is that we miscalculated the risk of a "death spiral" happening. We have received some criticism for this over the past week, and we deserve it. This criticism is fair and we accept it.

In this post, we will be transparent about the involvement of various Delphi departments in Terra, explain what our investment thesis was, where we think it was wrong, and the lessons we learned from this incident.

Delphi's involvement in Terra

Before we begin, it's important to provide some background on Delphi and how we are structured. "Delphi Digital" is a collaborative association of independently owned and operated entities that share the "Delphi" brand and certain shareholders, resources, people, and values. The "Delphi Ventures" entity, the "Delphi Research" entity, and the "Delphi Labs" entity collaborate under the "Delphi Digital" brand. Understanding this separation is key, as each division has very different levels of involvement in Terra. Below, we provide a description of each entity's involvement.

Delphi Ventures

The Delphi Ventures Master Fund purchased a small amount of LUNA (about 0.5% of our NAV) on the secondary market in Q1 2021. Since our initial purchase, we have only increased our exposure and are currently suffering a large unrealized loss. Even at LUNA’s highest price this year, LUNA and other Terra assets only accounted for 13% of Delphi Ventures’ NAV. In terms of deal count, less than 5% of Delphi Ventures’ total transactions have been in companies or protocols related to the Terra ecosystem. This includes Delphi Ventures’ participation in the recent LFG (February 2022) round, in which we invested $10 million, which is zero at LUNA’s current price. Delphi Ventures did not sell any LUNA in this event.

Delphi Research

First, a disclaimer. The core goal of the reports we publish under Delphi Research is to help publicize our team's learnings and provide people with insight into how these protocols work and the role they play in cryptocurrencies. As mentioned at the top of each article, these reports are for informational purposes only.

Delphi Research first covered Terra in February 2021. Since then, we have published six reports focused on Terra. Each report has a section at the top disclosing Delphi Ventures’ position and Delphi Labs’ involvement in the ecosystem. In addition, many reports have sections on the risks of potential UST decoupling. We will neither delete nor edit any Terra report, but will make it public so that anyone can go back and read our analysis and make their own judgment.

It is important to note that Delphi Research has not and will never accept payment to publish research. From a financial perspective, the balance sheet of the Delphi Research entity was not impacted by this event, except for the approximately $20,000 in UST subscription fees we received through Suberra. Likewise, we did not sell any UST.

Delphi Labs

Our software research and development company, Delphi Labs, has the largest exposure to Terra.

Delphi Labs spent over a year of research and development helping the joint venture build the Astroport and Mars Protocol on Terra. Delphi Labs has never sold any of the tokens it holds, nor has it made money from selling tokens. Delphi Labs is funded primarily by internal capital, contributed by individual Delphi Labs equity holders, in addition to a no-strings-attached grant of 30,000 LUNA (approximately $250,000 at the time) and 466,666 UST from TFL for work on the Mars Protocol.

Despite the outcome, we are very proud of the quality of the protocol that the Delphi Labs team helped build and the way the team handled issues throughout the process. Over the past year, Delphi Labs has made many innovations in this space, such as innovative token issuance mechanisms such as Lockdrop & LBA and other open source research contributions.

As for the future, after making a big bet on Terra and losing, we want to make sure we learn our lessons and make the right choices about where to focus our efforts. We have assembled a cross-functional team of the smartest people in Delphi Research and Delphi Labs, and we will take the time to ensure we evaluate all possible options and make the right long-term decisions. In addition, we also want to take the time to publish some post-mortems in which we review our history, investment thesis, and thought process related to Terra, why we bet big, and where we think we went wrong.

DISCOVERTerra

We started researching Terra in early 2021 and discovered this blockchain network that integrates algorithmic stablecoins into the L1 economy and focuses on real-world adoption through the Mirror Protocol.

Terra began building demand for its stablecoins through CHAI, a South Korean payment network with $1.5 billion in annual volume and over 2.5 million users at the time. In late 2021, Terra added support for CosmWasm smart contracts, allowing third parties to build applications centered around these stablecoins. With its first application, Mirror, giving users exposure to synthetic real-world assets and gaining significant traction, we are delivering on the promise of an ecosystem focused on creating real-world use cases for decentralized stablecoins.

