The big market event this week that is not
getting a lot of press is the collapse of the Terra stablecoin, which has shown itself
to be neither stable not an actual coin. Tether – another much larger stablecoin with
a market cap of 80 billion dollars has also come under pressure when it fell to around 95
cents yesterday before recovering somewhat. So, what is causing these stresses and do they matter
outside of the world of cryptocurrencies?
Ok, so first up, Stablecoins are cryptocurrencies
that are supposed to have a stable price in fiat currency, they are supposed to be pegged to a
currency like the dollar, the pound or the euro and while they are a small segment
of the overall crypto asset market, they are the most traded coins in the entire
crypto space – they actually matter a lot.
Now, a lot of you might be wondering why these
things exist at all. Why would anyone want to own a crypto version of the Dollar or the Yen or the
Euro, when actual Dollars Yen and Euros exist?
Well, the reason stablecoins
exist is to reduce the fees, transfer time and the privacy issues associated
with transacting in traditional foreign exchange. If you use stablecoins, you avoid the need for
multiple bank accounts – often in different countries to transfer funds internationally; you
just need one crypto wallet in which you can hold these coins that are supposed to be pegged to
your currency of choice.
Stablecoins are there to make peer-to-peer digital transfers possible
without a third-party intermediary like a bank. Cryptocurrencies are usually even priced in
terms of stablecoins as opposed to traditional currencies because of the quick settlement
times required in the digital asset market.
Now, a lot of what slows transactions down,
and makes them expensive in the traditional financial system are regulations
like know your customer rules, anti money laundering checks and international
tax avoidance regulations like FATCA. FATCA for example makes it extremely difficult for
Americans to open bank accounts abroad at all. It is so expensive for foreign financial institutions
to deal with American tax reporting requirements, that they would rather just not deal with
American customers at all unless they are very large accounts that transact enough so that the
fees outweigh the paperwork costs associated with regulatory compliance. Equally the things that
intrude on your privacy are required of banks as they need to ensure that you are not laundering
money evading taxes, or evading sanctions.
The reason people like stablecoins is
that once they have transferred funds from the traditional financial system into
a crypto wallet, they can hold those funds as a token that represents the dollar, the euro,
the pound – or even bitcoin, the national currency of El Salvador and that token should hold
its value in that currency while possibly paying you a suspiciously high interest rate…
Lets be clear, possibly the first sign that something might be a ponzi scheme is that
you are being pitched a low risk investment with an unusually high rate of return.
So skipping on from that for the moment, stablecoins are of great importance within the
world of decentralized finance (or DeFi) – where coded applications perform financial services
on a permissionless blockchain.
The stablecoins provide an anchor of stability and means of
payment built on distributed ledger technology, and they also move funds instantly. Thus as
DeFi grows so does the use of Stablecoins. And that is what we have seen, the value of
crypto assets placed in DeFi applications for use as collateral or liquidity – grew
from 30 billion dollars to 234 billion dollars in 2021 alone, according to Deutsche Bank.
Now, there are over 100 different stablecoins out there, but they can be roughly divided into three
groups: i) Off-chain collateralized, ii) on-chain collateralized, and iii) uncollateralized
– or purely algorithmic stablecoins.
Off-chain collateralized stablecoins like
Tether are pretty easy to understand, they use traditional reserve assets to stabilize
their value – so if you wanted to create one of these you could take a dollar from someone, put
it in a bank account and give them a crypto token that represents that dollar. When they wish
to redeem the token, you would burn the token and return their dollar to them.
This type of coin
has a central issuer, and to a certain extent, that is something that crypto people want to
get away from. They don’t like centralization.
The next type, “on-chain collateralized
projects”, are backed with other crypto assets. This occurs on-chain and uses smart contracts
instead of relying on a central issuer. If you buy one of these, you might lock your cryptocurrency
into a smart contract in exchange for stablecoins. You can later put your stablecoin back into the
same smart contract and withdraw your collateral. These projects are often overcollateralized,
so you might put up $2 worth of Etherium to get a dollars’ worth of a stablecoin, the excess
collateral being used to maintain stability.
