Stablecoins Are Unstable!

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 

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.
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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.

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..