Black Swans on the blockchain – a 365-day review
By David Kuang, Research Lead
Published Jun 02, 2023
The past year has been a wild ride for the crypto world, to say the least. Excessive leverage threw LUNA-UST into a death spiral. Major CeFi players like 3AC, Celsius, and BlockFi unraveled and became insolvent. And, well, we all saw what happened with FTX.
The chaos hasn’t been limited to crypto, though. Trust in the US banking system is at an all-time low. Customers are not confident they can count on “safe” banking basics like savings and checking accounts at federally regulated banks.
Even though these events are viewed as once-in-a-generation Black Swan events, it seems like there’s a new crisis every other week. So, why is that? While it’s tempting to point the finger at crypto, the reality is a little scarier to confront. The root cause of these issues is pervasive across our global financial system. To fully understand how we can move forward, we’ve looked at each crisis to see how we got here in the first place.
Will we ever live in precedented times? Let’s dig in.

The lunacy of LUNA

What if you could earn a fixed 20% yield on your dollars without any risk or volatility? Sounds too good to be true, right? Well, that’s exactly what Terraform Labs (TFL) tried to offer with its blockchain platform, Terra. Founded in 2018 by Do Kwon from South Korea, Terra had two main features that set it apart from other blockchains: its dual-token design and its native stablecoin support. Terra’s two-token system consisted of LUNA and UST. LUNA was the native crypto asset of Terra that secured the network and stabilized the price of UST. UST was a native USD-pegged stablecoin that users spent to transact on the Terra blockchain. Whenever someone wanted to mint new UST, they had to burn LUNA in exchange. This created a constant demand for LUNA and reduced its circulating supply over time.
“More and more, we are seeing layers upon layers of risk and systemic existential problems that are going to keep happening until one of them breaks. And when one of them breaks, then the whole house of cards will come toppling down. Whether it's ChainLink, a DeFi project, or a Layer 2, it’s almost inevitable that something is going to break at some point, and everything is going to come crashing down.” - Chris Blec
The most popular protocol on Terra was Anchor, a lending market that allowed users to deposit UST and earn a fixed yield of around 20%. Part of this yield came from Anchor accepting yield-bearing collateral to earn staking rewards and transaction fees. The vast majority was being paid out by Terra as effectively a marketing expense. As more users flock to Anchor to earn passive income, more LUNA gets burned and more UST gets minted. Thanks to this virtuous cycle, Terra had achieved impressive growth and adoption in the crypto space. In April 2022, LUNA reached a market capitalization of $40B, making it one of the top 10 cryptocurrencies by market cap at the time. UST also became one of the most widely used stablecoins in DeFi, with a total supply of over $18B at its peak.
What seemed like a dream come true for crypto users soon turned into a nightmare. It all started in May 2022, when certain market actors decided to launch a strategic attack to destabilize the UST peg in order to earn a profit. These actors coordinated to unstake approximately $2B worth of UST from Anchor and preceded to dump them for other stablecoins. This caused the price of UST to drop to $0.91 and sparked a mass exodus of users from Anchor. This also created a vicious cycle: as more UST was sold, its price dropped further, which triggered more selling pressure.
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But that was not the worst part. Due to Terra’s dual-token design, users could also redeem their UST for LUNA at a 1:1 price, regardless of UST’s market value. This meant that users could arbitrage between UST and LUNA by buying UST at a discount and exchanging it for LUNA at face value. This arbitrage opportunity was supposed to stabilize UST’s price by reducing its supply and increasing LUNA’s demand. However, it backfired spectacularly. As more users redeemed their UST for LUNA, more LUNA was minted out of thin air, leading to massive inflation of LUNA’s supply. This inflation eroded LUNA’s value and security, as well as its ability to stabilize UST. By May 11th, LUNA was valued as if it were a stablecoin, a far cry from its $80 price at just the start of May.
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This reflexive loop unraveled the entire Terra ecosystem in a matter of days. UST and LUNA’s meteoric rise showed the potential of algorithmic stablecoins to achieve mass adoption and high growth rates. However, their spectacular fall exposed the risks associated with these types of stablecoins: a collapse in the stablecoin’s value can lead to near-infinite minting of the sister token. The Terra story is a stark reminder that algorithmic stablecoins may offer attractive yields and greater scalability, but they also come with significant risks.
“Being only a few years old, DeFi needs to experience black swan events to thoroughly test its protocols. While some may not withstand the pressure and collapse, those that endure will emerge as the tried, tested, and trusted financial backbone of the future financial system.” - Ignas DeFi

