Q2 2022 was one of the most interesting and historic quarters for VC activity in recent memory
The public markets entered correction territory with the possibility of a recession on the horizon, and the private markets took notice.
Despite a general market slowdown, we know from prior experience some of the biggest and most successful companies were built during challenging economic times. There is much to cover from last quarter’s activity that applies to founders and VCs alike.
Welcome to our Quarterly VC Benchmark Report, where we analyze all of the notable VC activity over the past 3 months and stack it up against what we saw in the previous quarters and years. We scan across the US, Europe, and LatAm to bring you the best insights, be it you are an investor, founder, or just interested in the startup investing space. Let’s dive right in.
Q2 in a nutshell
Decline in funding, now what?
Q2 2022 saw a reduction in deal activity across the board. VCs took note of the decline in the public markets and in step conserved cash and scaled back new investments. No stage or geography was insulated from this trend, although some areas were more exposed than others.
We at TheVentureCity see this environment as a combination of multiple factors - some rooted in fundamentals and others in human psychological behavior. For example, raising interest rates does materially change return profiles of different asset classes, however broad-based layoffs to brace for economic slowdown is a human response to a perceived risk that has little to do with an individual company’s performance.
How should founders adapt?
To better understand this economic climate and effectively navigate it, we have published a document: Actionable tips for surviving an economic downturn for founders, by founders, to learn from each other. Throughout this report we will refer to advice from this document and how it applies to different stages and verticals.
Global VC activity saw a big drop
Q2 saw a noticeable contraction
Not since Q4 2019 has there been 2 consecutive quarters of VC contraction. The magnitude matters here: Q4 2019 saw a -15% decline in volume and -6% drop in deal count compared to Q2 of the same year. In comparison, Q2 2022 experienced a -32% slump in volume and -19% fall in deal count since Q4 2021.
It’s worth mentioning that Q2 2022 still produced $88B in deal volume across 6,138 deals, which in aggregate is still a staggering figure and topped Q1 2021. Compared to Q1 2022, this represents a -20% and -25% decline in deal volume and count, respectively. For YoY performance, Q2 2022 saw a -21% and -22% drops in both categories.
Behemoths back off
Some of the market contraction was driven by later stage funds tightening their belts. These massive funds typically make up a large part of the deal activity and volume each quarter, and in Q2 they pulled back from the market. Coatue Management (-24 QoQ deal reduction), Temasek (-14), T. Rowe Price (-10), D1 Capital Partners (-10), and Tiger Global (-4), amongst many other large funds, aggressively scaled back their deal count in Q2 relative to Q1 2022.
Ecosystem player’s perspective:
Macroeconomic factors in Q2 2022 sent shockwaves throughout the VC ecosystem and investors heard them loud and clear. Y Combinator published a now infamous letter to its founders, Sequoia published a deck, and Craft Ventures put out a lengthy Youtube video all in response to the new economic climate. They all arrived at the same general conclusion: we are entering an unfavorable fundraising environment and founders need to adapt accordingly. Referring back to the document mentioned earlier: Actionable tips for surviving an economic downturn, that we published in conjunction with founders in our network, there are a few main takeaways:
Gone are the days of raising enormous pools of capital and spending it aggressively to amass market share, even at the expense of profitable growth. Founders must focus on positive unit economics to ensure company stability and sustainability.
Extending runway is key right now - the winners often that emerge in the long term are not only the companies with the best product and teams, but are the last ones standing.
Focus on satisfying your customers. The companies that solve real problems and demonstrate strong user satisfaction and retention will attract investor interest.
VC perspective
From TheVentureCity
We believe the current market environment presents an opportunity, not a time to duck and cover. Every venture firm is built differently, each with a different set of priorities and strategy. At TheVentureCity, we prioritize founder support above all else, and have structured our fund accordingly. Combine that with the good fortune and sense of being austere by design when deploying capital over the past 6 months (6 new investments and 3 follow-on investments so far in 2022 with dry powder available), we maintain strong views and perspectives on the current market environment:
VCs should prioritize portfolio company support above all else right now. This can take shape in financial backing, operational support, valuable investor and customer introductions, and anything else they require.
