The hidden layers of safety

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Just a few days ago a cryptocurrency named Luna blew up. And there are a few things that make this particular blow up more notable than the others.

First is the fact that it was one of the largest crypto currencies by market cap. Sitting in top 5 with Bitcoin and Ethereum. Many people invest in blue chip companies, which are 10-20 largest companies, with the assumption that their size makes it an inherently less risky investment. Luna was a one of the blue chips of the crypto world.

And that brings me to the second reason why this blow up was a big disaster. The cryptocurrency was linked to a stablecoin named TerraUSD or UST. Stablecoins also live on blockchains like other crypto currencies but instead of being an independent currency they are supposed to be backed by an equivalent number of USD or other safe securities held by the issuers of said stablecoins. So if I want to issue 100 stable coins, I will keep with me 100 dollars at all times. Since USD is the reserve currency of the world, such stablecoins are considered very safe by crypto investors.

UST is an algorithmic stablecoin. What that means is instead of being backed by actual USD, the blockchain mints and removes coins from the circulation through another coin called Luna. The blockchain incentivises traders to convert Luna to UST and vice versa depending upon buying or selling pressure from the market. If UST starts to fall, blockchain makes more Luna to maintain the peg. Though this sounds a little fishy, this worked for small fluctuations in the market. And because UST had very high (up to 20%) staking yields which is like an interest on fixed deposits, investors flocked to the easy money. It is backed by US dollars isn’t it! What could possibly go wrong.

On one fine day, an investor purchased a huge quantity of TerraUSD and then sold it off in the market. This selling pressure caused the algorithm to create more Luna. This caused price of Luna to fall. In markets, fear and greed both compound. People started selling Luna because the price was falling. This sent the blockchain in a death spiral flushing the blockchain with more and more coins. When the dust settled, Luna and UST had lost more than 99.5% of its value.

What made this loss terrible was that because of its high yield, many people had put their savings in Luna hoping to get a sizeable return at supposedly no risk. There are testimonies of people on the social media who have lost their life’s savings.

This keeps happening where we lose the perspective on risk. A lot of money has been lost in explicitly risky investments like penny stocks and far OTM options. But that is the nature of those investments. Nobody in their right mind invests the money they are saving up for something important in such speculative investments. But the problem comes when we completely ignore risks of a type of security that is ‘generally’ considered safe. In the case of stablecoins there are many which have been around for a number of years and have given decent returns to the investors.

Bonds are considered safer than stocks. But a hedge fund ran by economic PhDs failed spectacularly in 1998 when they levered up and invested in Russian bonds. Now sovereign debt is considered safe. Theoretically, in any country, its sovereign debt is the safest investment. So Indian bonds in India, USA bonds in USA and so on. The managers of this hedge fund must have had similar notion about Russian bonds as well. Only the uncommon happened and Russia defaulted on its debt in 1998. Irony is, the hedge fund was called Long Term Capital Management. It lasted from 1994 to 1998, only 4 years. That’s not long enough by any stretch of imagination.

Similar incidents have happened repeatedly in India. DHFL bonds were peddled as very safe to retail investors by sales persons. Retail investors being retail investors bought them with the hope of making ‘safe returns’ that are higher than bank FDs. After DHFL defaulted, many are stuck, praying to get at least some of the capital back.

Punjab Maharashtra Co-operative Bank (PMC) is another such recent example. A bank is supposed to be ‘safe’. But painting all banks with the same brush is a fatal mistake. Well run, large banks are usually the safest ones. Smaller, local banks can be potentially riskier. With smaller banks, the rules can be bent, and books can be cooked more easily. In case of PMC, a large portion of its capital was loaned to a single entity which defaulted. As a result, bank suddenly had no money to pay its depositors. RBI stepped in and froze all assets of the bank resulting in people’s savings being stuck. Though the restrictions are being gradually lifted, if I had my life’s savings in that bank, I wouldn’t be able to sleep at all.

And this is where I see the paradoxical behaviour of investors seeking safe returns. Many will not invest in a diversified equity portfolio giving an average return of 10 percent but will line up to make FDs in local banks offering high interest rates. Or invest disproportionate amount of their portfolio in high yield bonds and be surprised when some of the bonds default. The ‘risk-free’ rate is called as such for a reason. Anything that is offered to investors above that as ‘risk free’ is in fact risky. Interest that the bank pays you on FDs and a company pays you on bonds is a reflection on the bank’s/company’s quality. Higher the interest rate, riskier is the investment. It will do well for investors to keep this in mind. And not blow away their risk free portfolio in supposedly risk free assets.