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FTAlphaville and the screw-up known as Terra. Why this stuff isn’t banned is beyond me.
The big story in crypto-land so far this week is the Terra stablecoin, which has proven to be neither strong nor stable.
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You’ll probably know already that, by applying the Code is Law principle to monetary policy, Terra wants to become the internet’s reserve currency. You’ll also know that it’s not going entirely to plan.
The idea behind algorithmic stablecoins — cryptocurrencies that are pegged to a reference asset — is a kind of bizarro-world version of private money creation. When a bank writes a loan, it simultaneously creates a matching deposit on the liability side of its balance sheet. Reserve-backed stablecoins employ a similar mechanic, being IOUs backed one-for-one by a balance sheet liability. But with algo stablecoins, a governance token replaces the balance sheet and the IOU is written into the protocol. It is, in the purest sense, creating money from thin air.
Terra’s code involves a proof-of-stake governance token called Luna along with a bunch of Terra coins designed to maintain a one-to-one ratio peg with real world currencies — TerraUSD, TerraGBP, TerraJPY etc. A person can swap Luna for a pegged Terra coin, and vice versa.
Terra’s white paper talks of “price stability via an elastic money supply, enabled by stable mining incentives”. If that’s all too dense, Coinbase also has a good, comprehensive explainer. In essence, liquidity see-saws automatically between the IOU token and the quasi-balance sheet liability token to create arbitrage opportunities at negligible cost.
Rising demand for either coin increases its supply. But because one Terra coin is always worth its peg value in Luna, there’s an arbitrage on offer to switch to Luna whenever it’s trading below peg. And whenever the Terra coin is above its peg, the incentive is to switch back by burning Luna. Simple, right?
It’s usually about now in the explanation that first principles assert themselves. Though there’s undoubted value in a transaction protocol that offers low friction censorship-free global transactions, which is what Terra promises, there’s no reason why the tokens employed should have any inherent worth.
Enter, decentralised applications. The most popular, Anchor Protocol, is a money market for Terra coins whose near-incomprehensibility seems to be by design. All its users have needed to know was that deposited Terra tokens earn a (tokenised) annual yield of between 18 and 20 per cent. Yes, really.
And you’ll know what happens next. Along comes some 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. Its proposal involved staking Terra tokens inside a box levered 8x, so it would more than double money within a year risk free! What could possibly go wrong?
Well . . .
Remember QuadrigaCX, the Canadian crypto-ponzi platform that imploded shortly after the reported death of founder Gerald Cotten? Amateur investigation 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 collapse.
Once that news broke, the whole Frog Nation token universe crapped out. Liquidated Terra-coin holdings sunk Luna (whose price can be thought of sort of like bitcoin calculation difficulty) and nearly broke the peg. The see-saw mechanism that kept things orderly in rising markets turned out to be weak in falling markets, when traders were selling both coins. (With typical jejunity, the techbros have christened this problem a bank run.)
The good news is that Terra has a central bank. The Luna Foundation Guard is a non-profit that pays those 20 per cent interest rates from its treasury. It’s also prone to intervention whenever things are looking dicey, as explained in an excellent Twitter thread by Ava Labs president John Wu.
Unfortunately, Terra has a central bank whose MPC involves laser eyes-types like Terraform founder Do Kwon and Kanav Kariya of Jump Crypto. The Luna Foundation Guard has been bolstering reserves over recent months, but its choice of reserve asset was bitcoin.
As trades go, it hasn’t gone great. And once a central bank is on fire, it’s an open invitation to Soroses either actual and imagined.
Huge selling over the past few days might have been a coordinated attempt to break the Terra peg, or just a death spiral once the market cap of Luna drifted too far below that of Terra.
Since one Terra coin is always worth the peg value in Luna, the obvious trade once the peg broke was to switch Terra for Luna then sell the latter. Switching further unbalanced the market and pressured the Luna Foundation Guard into defensive measures that are burning through its already depleted reserves.
Excitable types have called this unravelling a Lehman Brothers moment for the whole crypto space. That’s likely to be hyperbole. The sell-off in bitcoin etc. over recent days has been for broad, dull macroeconomic reasons and alternative algo stablecoins such as Dai (which is collateralised by user deposits that can be margin-called) have so far functioned as designed.
Nevertheless, the next generation of DeFi entrepreneurs will need to settle some nerves given the capital destruction that’s been required to protect a project whose practical uses beyond tortuous financial engineering are, at best, unproven:
And how long will the moratorium last? Er . . .
Edit: And, just in case you think that this is happening at the only the kooky end of crypto, here’s the mainstream, also from Alphaville:
Microstrategy says its business model is built around two core strategies: buying and holding vast, vast quantities of bitcoin and developing software, in that order.
It’s an excellent plan when the price of bitcoin is on the up. Chief executive Michael Saylor, lord of cyber hornets, sees no reason why a single token (of which his company owns at least 129,218, valued in total at just over $4.1bn at pixel time) won’t eventually be worth more than $10mn and “keep going up forever” after that.
Alas, the world’s biggest digital asset by market cap has plunged more than 14 per cent in the past five days and is currently hovering around Microstrategy’s average in-price of $30,700.
The company’s shares are down 31 per cent in a week as a result. Its market cap has fallen to around $2.47bn, well below the value of its bitcoin holdings.
“Digital asset impairment charges” came to $170.1mn in the first quarter of the year, contributing to a net loss of £130.8mn. And things could yet get worse.
Microstrategy bought $215mn worth of bitcoin in the first three months of the year, funded by a combination of “excess cash” and a small, bitcoin-collateralised loan of $205mn from Silvergate Bank, repayable over the next three years.
Chief financial officer Phong Le told investors last week that bitcoin sinking below $21,000 would trigger a margin call on that loan, though he stressed that Microstrategy could always funnel more bitcoin into the collateral package. That may be a way off yet, but Jay Hatfield, chief investment officer at Infrastructure Capital Management, expects bitcoin to drop below $20,000 by the end of the year as the Fed shrinks its balance sheet.
Le may have put on a brave face (twice stressing that Microstrategy is in a “pretty comfortable place” right now), but the company admits its “substantial indebtedness” and interest expense could have “important consequences”, including:
- limiting our ability to obtain additional financing in the future for acquisition of additional bitcoin
- increasing our vulnerability to a downturn in our business and to adverse economic and industry conditions generally
- placing us at a competitive disadvantage as compared to our competitors that are less leveraged
Microstrategy’s total debt is $2.405bn, according to its most recent regulatory filing. Annual interest expenses have soared to around $44mn, meanwhile, equal to “about half” of the company’s Ebitda from last year once you “adjust out the bitcoin depreciation”.
So, no need to panic . . .