Staying true to our product-led growth mentality, we are actively investing and seeking the next amazing startups building the future. It is well documented some of the best companies are built during challenging market conditions, and we intend on taking advantage of that trend.
Most market sentiment is portraying doomsday situations, causing investors to proceed cautiously out of fear their new investments will struggle to raise follow-on financing. However we see a different situation playing out, which we will explore in the next section.
A market flush with capital
Things aren’t always what they seem
From all the news and media coverage of current market conditions, many investors and founders alike are convinced that capital is tough to come by. This is in part due to discretion by managers and not because of lack of capital in the market. Below is an illustration of historic fund capital raises dating back to 2013. We know over the past decade VC firms typically wait 2-3 years before raising new funds, and they deploy them slower during unfavorable market conditions. We can then reasonably infer there is $40B+ of dry powder available in the market from fund vintages dating back to 2020.
Founder perspective:
The reality of the capital markets is important for founders to understand, and if need be, inform VCs about. There are certainly unfavorable market conditions afoot that will tamper investment activity and make it more challenging to raise rounds, especially at attractive valuations. However, founders should breathe a sigh of relief that VCs raised massive amounts of capital in prior fund vintages and much of it is still sitting in the bank, waiting to be deployed.
The best and brightest companies will still receive strong investor interest. The bar has been raised, but companies solving urgent and real problems with novel products that have strong unit economics that are built by strong teams will get funded.
VCs may try to drive down valuations due to anticipated lack of competition, leading to perceived better negotiating power. Founders should start fundraising early (runway greater than 9 months) to put themselves in the position to command the valuations they deserve.
VCs generally have capital to deploy, and founders should be aware of this fact when moving towards closing conversations and considering potentially unfavorable terms.
Let’s Look At The Numbers….
US VC landscape in Q2 ‘22
US activity sinks to nearly $60B
The US was a microcosm for the entire VC ecosystem in Q2, as it represents the lion’s share of all funding. Total VC activity in the region slumped to $61.8B across 3,693 deals, a -21% and -20% decline QoQ and YoY, respectively. Despite this contraction, the US still represented 70% of all VC funding, consistent with last year. There were several noteworthy unicorns that raised: SpaceX closed a $1.7B round at a $125B valuation, Epic Games brought in $2B at a $31.5B valuation, and Faire attracted $816M from investors at a $12.6B valuation.
Europe VC landscape in Q2 ‘22
Europe the most insulated across all geographies
Across all the areas we cover, Europe fared the best compared to the rest. While the VC category as a whole shrunk by -20% QoQ, Europe generated $24.9B in volume across 2,266 deals, a -13% and -21% shrinkage QoQ and YoY, respectively. Some of the notable names that drove growth in the region were Trade Republic, which raised $1.2B on a $5.3B valuation, SumUp, which attracted $627M on a $8.5B valuation, and Personio which brought in $470M on a $8.5B valuation. One more note on geographic growth: of the top 10 largest deals from Q2, 6 of them (3 each) hailed from the UK and Germany.
LatAm VC landscape in Q2 ‘22
LatAm activity continues to tumble
Latin America was hit hardest by recent market conditions. From a high in Q3 2021 of $4.8B poured into Latin America startups, that figure has fallen to $1.5B across 179 deals in Q2 2022. Q2 2022 represents a -57% decline QoQ and -40% drop YoY. Anecdotally, we have heard US investors are focusing on portfolio company performance, and when they invest in new companies they often are based nationally.
Founder perspective:
The funding news coming out of Latin America can be disheartening for founders to hear. Because of factors out of their control they are getting hit hardest by this economic downturn. Couple that with political unrest and that has produced unfavorable funding conditions for early stage companies. Below are some reminders for founders in Latin America:
Latin America produces some of the most resilient and resourceful founders on the planet. They often deal with more obstacles that founders from other geographies and for that reason become more equipped to achieve success.
