Every once in a while I look under the hood to see the inner workings of a crypto. There are thousands of cryptos and new ones are constantly being innovated under less than reliable protocols. They all promise a new era in crypto but mainly exist as vehicles for wealth creation for the early adopters and wealth extraction from the late adopters. Much of crypto levitates on a perpetual inflow of capital for dubious innovation with no underlying economic foundation.
Terra perfectly illustrates this concept. It was the third-largest stablecoin that combined with its governance token Luna had a market cap of $45 billion. Today Terra and Luna continue to unwind to an apparent unsalvageable zero net worth. The collapse happened amazingly fast overnight from May 9-10.
Terra is an algorithmic stablecoin that pegs to the dollar at 1:1 and uses arbitrage to maintain the peg. It’s algorithmic protocol precludes any traditional hard asset backing such as cash, T-bills, or commercial paper. Its value and stability rest on its contrived protocol and requires trust in the algorithm to sustain itself. Terra established its trust by scaling to the third-largest stablecoin. The protocol must work if $45 billion of capital flowed into it. At least that is the narrative.
Terra incentivized incoming capital from a corresponding Anchor Protocol that pays 20% APY for terra deposits or luna loans converted to terra. Another protocol, Abracadabra Degenbox (yes, it is magic money) was created to leverage terra within the Anchor Protocol. Why accept a 20% return when you can leverage it up and abracadabra, you get 100% APY. This is a classic Ponzi. The early 20% returns are funded by the later deposits and subsidized by the TLF, Terra Luna Foundation. There is also an LFG, Luna Foundation Guard, that is supposed to dampen volatility in Luna. The LFG is basically a centralized slush fund for Terra’s cult leader creator Do Kwon to use as he sees fit. So much for the decentralization part of DeFi. Terra scaled and worked right up until the point that it didn’t.
The details of how Terra, Luna, and Anchor worked are too complicated to go into, but it is basically a Rube Goldberg algorithm crypto contraption built upon a Ponzi foundation. It requires arbitrage between the terra pegged stablecoin and its created out of whole cloth governance token luna. If terra loses its peg at one terra to the dollar and can’t be reestablished, the algorithm that maintains the equal value between terra and luna breaks down into a death spiral. The decreasing value of terra decreases the value of luna which increases luna supply and decreases the value of terra, etc. down to zero. Here is a detailed explanation of the Terra experiment.
All algorithmic stablecoins have no hard asset backing. You can’t create something from nothing and leverage it to stability. The massive returns are a huge attraction for capital in the early stages, but sustaining the stablecoin ecosystem requires an underlying asset that provides tangible worth.
The largest stablecoin is Tether with a recent $83 billion market cap. Tether is supposedly backed by hard assets. In its 2014 origination, Tether claimed:
Every tether is always backed 1-to-1, by traditional currency held in our reserves.
In February 2019, this text changed to:
Every tether is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities (collectively, ‘reserves’).
Tether has never in its operational history provided an audit of its reserves despite repeated promises that an audit is just around the corner. Tether’s entire corporate existence is a series of fraudulent mishaps, yet tether has become the backbone of the entire cryptosystem. Tether is under increasing scrutiny and regulatory pressure from the NYAG, SEC, and U.S. Treasury, and FOIL litigation on the composition of Tether’s reserves. Tether recently lost its case at the NY Supreme Court to keep its reserve data hidden.
The terra collapse resulted in a rapid 30% decline in the price of bitcoin. The entire paired crypto space declined in tandem. A tether collapse will be far worse and will further erode tenuous trust in many cryptos.
Stablecoins are built on an underlying Ponzi. Whether it’s Tether with its unaudited fictional reserves or Terra with its algorithmic protocol that requires Rube Goldberg yield farming to maintain a semblance of liquidity, stablecoins are inherently unstable.
A big question is why do stablecoins even exist? The original Satoshi vision was for a decentralized payment system to compete with central bank fiat. Satoshi’s vision assumed bitcoin currency stability that would not require a stablecoin. The Bitcoin fixed supply flaw resulted in volatile bitcoin prices that negate its utility for everyday transactions. Stablecoins exist to dampen the volatility of decentralized cryptos, such as bitcoin, and provide a liquidity bridge to less unstable fiat. IOW, a stablecoin Ponzi became the foundation for the stability of perpetual volatile fixed supply crypto.
There’s a larger picture behind all this. It’s the coming move to CBDC which is not compatible with decentralized crypto, yet requires continuing crypto innovation to achieve its implementation. Crypto is coming full circle. Satoshi’s original vision based on its flawed fixed supply protocol is responsible for the coming CBDC digital fiat that will supplant decentralized crypto. Satoshi’s vision is enabling a more aggressive and entrenched central bank fiat monster. CBDC is a critical component in the global move toward economic, health, social, environmental, and security based systems of totalitarian control. It’s coming to a sovereign nation near you.
Brilliant work Mike as always.