The big story in crypto so far this week is the stablecoin Terra, which has proven to be neither strong nor stable.
You probably already know that Terra wants to be the reserve currency of the internet by applying the Code is Law principle to monetary policy. You will also know that it will not go entirely as planned.
The idea behind algorithmic stablecoins — cryptocurrencies pegged to a benchmark asset — is a kind of weird-world version of private money creation. When a bank takes out a loan, it simultaneously creates a deposit corresponding to the liabilities of its balance sheet. Reserve-backed stablecoins use a similar mechanism, being IOUs backed one-for-one by a liability on the balance sheet. But with stablecoin algos, a governance token replaces the balance sheet and the IOU is written into the protocol. It is, in the purest sense, about creating money out of nothing.
Terra’s code involves a proof-of-work governance token called Luna along with a bunch of Terra coins designed to maintain a one-to-one ratio with real-world currencies – TerraUSD, TerraGBP, TerraJPY, etc. A person can exchange Luna for a pegged Terra coin, and vice versa.
Terra’s whitepaper talks about “price stability via an elastic money supply, enabled by stable mining incentives.” If this is all too dense, Coinbase also has a good full explainer. Essentially, liquidity switches automatically to create arbitrage opportunities at negligible cost.
Growing demand for either coin increases its supply. But because a Terra coin is always worth its peg value to Luna, there is an arbitrage offered to switch to Luna whenever it trades below the peg. And whenever the Terra coin is above her ankle, the incentive is to change by burning Luna. Simple, right?
It is generally around now in the explanation that the first principles assert themselves. While there is indisputable value in a transaction protocol that offers low-friction, censorship-free global transactions, which Terra promises, there is no reason why the tokens used should have any inherent value.
Enter, decentralized applications. The most popular, Anchor Protocol, is a money market for Terra coins whose near-incomprehensibility seems to be intentional. All its users need to know is that deposited Terra tokens yield an annual (tokenized) return of between 18-20%. Yes really.
And you will know what will happen next. Along comes an enterprising company that builds a box. . . or in this case, a cauldron:
The graphic above is from Abracadabra.money, which is part of a collective of projects known as Frog Nation. His proposal involved staking Terra tokens in an 8x leveraged box, so he would be more than double money within one year risk-free! What could go wrong?
Well . . .
Remember QuadrigaCX, the Canadian crypto-ponzi platform that imploded shortly after the reported death of founder Gerald Cotten? Amateur investigative work in January connected Frog Nation with Omar Dhanani (aka Michael Patryn), a QuadrigaCX co-founder whose criminal record provided the big reveal in a Netflix documentary about the meltdown.
Once this news broke, the whole universe of Frog Nation tokens came crashing down. The liquidated Terra-coin holdings sank Luna (whose price can be seen as a kind of bitcoin calculation difficulty) and almost broke her ankle. The seesaw mechanism that kept things in order in rising markets proved to be weak in falling markets, when traders sold both coins. (With typical jejunity, the techbros dubbed this problem a bank rush.)
The good news is that Terra has a central bank. The Luna Foundation Guard is a non-profit organization that pays these 20% interest rates from its cash. He is also likely to step in whenever things seem risky, as explained in a great twitter feed by Ava Labs President John Wu.
Unfortunately, Terra has a central bank whose MPC involves laser eye types like Terraform founder Do Kwon and Jump Crypto’s Kanav Kariya. The Luna Foundation Guard has been building up its reserves in recent months, but its choice of reserve asset was bitcoin.
As the exchanges progressed, it did not go very well. And once a central bank is on fire, it’s an open invitation to real and imagined Soroses.
The massive sales of the past few days could have been a coordinated attempt to break Terra’s ankle, or simply a death spiral once Luna’s market cap drifted too far below Terra’s.
Since a Terra coin is still worth the value of the peg to Luna, the obvious trade once the peg was broken was to change Terra to Luna and then sell the latter. The switch further unbalanced the market and prompted the Luna Foundation Guard to take defensive actions that burn its already depleted reserves.
Deploy more capital – stable guys
— Do Kwon 🌕 (@stablekwon) May 9, 2022
The excitable types called this outcome a Lehman Brothers moment for the entire crypto space. This is probably hyperbole. The selling of bitcoins etc in recent days has been driven by broad and boring macro reasons and alternative stablecoin algos such as Dai (which is backed by user deposits callable on margin) have up to this worked as expected.
Nonetheless, the next generation of DeFi entrepreneurs will need to calm some nerves given the destruction of capital that has been necessary to protect a project whose practical uses beyond tortuous financial engineering are, at best, unproven:
And how long will the moratorium last? Uh. . .