The best things founders can do are maintain runway at low levels and focus on sustainable growth. There are so many ways technology can disrupt traditional business processes in LatAm and there lies the opportunity.
VC perspective
We view the pullback in VC activity in Latin America as an opportunity for us and other investors to partner with some of the best founders in the region. LatAm has continued to prove itself as a region ripe for innovation and capable of minting massive success stories
The fundamentals and drivers of growth in the region have largely remained the same (as discussed in our Q1 2022 benchmark report) - fintech, growing internet adoption, and high cell phone penetration are allowing business to flourish.
We at TheVentureCity are excited to continue to partner with Latin American founders who are building tomorrow’s unicorns.
Same verticals lead, but new ones emerge
Investors play their hits
Venture investors wired $88B to startups in Q2, almost $62B of it going to just 3 verticals, a whopping 70% majority. SaaS ($22.2B), TMT ($20.9B), and Fintech ($18.8B) proved to be popular amongst founders and investors and regarded as the safest, sustainable growth plays in this environment. SaaS, especially at the enterprise level, was regarded as one of the best places to invest, and outpaced TMT, which led in Q1 2022. In uncertain environments, investors typically look to safer bets characterized by recurring revenue, high margins, and proven business models - all characteristics of SaaS businesses. However, new entrants entered the top 7 - CleanTech ($7.3B) and Industrials ($6.9B) saw expanded activity and replaced Big Data and Supply Chain Tech from Q1’s top vertical rankings.
Industry Spotlight
Web3 and Blockchain
Web3 was not immune to the market forces at work in Q2
Web3, crypto, and blockchain deals ticked up in Q1 2022, but suffered a small setback in Q2, notching $7.5B in funding over 460 deals. This was a -11.7% contraction QoQ, but still represented a massive 62% expansion YoY. These numbers are telling: on a relative basis, Web3 continues to see growing interest from investors, and many see it as the future of the internet. Relative to the VC space as a whole and other sectors, Web3 received more interest than just about any other space.
Peeling back the curtain
Crypto saw massive setbacks in Q2
Despite the continued interest in Web3 deals in Q2, it was no secret crypto underwent a difficult period in what many industry players called another “crypto winter”. As a proxy for interest and adoption in the space, we can look to Bitcoin’s price as one way of assessing the health of the industry. Bitcoin topped over $67k in mid Q4 2021, then tumbled to the high 30k’s/low $40k’s for a few months in Q1.
This wasn’t a massive cause for concern
As fluctuations in the crypto asset class are typical. It was not a concern however until starting right at the beginning of Q2 Bitcoin followed a swift and steep decline to below $20k by mid June. In tandem with Bitcoin’s drop in price, cases of fraud, massive depreciation of digital asset value, and in some cases massive bankruptcies have emerged. There are still many bright spots in the space, but investors have become more judicious in how they invest in crypto and Web3. We will investigate some of these major trends and news stories later in this benchmark and come to conclusions on how to approach the space moving forward.
Spotlight: Miami
Florida insulated in Q2
Florida, overall, continues to see strong long-term growth
Like the rest of the VC market in Q2, Florida took a hit in funding levels. However, it was less severe than most other markets and still elevated in the perspective of long-term health of the regional industry. Investors poured $1.7B across 159 deals into Florida-based startups, just a -8% drop QoQ and a massive 126% increase YoY. The results are telling: Florida continues to develop as a startup hotbed and many exciting founders are building in the region.
Miami-based companies
The weather isn’t the only hot thing in Miami
Miami has grown to become an emerging tech hub, and Q2 continued to prove that trend. In particular, 3 promising companies from Miami all raised at valuations $100M+ all in their Series A rounds, a massive achievement and signal for great things to come. Meow enables crypto businesses to earn yield on their corporate treasuries; they raised $28M at a $128M valuation from Coinbase Ventures, Lux Capital, Slow Ventures, and Gemini. Another startup in the crypto space, OnChain Studios, has created a NFT studio to offer digital toys. OnChain Studios raised $26M at a $118M valuation from a16z, Dapper Labs, and Draper Associates. Lastly, Nue Life, a mental wellness application designed to deliver at-home therapy, raised $23M at a $103M valuation from Pareto Holdings, Magic Fund, and several notable angels. We are excited about the continued explosion of startup growth in Miami as well as the other core regions we operate in.