The ecosystem is growing rapidly, but still lacks builders and key financial modules such as exchanges and credit. We have a deep understanding of these fundamental elements through research, investment and construction in the field, and decided to help build these fundamental elements through Delphi Labs.

These key blocks will enable builders to create new products that provide additional utility to UST. Our goal is to keep the supply of UST in line with the increased utility.

Anchor

Anchor was launched in March 2021. Initially, it fit perfectly with our investment thesis. The idea is to use PoS assets as collateral to provide depositors with a stable yield. This allows individuals to help secure the PoS network while also giving them the option of giving up PoS yield in exchange for higher borrowing rates.

When Anchor started, it was common to see annualized mining returns of over 3 digits, so 20% annualized was considered an attractive but reasonable starting point. Anchor reserves exist to absorb the imbalance between the yields paid to UST depositors and the yields obtained from borrowers' staked assets. When operations are in deficit, the protocol will allocate ANC to incentivize more deposits of staked assets.

But the mining era passed, and the returns shrank, but Anchor's yield remained at 20%. This allowed UST deposits in Anchor to continue to grow, which only accelerated the reserve deficit. In response, the original rebalancing mechanism was abandoned, and instead Do donated directly to the reserve. This is a classic algorithmic stability error. Using unsustainable incentive mechanisms to guide supply is obviously effective in economic booms, but the size of liabilities that can be immediately recovered is often underestimated in recessions. This is mainly because of the domino effect of bank runs, which can destroy the confidence of even some of the strongest holders.

This is why we believe that the LFG and BTC reserves are an important step to mitigate this problem. It effectively converts part of the excess UST demand into exogenous reserves that can be used to defend the anchor when necessary. Generating partial exogenous collateral while reducing the Anchor yield will greatly reduce systemic risk in the network. We believe that high levels of external collateral are necessary in the long run, and we think this is the way to achieve this goal. Unfortunately, it is not growing fast enough compared to the supply of UST, and combined with the decline in the value of the BTC reserve, the debt burden is too large to defend.

Looking forward

We believed in the Terra ecosystem and made a big bet, which ultimately did not live up to our expectations and cost us a lot of money and time. Fortunately, Delphi is completely self-funded, and when we make such a big bet of confidence, it is our own capital that is at risk. We understood the risks of the algorithmic model up front and tried to be transparent throughout the process; however, it is clear that we miscalculated the risks. To the strong critics of Terra's algorithmic design, you are right and we are wrong.

Anyone who knows us, both as a business and as individuals, will know how heartbreaking it is for us to see the space we have worked so hard to advance set back by events like this. We are committed to doing everything we can to leave a positive impact on crypto and the world. We always say that actions speak louder than words, so we will let our work and efforts speak for what comes next.

DeFiance founder Authur: This is an incredibly humbling and difficult thing

Some personal thoughts and reflections on recent events.

As an early DeFi participant and advocate, I have always believed that decentralized currencies and networks require a decentralized financial stack to support it.

Otherwise, we would just be transferring crypto between centralized custodians.

Many of the foundational DeFi protocols built during the 2018-2019 bear market emerged and flourished in this cycle, becoming core financial primitives built on top of them. They continue to prioritize security, protocol risk management, but have also become less interesting.

As the bull market continues, more participants are chasing higher-risk opportunities, and many are even proud of their high scores. Some products have brought huge gains, and the voice of DeFi 2.0 replacing 1.0 has become popular.

As DeFi-focused investors, we are often mocked for missing out on "DeFi 2.0". The market at large often rewards this risk-taking opportunity. This has led to many discussions, research, and debates internally about what is a real, sustainable, and unsustainable "narrative".

But the market does make us more enlightened about how to build and successfully bootstrap projects. After all, we have been proven wrong many times to the skeptics of many teams and projects. (The response is real)

While we continue to support DeFi on Ethereum, we recognize that there is real demand for DeFi built on other chains. However, we do not take an EV-based investment approach and only invest in projects on chains where we believe the ecosystem will thrive in the long term.