Now, last up, we have purely algorithmic
stablecoins.
These don’t use traditional assets or cryptocurrency as collateral. Instead, their
price stability comes from the use of algorithms and smart contracts that manage the supply of
tokens in circulation with a goal of pegging them to the value of a Fiat currency like the dollar.
Ok, so before I get to explaining the problems with Terra let me tell you about today’s video
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Ok, so Terra, which has been all over the news
this week is an algorithmic stablecoin. So how does it work? Well, Terra’s code involves
a proof-of-stake governance token which is called Luna (crypto people have a thing for the
moon) along with a bunch of different Terra coins that are supposed to maintain a one-to-one
peg with real world currencies — TerraUSD, TerraGBP, TerraJPY and so on. Rising demand for
any of these coins increases its supply, but each Terra coin is always worth its peg value in
Luna. Traders can swap the governance token – Luna for a pegged Terra coin, and vice versa.
For the
sake of simplicity, we’ll just discuss UST, which is supposed to always be worth one US dollar.
The idea is that the price of UST is maintained by an arbitrage relationship with the governance
token Luna. So, one UST is supposed to be always worth one US dollar, and you can always exchange
one UST for whatever quantity of Luna is worth $1 at that point in time. So, if UST
trades at a discount to a dollar, you can buy it at that discounted price (lets say
99 cents) and exchange it for $1 worth of Luna, making an instant profit.
If it trades
above a dollar, you can buy $1 worth of Luna (for $1) convert that into a UST, and then sell
that for more than a dollar, once again making an instant and supposedly risk-free profit. The idea
is that because of this arbitrage relationship, while the price of Luna can fluctuate,
the price of Terra should always be $1: If it trades above or below $1, people will
exchange Terra for Luna or Luna for Terra until the price of Terra gets back to $1. If you
want more detail on how this is supposed to work, I have put a link to the Terra / Luna
whitepaper in the video description.
The core idea though, is that because one Terra
coin is always worth its peg value in Luna, there are opportunities to profit
whenever it trades above or below its peg, thus it should in theory never move from its peg
for long, at least that is how it is pitched.
OK, so hopefully you can already see how
this can go wrong, the whole system relies on the idea that no matter what happens, Luna
always has some value, and as its value falls, you can issue more and more of them until you have
issued enough to keep Terra’s value at a dollar. But of course, there is no reason to believe
that you can issue an infinite number of coins at a positive price point.
A coin that is
backed by nothing but the faith of investors. In a situation where Luna is falling consistently,
the code assumes that there is no point at which they are trying to issue more Luna at lower
and lower prices and there are no buyers.
If this type of idea worked, companies like
Lehman Brothers would never have gone bust, as they could have always have just
issued billions of dollars of new shares, if even at a fraction of a cent and used
that capital to pay off debt holders. In the real world, capital is not just
always available. This makes no sense.
Now, the structure of the Terra / Luna pair is
remarkably similar to what is technically known as “fixed value convertible bonds” but
which are referred to in the industry as death spiral bonds. This type of bond is sometimes
issued by companies that desperately need cash and have no other way of raising money. It always
ends the same way though – in a death spiral…
With a regular convertible bond, a $1,000 bond
would convert into a fixed number of shares, but in a death spiral bond – sorry I meant to say
“fixed value convertible bond,” the $1000 bond instead converts into let’s say $1,500 worth
of stock – no matter what the stock price is. This feature is where the problem lies.
The
bond investor might sell some stock short, in order to hedge the bond, but this would push
down the stock price, meaning that the bondholder is guaranteed more stock upon conversion, so
they then sell even more stock short. This cycle continues on until the stock price hits zero.