Founder perspective:
Miami continues to prove that it’s becoming a capital of capital. Not only did it show to be more insulated from the Q2 pullback, but Miami continues to produce strong companies, especially in crypto. The city and its mayor strategically identified crypto/blockchain as an emerging technology and vertical that has massive applications and upside, but requires specific technical expertise to enter. This decision, combined with economic, weather-related factors in tandem with COVID, and a push by the local government, have helped Miami become one of, if not the largest, crypto hubs in the world.
Founders from companies like Blockchain.com, FTX, and MoonPay have recognized this trend and have doubled down their efforts to build and hire in Miami. Meow and OnChain Studios are just the most recent cohort of companies based in Miami that have raised massive rounds as of late.
Other founders have taken notice: crypto entrepreneurs have moved to Miami in droves to capitalize on the emerging community and talent pool that is growing in the region.
VC perspective
Miami presents a unique opportunity for crypto investors to build a reputation in an emerging hub. It is well documented Silicon Valley produced prestigious VC funds because they were located close to the companies being built there - the capital was second to the region behind the talent.
We are seeing a similar trend happening in Miami: crypto talent has been flocking to the city, and capital and funds are slowly trickling in as well.
Massive names with crypto practices such as Founders Fund, Softbank, Citadel, and many others are establishing deeper roots here. We feel fortunate to have been operating here officially since 2017 and can take advantage of this serendipitous trend that’s only growing.
Spotlight: Madrid
Spain funding drops in Q2
Spain sees decline, but optimistic growth long-term
Spain, like most regions on the planet with startup activity, was not insulated from the broader market pullback in Q2. Spain produced $679M in funding volume across 112 deals, a 38% slump QoQ. However, this short-term performance is not an indicator of how far the region has come: $679M Q2 funding represents a 41% increase YoY from Q2 2021. Combine that with the fact that deal sizes jumped from $2.7M to $6.1M in just one year, and one can see that Spain is growing quickly in terms of fundraising activity, and companies in the region are maturing and raising larger rounds.
Major movers
Madrid minting companies on the rise
Madrid-based companies made waves in Q2 - 3 of the top 10 largest Spanish deals from Q2 were from Madrid. BVNK, a banking and payments platform built on crypto to enhance digital asset services, raised $40M on a $340M valuation from Tiger Global and Base Capital Partners. Tinybird, an analytical software company that helps data teams deliver real-time answers, raised $37M from CRV and Crane Venture Partners. Savana, developer of an AI health record platform designed to improve medical record management, raised $25M from GED Capital and Seaya Ventures. This batch of fresh funding further cements our conviction that Madrid will continue to grow into the tech hub it is poised to be. We are proud to back Madrid-based startups like Cabify, Spotahome, Fuell, and Dixper as we call Madrid our 2nd home in addition to Miami.
Spotlight: Brazil
Brazil’s performance in Q2
Brazil hit hard by market slowdown
Brazil unfortunately suffered a large pullback in funding for startups in its region in Q2. Q2 produced $634M in volume across 85 deals, which is a -62% decline QoQ. Brazil’s funding volume topped in Q4 2021 when it crossed the $2.7B threshold. This two-quarter drop represents a -76% decrease in funding volume. Compared to 1 year ago, Q2 2022 produced 66% less capital injected into startups. These numbers are disappointing given the level of excitement in the region in prior quarters and the quality of startups building in many areas of Brazil.