CeFi crisis

“CeFi and traditional finance necessitate trust, assuring your assets won’t be mismanaged or lost. Recent failures of prominent companies such as Celsius and FTX have highlighted that such trust is not always warranted.” - Ignas DeFi
Centralized Finance (CeFi) is far from immune to crisis. CeFi refers to crypto platforms that offer financial services such as lending, borrowing, trading, and investing. Unlike DeFi (decentralized finance), which relies on smart contracts and peer-to-peer networks, CeFi platforms are operated by centralized entities that have control over users’ funds and data. Some users prefer CeFi platforms because they offer higher interest rates, lower fees, faster transactions, and easier access than self-custody or managing their own DeFi wallet, which can be cumbersome and difficult to use for retail users as well as very expensive due to high gas fees. However, CeFi platforms also come with significant risks, such as hacking, fraud, regulation, and insolvency. In 2022, a series of events had a cascading effect on the CeFi sector. The collapse of the Terra ecosystem and the death spiral of LUNA was the first domino to fall, triggering a broader market downturn that wiped out more than 60% of the total market capitalization of the crypto space in two months. By July 2022, the total market cap of crypto reached an all-time low of $1T on CoinMarketCap, down from a peak of $3T in November 2021.
One of the victims of this market crash was Celsius, a prominent CeFi platform that offered high-interest savings accounts for crypto depositors. Celsius relied on lending out users’ funds to generate yield and pay interest. However, as the market plummeted, many borrowers defaulted on their loans or liquidated their collateral. This caused a liquidity crunch for Celsius, which could not meet its obligations to its depositors. On June 12th, 2022, Celsius announced that it was pausing all withdrawals due to “extreme market conditions”. This sparked a massive bank run, as users tried to withdraw their funds before they were gone. Celsius had over $10B worth of crypto assets under management prior to the freeze.
Meanwhile, another CeFi player was facing a similar crisis. 3AC was a crypto hedge fund that managed over $10B worth of assets across various strategies. One of its strategies involved taking leveraged positions on ETH using staked ETH (stETH), a tokenized version of ETH that allowed users to earn staking rewards without locking up their ETH. However, as ETH’s price crashed from over $3K in May to under $1K in June 2022, 3AC failed to respond to margin calls from its lenders. On-chain analysts from Nansen discovered that 3AC was selling stETH at a loss to cover margin calls on leveraged positions. Both Celsius and 3AC eventually filed for bankruptcy.
Perhaps the most significant event of 2022 was the collapse of FTX in early November. In less than 10 days, FTX went from being the largest US crypto exchange to worth nothing. The reason? The company was using its native FTT token as collateral on the balance sheet, which meant that its assets were tied to a risky and volatile token. When reports of this practice emerged, investors panicked and withdrew their funds from the exchange, causing a liquidity crisis. As a result, FTX’s operations came to a halt and depositors lost their money. This event sparked concerns about the lack of transparency and accountability in CeFi, where a small group of insiders controls a significant amount of assets and can make decisions that benefit themselves at the expense of retail investors.
The issues in CeFi are compounded by a lack of regulation and oversight in the crypto industry, allowing companies to operate in a gray area and engage in risky investments or decisions that harm customers. The demise of firms like 3AC, Celsius, and FTX highlights the risks and shortcomings of CeFi, where companies offer high-yield savings accounts and other financial products that promise high returns to investors. For these intermediaries to make money, they often engage in risky investments or make decisions that benefit insiders at the expense of customers, leading to liquidity crises and bank runs that harm innocent investors. As the crypto industry grows and matures, we need more transparency, accountability, and regulation to ensure the long-term stability and sustainability of the sector.