OK, so, you might wonder why anyone would store their money in an unbacked algorithmic stablecoin,
especially because it is fairly obvious that there is nothing really there other than two coins that
some guy made up, one of which he says is worth a dollar, and he bases this on the idea that he
can issue an infinite number of the other coin to keep the first one at a dollar. On top of that,
there have been other algorithmic stablecoins just like this one that have blown up in the past.
You would imagine this is a fairly small market. Well it’s not, there are around 18.5
billion dollars of UST in circulation.
OK, that’s a big number, but there are a few
reasons people might put their money in Terra – a synthetic dollar.
One is that there is a lot of
demand for stablecoins in general, and the other is that through the anchor protocol, Terraform
Labs, the entity that created Luna and Terra, pays an unsustainably high, and frankly unexplainable
19.5% interest rate on UST deposits.
OK, so, around this time last year Terra lost
its peg to the dollar (on a much smaller scale than it has this week) and afterwards when it
had recovered to par, its founder who calls himself the “King of the Lunatics” (fair enough)
decided to diversify and so, while Luna was high, he sold a lot of Luna and set up a foundation
called the Luna Foundation Guard to buy up Bitcoin and several other cryptocurrencies so
that there would be reserves available for use as an additional backstop against a severe drop
in Terra.
This at least diversified them away from the two coins they had made up, they now
had reserves containing other coins that other people had made up. The is not as good a solution
as it might at first sound, as it’s reasonable to believe that all crypto assets are correlated
to each other, and in a situation where there is a general crypto sell off, it would become
very difficult to support the dollar peg.
Now, some people argue that “The King of the
Lunatics” did this, partially because it made the Luna Foundation Guard one of the largest bitcoin
holders, and bitcoiners would hopefully then stop criticizing Terra, as they wouldn’t want
to see Terra break its peg, and cause a bitcoin whale to start dumping bitcoin to defend Terra.
Anyhow… over the weekend, UST started to fall, ticking to 99 cents. On Monday, it briefly fell
to – lets say below 70 cents, recovering on Tuesday to around 93 cents. Yesterday it fell
as low as 30 cents, and seems to be bouncing back again. At the time of this recording, it
is at 55 cents and things are not looking good. Here is a seven day chart. It is not exactly
stable. If this was your level of stability, you would be in a straitjacket right now.
The problems in Terra began spreading throughout the crypto space, and the sell off in
bitcoin can at least partially be blamed on this. As I mentioned earlier, we saw a much larger
stablecoin Tether break its peg yesterday. Tether is an 80 billion dollar stablecoin
that is allegedly backed with reserves, however, the reserve figures have not been audited
under generally accepted accounting principles.
Tether was co founded by the kid from The
Mighty Ducks, who tried to calm the market yesterday while wearing a funny hat.
If you are not involved in crypto, you might think that this is a niche
topic and of little importance, but financial regulators do appear to be concerned.
On Tuesday this week US Treasury Secretary Janet Yellen brought up what she described as a run
on UST in her testimony to the Senate Banking Committee in their hearing on risks to the
stability of the U.S.
Financial system.
The losses in Terra are not really the same as
a run, like a bank run, or a run on a backed stablecoin. In those cases, you have people
demanding their deposits back immediately, as they fear that the assets are not backed.
In such a situation (assuming that the coin is actually backed), the assets that back the coin
might have to be sold off quickly and due to poor liquidity, investors might sustain losses, but
they should still get most of their money back. With an unbacked stable coin whose value is
mostly held up by the faith of the investors, and an arbitrage strategy which doesn’t
reasonably work in a stressed market situation, losses can be expected to be much more extreme.
The fact that a panic in an algorithmic stablecoin likeTerra is spreading to backed stablecoins
like Tether, could be of concern to financial regulators, as it starts to impact the non
crypto world if they have to start dumping the money market instruments that they claim to own.