Success stories
São Paulo boasts more unicorns
The news wasn’t all negative coming out of Brazil. As we have seen in prior quarters, some of the most exciting companies emerging out of Latin America are native to São Paulo. Also like previous quarters, most of the massive rounds we will cover coming out of São Paulo are fintechs or touch financial software. Solfácil is building a novel approach to allow consumers to access credit lines for installing solar energy without large upfront investments. Solfácil raised a $100M Series C (likely at a unicorn valuation) from QED Investors, SoftBank, and Valor Equity Group. Unico raised $100M as well in a Series D financing round at a $2.6B valuation to continue building out its facial recognition software for businesses to close security loopholes. SoftBank, General Atlantic, and Goldman Sachs Asset Management participated in the round. Lastly, Stark Bank raised $45M at a $1B valuation from Ribbit Capital and Bezos Expeditions. Stark Bank is a digital bank that enables businesses through APIs and hassle-free integrations to access their online payment gateway. Despite a pullback in funding this quarter, Brazil continues to see leading companies raising massive rounds, especially in its growing tech hub, São Paulo.
VC perspective:
Although Q2 produced low funding numbers in Brazil and LatAm as a whole, we are still bullish on the region and eager to support founders from these geographies.
The foundational factors in the region - high internet and cell phone adoption with low digital business and banking penetration, still persist, leaving a massive gap for opportunity. We view the funding pullback from the region as largely externally macro driven, rather than due to movements on the ground level.
Some critics may point to political unrest in LatAm- as active investors in the region for years, we know this is a constant within Latin America and likely will be for years to come.
This does not necessarily impede innovation and growth, and over the long-term we believe the region will continue to produce many success stories that we hope to support along the way.
Spotlight: Women in VC
Investment for female founders
Female-founded companies see setbacks, but in line with market
Startups with at least 1 female co-founder saw a drop in funding in Q2, these startups produced $10.4B in capital inflows on 799 deals. This was a decline QoQ of -21% and a drop from a relative high 2 quarters ago of $15.4B (-32%). These percentage drops are consistent with global VC flows, showing that female co-founded companies are not receiving disproportionate negative treatment compared to their male-only counterparts.
However, that does not detract from a general problem: female co-founded businesses still only represented 12% of the Q2 fundraising market and female-only founded businesses hovers around 2%. Much more work needs to be done for investors to back female-founded businesses, to proactively support women in the C-suite, and to encourage women to found businesses.
Female founder spotlight
Female founders on the rise
This quarter we want to highlight one of our exceptional female founders who is building a novel solution for families and their children. Cheryl Sew Hoy is building Tiny Health, the first microbiome test kit from preconception to toddlerhood to help parents understand and improve their microbiome. Healthy microbiomes are linked to early child development and many early-year chronic health conditions like asthma, diabetes, and allergies. Helping parents get a handle on the science involved with microbiomes can help them raise healthier and happier children. We are honored to back Cheryl in her second venture (she founded Reclip.It, acquired by Walmart Labs), she is a true professional and visionary in the health space. Cheryl is the epitome of a disciplined founder, she has been thoughtful in how she grows and hires, and is positioning her business correctly in this market so she can build a sustainable business for years to come.
VC perspective:
We are proud to support female founders. Even in 2022, we observe female founders are ignored and do not receive the capital support they deserve for the amazing companies they are building. Change is happening, but it needs to happen more aggressively on the cap table, in the C-suite, and in the boardroom.
We are proud that we have the ability to make meaningful change to address the disparity of funding for female-founded startups. We believe this is one of our core differentiators and competitive advantages.
Diving deeper into the stages tells us what’s happening at ground level...
Seed Funding
Seed not insulated from rest of the market
Even seed companies could not avoid the effects of a slowing VC market. Despite seed companies being far from the IPO markets in terms of company profile and investor type, seed investors took notice of general capital market slowdown and adjusted accordingly. Investors are conscientious that Series A and B investors will demand strong unit economics and paths to profitability as prerequisites to getting follow-on funding. It will become tougher to raise new, large rounds based on pure vision and market opportunity. Q2 2022 saw a drop in seed funding to $6B across 1,750 deals, representing a -23% drop in volume QoQ. Deal sizes remained fairly consistent from last quarter at $3.4M/deal ($3.8M/deal in Q1). The overall sentiment of the space isn’t all bad - YoY growth was still positive at 11%.