Banking blowups

Fractional reserve banking allows banks to lend out a portion of the deposits they hold and keep only a fraction in reserve. This practice makes financial institutions vulnerable to bank runs, where depositors withdraw their money all at once, and banks don’t have enough cash on hand to meet these demands. To mitigate this risk, banks are required to maintain healthy collateralization levels, which require them to hold a certain amount of their assets in liquid instruments like cash, government bonds, or other highly liquid securities.
In some cases, collateralization levels may not be sufficient for unexpected events, like a sudden change in the value of the assets held as collateral. This was the case for Silicon Valley Bank (SVB). SVB experienced a bank run in March 2023 due to its investment in long-dated US Treasuries, which lost value when the Federal Reserve began raising interest rates as part of its Quantitative Tightening policy. This led to a liquidity crisis that caused the largest bank crash since the 2008 financial crisis. The liquidity crisis at SVB had far-reaching effects on the financial system, including on Circle, the issuer of USDC. Circle held deposits with SVB, and the bank's troubles sparked concerns about the safety and stability of USDC and other stablecoins.
As news of the crisis spread, users rushed to exit their USDC positions, leading to a panic selling frenzy that caused volatility in crypto markets. This underscored the importance of trust and transparency in the stablecoin ecosystem, as users rely on stablecoins to maintain the value of their assets and facilitate transactions in the DeFi economy. The fear of a major stablecoin depegging, as seen with UST, was still fresh in everyone's minds. As a result, the value of USDC and other USDC-dependent stablecoins, like DAI, fell significantly. The severity of a prolonged USDC depeg could have been catastrophic, given its composability across DeFi. There were some bright spots amidst the chaos. Liquity’s LUSD stablecoin held its peg to the US dollar, highlighting the importance of transitioning away from fiat-backed stablecoins.
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Just two days later, Signature Bank became the second bank to fail in this crisis. Signature Bank was a New York-based regional bank that specialized in serving privately owned businesses, particularly in the real estate and crypto sectors. In fact, it was one of the few US banks that was friendly to crypto companies. The issue was many of its deposits were uninsured by the Federal Deposit Insurance Corporation (FDIC), meaning they exceeded the $250K limit. After SVB collapsed due to losses on its long-term US treasuries and exposure to crypto volatility, it sparked panic among depositors at Signature. The bank was ultimately taken over by the FDIC and sold its assets to a consortium of banks led by Wells Fargo. The SVB and Signature failures highlighted the interdependence of the traditional banking and crypto sectors and the potential for systemic risks and contagion.
Another bank that suffered a similar fate was First Republic Bank (FRB), a San Francisco-based lender that catered to wealthy clients. FRB had grown rapidly by offering low-rate mortgages and services to its affluent customers in exchange for leaving cash at the bank. As these assets lost value, FRB could no longer repay its debts nor meet the demand of spooked depositors who wanted to withdraw their money. On May 1st, regulators seized FRB and sold it to JPMorgan Chase, which agreed to take over all of its deposits and most of its assets. The deal was arranged by the FDIC, which avoided using its emergency powers and minimized disruptions for customers. However, the deal also made JPMorgan even bigger and more powerful, raising concerns about the concentration of risk and influence in the banking sector.
These events highlight the fragility and vulnerability of the traditional banking system, which relies on fractional reserve banking and collateralization levels that may not be adequate for extreme scenarios. They also contrast with the resilience and adaptability of DeFi, which offers alternative ways of creating and managing money without intermediaries or central authorities.

Key takeaways

What can go wrong, will go wrong. Risk management is rarely talked about in crypto because it is not sexy. But you just need to make one mistake, and all your money is gone.” - Ignas DeFi
A year of Black Swans was a sobering reminder of the risks in DeFi and CeFi, as well as traditional finance.
  • Algorithmic stablecoins, while offering attractive yields and greater scalability, come with a significant risk of death spirals.
  • Centralized stablecoins are vulnerable to external market forces, as demonstrated by the collapse of SVB and the depegging of USDC.
  • CeFi’s opaque and unregulated financial system will always make it vulnerable to crisis.
However, it also showed the resilience and innovation of DeFi, which offers more transparency, security, and efficiency than CeFi. DeFi is not immune to risks, but it can be managed and mitigated with the right research and tools.
At Exponential, we offer several tools to help investors do just that. Our DeFi Graph provides a comprehensive risk assessment of pools based on factors like smart contract risk, collateralization ratio, and governance structure. Rate My Wallet (RMW) allows users to assess the risk profile of their existing holdings and make informed decisions about where to allocate their assets. Finally, our alert system allows users to stay up-to-date on changes in yield and risk ratings for their favorite pools. As the crypto market continues to grow and evolve, it's crucial to remain vigilant and informed to make the best investment decisions possible. We’re here to help.
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