Some of the panic in crypto is already affecting real world, as we see the prices of monkey art
– a historically safe asset class- collapsing.
Yesterday Do Kwon – The King of the Lunatics
tweeted a thread announcing his plan to fix things. One of the problems that he highlighted
is that the smart contracts that do the exchange between Luna and Terra can’t print new Lunas fast
enough, causing the arbitrage mechanism to fail. His proposal is to print Luna faster to clear out
the backlog and issue a lot more Luna, so that one Terra can reliably be exchanged for $1 worth of
Luna, which should only speed up death spiral.
Another solution put forth is for the Luna
Foundation Guard to step in, selling bitcoin and their other crypto assets to support the
price of Terra, stabilizing the price.
This is possibly a better approach, but at its core
terra is deeply flawed, and there is no reason to believe that once all of the bitcoin has been
sold, that the death spiral does not start again.
There are articles out there stating that the
Luna Foundation Guard are attempting to raise an additional billion dollars to shore up UST
by selling Luna to investors at a 50% discount. These investors will then be tied up for two
years before they can sell this discounted coin. Lets be serious here, this is a coin that
was trading at around $95 dollars two weeks ago, it was at 50 cents yesterday and is at
20 cents at the time of this recording. If you bought it at a 50% discount from pretty
much any price, I’m not sure that you would be comfortable with holding it for two minutes not
to mind two years.
But, best of luck with that…
Now, a panic wouldn’t be a panic without
blaming short sellers, hedge fund managers or other billionaire boomers, and so all
over Twitter there are people blaming Kenny G – The soft jazz saxophonist??
for orchestrating an attack on Terra. I’m guessing the goal is to turn a stablecoin
into a meme stock. You might maybe hope that big investor could get involved, inject capital and
provide some external validation for the project, a bit like when Warren Buffett invested
in Goldman Sachs during the Credit Crunch, unfortunately Elon Musk – the most likely savior
has a lot of his capital already tied up with the Twitter deal, so this probably won’t happen.
In fact it’s possible that Elon’s whole plan to make Twitter profitable involves charging people
to remove NFT’s from their profile pictures, so that in years to come they can claim to
have known it was all nonsense at the time.
The truth here is that it doesn’t actually
matter what caused the price of Terra to unpeg. The design of the product was
fatally flawed from the start and thus it was just a question of when this
would happen, rather than if it would happen.
Look, I’m no fan of Kenny G. In fact, I cant
stand soft jazz – it just makes me angry, but if you have investments and when they go wrong
you are blaming short sellers, hedge funds or some other invisible evil force, you are just not
thinking straight. Kenny G didn’t talk you into investing in your failed investments – possibly
other people did, and they are maybe more to blame. But no single investor or market maker or
fund manager decides the price of any asset, there are no big conspiracies, no good and evil to be
found in market prices. The idea that everyone on a reddit board can decide to hold an asset forever
and become infinitely rich makes no sense.
When you look at a project like Terra, there
are so many bizarre things that make no sense, amusingly, you can earn a higher rate of interest
lending it out than you pay to borrow it. This can’t work. A fairly simple takeaway
though is that if something is supposed to be stable and low risk, it should not
be paying 20% interest.
A return of 20% a year is between two and three times the expected
return of a stock market investment, where there is an actual company making and selling products
or services. Simple logic tells you that something with two to three times the return of the stock
market should have two to three times the risk of a stock market investment. Something with two
to three times the risk of the stock market, possibly shouldn’t have the word stable in its
name. Let’s remember that Bernie Madoff “The King of the Ponzi Schemers” (he didn’t actually call
himself that) only promised 12% annual returns, and he had more volatility in his returns than
Terra – at least up until last week anyhow.
If you found this video interesting, you should
watch this one next on the likely regulations coming for stablecoins.
Don’t forget to check
out today’s video sponsor Private Internet Access using the link in the description below. Have
a great day and talk to you again soon, bye..