Founder perspective
We are proud to offer our crowdsourced document from founders: Actionable tips for surviving an economic downturn, as advice to other founders on how to navigate this environment. The sections in there that should prove to be most helpful to seed founders surround team, product, and finance.
Getting the team in place as early as possible with the appropriate skill sets in order to build product and scale is crucial - filling voids in skill set early on can give companies unfair advantages as they build bigger.
Moving towards product-market fit means continuing to hone in on the key desires of your ICP (ideal customer profile) and what makes your product indispensable to them. Getting as close to your customers and listening to them is crucial. Superhuman’s founder, Rahul Vohra, published an amazing piece on his journey to PMF.
Runway is power. Especially at the seed stage when PMF is often not a reality and teams need time to iterate and try things out, runway becomes even more important. We are seeing many companies going out for seed extension rounds right now; to be determined how many and which companies receive them. Founders with disciplined burn rates who extend runway before ramping up and scaling will have unfair advantages in the battle to be the last ones standing.
Early-Stage Funding
Early-Stage continues to tumble
Early-stage deals (Series A & B) went on a tear in Q4 and 2021 as a whole as valuations continued to expand across the industry. Investors established a new standard of what’s possible in terms of capital deployed and the rate it could be invested. Q2 is a far cry from two quarters ago and the space has returned to a state of normalcy. Series A and B deals produced $24B in funding volume across 1,857 deals, a -16.4% decline QoQ - more insulated from the rest of the industry. However, this number is a far cry from Q4’s $39.5B figure, which represents a 39% contraction in two quarters.
More of the same
Evaluating investors by activity
Even though the metrics changed QoQ in terms of activity, the names did not. Over the prior quarters we highlighted how mega funds are moving downstream to the Series A & B stages and using their robust capital reserves and networks to deploy capital at impressive clips. Despite some recent lackluster performance (to be discussed later), much of the dry powder in the market is concentrated in a small number of mega funds, allowing them to deploy capital at a fervent rate. Last quarter the most active investors at early stage were a16z, Dorm Room Fund, Lightspeed Ventures, with other notable names like Insight, Sequoia, and Coinbase Ventures cracking the top 10. Q2 looked relatively similar: the top 5 funds by activity were Insight Partners (23 deals), Alumni Ventures (22 deals), Tiger Global (21 deals), followed by YC and a16z.
Founder perspective:
Referring back to the crowdsourced document from founders we put together, Actionable tips for surviving an economic downturn: in addition to product-focused advice, tips around sales, marketing and data collection may prove most useful. At this stage, founders have likely reached PMF and are interested in how they can most quickly and efficiently scale growth.
Founders need to assess which growth strategies will allow them to scale the best. This is often based on the type of product they have, market they are serving, customer profile that purchases their product, and how other players in the market operate (channel partners).
Often, these founders need to test different growth channels to see what works best. The key here is to develop a repeatable process that works at scale. Ideally, founders make $3-4+ for every dollar they spend to scale.
Data is core to these stage companies. Developing a way to get instant feedback on scaling strategies allows founders to tinker and refine their approach. Consistency and quickness to this feedback loop is key.
Late-Stage Funding
Late-Stage comes in for a bumpy landing
In 2021, late-stage VC boasted one of the most impressive growth clips of any asset class ever - more than doubling in the matter of a year. On the back of this, 35 funds raised over $1B in just the first half of 2022 (the largest being Insight Partners’ $20B 12th fund). However, capital deployment is slowing as late-stage deals depend on healthy IPO markets. If these slow, then investors may slow deployment in companies that would theoretically IPO in the next 1-3 years. Late-stage deal activity for Q2 arrived at $57.6B across 1,886 deals, falling -21% QoQ and -29% from its Q4 high.
