What does the Terra/LUNA crash reveal?
Another round of Cryptogeddon is here and this time it is Terra that is leading the way down the abyss.
What happened? Why did Terra collapse? I’ll explain it all here.
What is Terra? TerraUSD is a ‘stablecoin’ pegged to the dollar(with different versions pegged to other currencies). That means, theoretically, one TerraUSD(UST) should always be worth 1 dollar.
How is this achieved? Typically if you want to peg an asset to another, you hold enough of the asset you are pegging to, so in this case you would hold a whole bunch of dollars. And no matter what happens in the outside markets, you offer a window where they can exchange the asset being pegged for the one being pegged to at a fixed rate i.e. in this case, a window where you can exchange UST for 1USD of cash.
That’s how some of the other stablecoins like Trust Token’s TUSD operate. However Terra took a different approach - instead of holding dollar reserves, they attempted to maintain the peg via some complicated financial engineering.
You have two coins UST and LUNA. UST is supposed to always be worth $1. LUNA is worth whatever the market values it at. The protocol that Terra has created allows you to always burn 1UST for $1 worth of LUNA and vice versa - $1 worth of LUNA for 1UST. By burn here we mean destroy the coin, remove it from the money supply.
The hope is that if the price of UST goes above $1, people will burn $1 worth of LUNA for 1UST, thereby increasing the supply of UST and so helping bring its price down to $1 and in the meantime being able to sell that newly minted 1UST for more than $1 and make a profit. Reverse the scenario for when the price of UST goes down. So in theory, everyone wins.
You can then have the best of all the worlds. A stablecoin that can be used for interfacing with the outside world and another coin that can soar in value like bitcoin and you can go back and forth between as you please. As per their whitepaper the creators of Terra did a whole bunch of simulations in various economic scenarios and found that their creation was stable.
Confidence in the system helps keep the stability. This confidence is maintained by a lot of good marketing among other things. Marketing like it’s not just a coin, it’s an ecosystem. People are building amazing applications on top of it. You can earn coins just by holding them(staking). And all that good stuff.
But what happens when you get a run on the bank? What happens when people want to sell both LUNA and UST? You get the collapse you see now. Clearly this was not factored in the simulations.
Terra is now less than 50c and the price of LUNA collapsed from 80 dollars to 1c. Yes that is 1 cent from 80 dollars. Why doesn’t the arbitrage work anymore? Shouldn’t people be pocketing the difference handily? Surely you can buy Terra now for 50c and exchange it for $1 worth of LUNA? Then sell the LUNA and pocket the profit. As is glaringly obvious, if the LUNA price is collapsing, this won’t work well. By the time you sell the LUNA, its price will have dropped and you will have lost your gains and maybe more. The arbitrage becomes too risky and on one wants to take it on anymore.
So the financial engineering fails and it all goes down into the abyss.
What caused the run on the bank? We don’t know, in the months to come some intrepid souls will find out, but in a free floating system, these can always happen.
What is Terra proposing as a fix? Among other things, to make it easier and faster to mint LUNA and even faster, i.e. increase the money supply on one end in the hope that this will make it easier for UST holders to swap their UST to Luna, thereby bringing the price of UST back to $1. Or use their reserves to buy up Terra, shoring up its price.
Printing money to ward off crises, burning reserves - isn’t this what fiat money systems do, something crypto was meant to avoid? Unfortunately, yes. As I wrote before, every group of coin ‘managers’ will have to be the Federal Reserve for the money they have issued, and will face all the problems the Fed faces. Terra indeed has a 'Treasury' department.
Can Terra recover? Will their measures to save the coin pair work? Will UST come back to $1 and will LUNA recover? We shall see. If they do miraculously succeed they will need to add more controls to prevent such a recurrence and restore investor/participant confidence. So, once again they will have to act as the Fed does. Is this really the sign of a truly decentralized system? The rules can be changed, money can be printed. At least with the Fed you have some recourse at the ballot box every four years. What recourse do you have with coins?
Stepping back, does this all seem familiar? Remind you of the Big Short, the housing bubble, credit default swaps, CDOs, CDO squared etc etc?
As I wrote in the case for the prosecution against NFTs, the financial engineering that was once the exclusive domain of Wall Street is now, for better or worse, available to the common man in the crypto world. When the going is good there are profits galore, when bad, armageddon.
Except that we couch it all in yoga babble which Wall Street never did - we talk about how we are changing the world for the better, connecting people etc etc etc.
Are we really? It is hard to see the gain for the ordinary mom and pop from all this moving of bits and bytes in this Terra debacle. So many smart minds are working on reinventing the wheel. Say what you want of Elon, but at least he is building real things - rockets that will get us to Mars.
And you dear investor, why did you buy that coin anyway? You read their whitepaper and decided it was a fantastic innovation? You look at what people are actually doing with the coin like buying/selling actual things and are convinced this is a winner? Nah…mostly likely you bought it because you hoped it would go up quickly and you could sell for a good profit.
There is value to the blockchain as I outlined in the case for the defense for NFTs. However in any gold rush there will be all kinds of false leads. You invest at your peril.