DeFiance had the opportunity to invest in many competing L1 treasury OTC exchanges, but passed on most of them even when the alt L1 narrative was popular. Instead, we continue to focus on DeFi and be selective in our support.

I have been skeptical of algorithmic stablecoins and Terra since 2018 due to the inherent fragility of this design. However, Terra’s success in 2021 has challenged my view and we are seeing a large number of legitimate and respectable people supporting Terra (Jump/Delphi/Hashed)

The Terra ecosystem also has one of the best UI/UX and developer talent, and is a leading protocol built with the Cosmos SDK. With the creation of LFG, we believe the Terra model can thrive by:

• Partial Collateral Model (BTC Backed)

• Anchor adjustment

• UST supply increases/decreases at a more gradual rate

• UST Broader non-reflexive/mainstream use cases, such as payments

• Large community (especially in Asia)

Ultimately, it will be not only the success of UST, but also the success of crypto-native stablecoins backed by sovereign blockchain networks.

However, the fragility of this design was once again exposed in a weak market environment. We greatly underestimated how powerless the smartest, most capable group of people can be in a hostile environment when natural physics and fundamental principles are against you. Deference to the “smartest person in the room” and the hubris of leaders and the community in the face of legitimate skepticism and criticism greatly contributed to Terra’s downfall. No one is above the market, and the downfall of hubris was once again demonstrated.

Somewhere along the journey many of us lost our way and I lost a lot of respect for people I once held in high regard. Rigorous debate backed by extensive research and analysis was not welcome, instead lazy personal attacks to dispel skepticism were used.

“Your opinion/view is worthless/wrong because I’ve been proven right in the past and I’m more successful and/or richer than you” becomes a common type of argument used by many of us around us, forgetting how worthless they were just a few years ago.

While I would normally avoid such behavior, I did nothing to call out and advise some of my friends/industry associates not to act in this manner. After a while, I also partially swayed and got used to this behavior.

As the industry grows exponentially, the role of Web 3/Crypto VC as a public signaling function becomes increasingly important in the absence of universal standards that can be used to assess the legitimacy of Web 3 projects. We all need to hold ourselves to a higher standard.

This role is well understood in the non-Web 3 VC world, even if some of them have succumbed to market pressure from competition from other types of investors (e.g. Tiger/Softbank).

This has led to some major debacles, such as WeWork, which has dented VC’s reputation in the public sphere.

I highly recommend this book to understand the history of venture capital and the role it played in shaping the tech industry:

https://www.amazon.sg/Power-Law-Venture-Capital-Making/

This incident will undoubtedly set the industry back several years and attract increased and justified scrutiny from authorities and regulators. We need to do better than we have to show that this industry is worth supporting and advocating for.

That being said, cryptocurrency is the freest market in the world, so actors like this will always emerge, and we ourselves should be more critical and scrutinous to prevent this from happening again.

We need to be more professional!

I believe there should be support for a more comprehensive disclosure framework for DeFi, so we should push for maximum awareness/education before encouraging use/access to DeFi, rather than enforcing a KYC/AML nightmare like in the tradfi world.

A reputable, independent and well-governed DeFi directory with a comprehensive disclosure framework makes sense and should do a lot to close the knowledge gap. For example @MessariCrypto disclosure registry is more detailed. Perhaps it could be spun off as a crypto public good.

This is an incredibly humbling and difficult thing for me personally to do. We were generally correct in being bearish and therefore much more cautious, but many of our assumptions were challenged and invalidated. We could have done more to prevent this from happening.

We were too liberal with our portfolio teams, industry partners, and key leaders, and accepted many unacceptable behaviors and actions.

Going forward, we will only invest in teams/projects that we can fully and ethically support.

I will be more aware of the impact we have in shaping outcomes and public perception of this industry.

This sentence will be remembered: With great power comes great responsibility.

I also want to commend the rational skeptics who were willing to stick their necks out, endure the wrath of the mob, and call this whole thing out: @Galois_Capital in particular risked his industry reputation, along with all the other major influencers who were warned of the risks. Well done!