Big funds hit hard
It’s lonely at the top
Going beneath the surface, late stage funds are getting ripped apart left and right. Even though they have massive capital reserves and are therefore deploying at a strong pace, their losses are mounting. Most notably from this bunch is Tiger Global, which is down 50-60% across several of their funds. This is due to 2020 and 2021’s trend of deploying massive amounts of capital at a fervent pace, thus condensing the timeline to investment, increasing competition, and pushing valuations up. This trend has begun to reverse, but across the industry the damage has been done. Expect to see dealmaking practices and valuations continue to adjust as this market environment persists.
Industry Spotlight: Crypto
What went wrong in Crypto?
In 2021 Web3 and crypto was on a tear. Companies in the space were raising at astronomical valuations, talent was pouring into the space, and investors flocked to bid up the best deals. What could go wrong?
What has unfolded in the past few months has been nothing short of jaw-dropping. Companies are folding and bad operational practices are rampant. Warren Buffet’s famous quote rings true: “Only when the tide goes out do you discover who’s been swimming naked”. We will cover some of the most notable stories from the past few months, and how we as an investors are going about navigating the environment moving forward.
A collapse of epic proportions
What was the Terra network?
Possibly the largest knock against the crypto ecosystem yet came in the form of the Terra/Luna ecosystem crumbling in the matter of days. For backstory, the Terra blockchain was built on Cosmos SDK and allowed developers to create custom blockchains and build their own decentralized applications (dApps) on top of Terra. Terra’s founders, most notably Do Kwon, created an algorithmic stablecoin network that was designed for peer to peer transactions. These stablecoins were pegged to notable fiat currencies. One of the major projects within Terra was TerraUSD (UST), which reached a market cap high water mark of almost $19B.
How did TerraUSD (UST) and LUNA work?
Unlike other major stablecoins like USDC (USD Coin) and USDT (Tether) that depend on a reserve of assets to maintain their peg to the dollar, UST utilized a smart contract-based algorithm to maintain UST anchored to $1. To do this, Terra had a counterpart coin, LUNA, to counterbalance any discrepancy in supply and demand. Users could always swap LUNA for UST, and vice versa, at a guaranteed price of $1. For example, if there was excess demand for Terra and the price rose above $1 temporarily, LUNA holders could bank a risk-free profit and swap LUNA for Terra. When this happened, a percentage of LUNA would be permanently removed from circulation and some would be deposited into a community treasury. These actions would make LUNA more scarce and more valuable, thus increasing the price of LUNA. Since more users exchanged LUNA for UST, minting more UST tokens would devalue it and bring the price back down to $1. Due to growing demand for UST over time, that ensured UST would increase in market cap, causing LUNA to increase dramatically in price. LUNA at its peak had a market cap in excess of $20B.
How did it all come crashing down?
A small cohort of critics pointed out early on that because Terra depended on algorithmic trading and not a war chest reserve of assets (similar to how banks work), then theoretically large sell-offs could depeg the currency from one dollar. This was exactly what happened - on May 7 a group of large crypto whales (or one massive attacker, the identity of the culprit isn’t known) initiated a massive sell-off that dropped UST’s price to $0.98. Due to LUNA having to manage UST’s peg across both centralized and decentralized trading venues, weak tokenomics in the Terra ecosystem, and the substantial discrepancy of UST from its pegged value when it was viewed as stable and safe, this caused a panic selling spiral. After 5 days, $40B of value had been wiped out, and the collapse of the Terra ecosystem led to $300B of losses across the entire crypto economy.
The rise and fall of one of crypto’s biggest lenders
From $25B AUM to bankruptcy
Celsius, at its height, was one of the largest crypto lenders on the planet. Users would create wallets on its platform and then Celsius would invest the capital into yield-generating assets, and then distribute most of the returns to shareholders. In some cases, Celsius claimed users could generate 18% yield on their deposits. However, by June 12, 2022 Celsius was forced to pause all withdrawals due to liquidity issues and faced insolvency. What went wrong for Celsius as a centralized financial lender:
Exposure to UST: The CEO of Celsius, Alex Moshinsky, initially claimed when questioned that Celsius had minimal exposure to UST at the time of the crash. It hasn’t been divulged how much exactly was allocated to Anchor (Terra’s DeFi protocol that delivered 20% APY), however this claim was later disproven by onchain data. Celsius wallet holders actively participated in Terra’s ecosystem, contributing to large sums of lost capital.
Staking trap: A core way of generating yield in the crypto ecosystem is by staking ETH. Staking is necessary in a proof-of-stake ecosystem where assets are pledged in an effort to create a new block on the blockchain, and the user who pledges the crypto is rewarded. However a core piece of staking is lockup of assets - they count as committed capital until the new block on the blockchain is successfully created. There are several platforms who provide liquidity for locked-up ETH, notably Lido. When a user with ETH stakes with Lido, they receive stETH in return, a token to represent their ETH, which is fully liquid. Importantly, ETH and stETH are not pegged to each other. This played poorly for Celsius - prior to announcing bankruptcy Celsius only had 27% of its Ethereum liquid, with $400M staked and another $400M in stETH. The issue was that at one point stETH was dropping in price quickly, so Celsius would have been forced to take a loss if it sold. Regardless, Celsius couldn’t recover much of its illiquid ETH due to other investors exchanging stETH for ETH at the same time (more panic selling).
Leveraged positions: Celsius held large positions with DeFi lending platforms that provided strong yield: Aave, Compound, and MakerDAO. These lending platforms allow investors to generate yield on overcollateralized loans. For example, Celsius would pledge $150 of ETH for a loan of $100. If the price of ETH dropped by a certain level, Celsius would have to post more collateral or repay the loan, otherwise the lending platform would demand repayment. This was exactly what happened with Celsius due to deterioration of ETH’s price - they ultimately paid these platforms over $900M for debt repayments, opening up the door to controversy of who are senior creditors in the event of crypto lender bankruptcies.
A hedge fund caught holding the bag
Three Arrows Capital closes shop
Three Arrows Capital once managed $12B+ and was one of the most respected crypto hedge funds in the world. They were investors in many of the most prolific crypto projects and attracted capital from the industry over due to their superior returns. However, in the matter of weeks, the hedge fund went under and as of July 12, 2022 the founders of the fund are on the run, avoiding creditors who are demanding repayment of their capital. What brought them down was similar experiences to Celsius: exposure to the Terra ecosystem, forced selling at a discount of stETH (and they could not liquidate much of their position), and repayment of over collateralized loans in DeFi protocols Aave and Compound.
What we can learn from this
Main takeaways and ways to navigate crypto moving forward
What happened in crypto the past few months can be likened to what happened during the 2008 financial crisis. The financial crisis was orchestrated when financiers took undue risks with mortgage bonds, misunderstood the value of the assets when they slowly started to fail, and importantly, there was a long line of asset managers that were unprepared from a cash perspective to cover their losses, leading to bankruptcies. In this case, the collapse of the Terra ecosystem, due to its algorithmic trading nature and inability to repeg to the dollar, set off a chain of events that led Celsius, Three Arrows Capital, and many other firms to go under. Terra at the time represented a large piece of the crypto ecosystem, but the problem was massively exacerbated due to other firms failing to observe diligent risk management and liquidity practices.
Regulation likely underway
As investors and observers, we can take away that a consistent theme with hot markets and new technology is there is often massive exuberance, but eventually the music ends. These events will likely lead to regulation (this is already happening in the EU), the CEO of FTX, Sam Bankman-Fried, actually called for regulation prior to these market events happening. When investing and evaluating crypto, and any asset, it is critical to evaluate risk management practices and observance of cash and liquidity positions. This will help us and other investors make disciplined, thoughtful decisions. As Andrew Grove, founder and CEO of Intel, famously titled in his book about corporate practices: only the paranoid survive.
