Stablecoins: Neither Stable nor Coins
"Like, you know how this plays out."
Today I want to tell you what a stablecoin is and what happened to an algorithmic stablecoin called TerraUSD yesterday because if you understand it, you suddenly have access to some of the darkest comedy available right now, which otherwise masquerades as boring business news. I’ve been chortling for twenty four hours, and I’d like you to join me.
What’s a stablecoin?
Say you have a lot of crypto beanies, and your job is to make more by shuffling them around between different immutable spreadsheets. The crypto beanie values go up and down wildly, and sometimes you just want to have a little nap without getting “rekt while you sleep” as Liz Lopatto put it. You could sell your beanies for U.S. government dollars, but crypto is a river full of piranhas where every little fishie takes a bite out of you on every transaction. Even worse, getting real cash out of the Scamazon River also involves “know your customer” laws, where you have to “prove” you “didn’t steal all these beanies” etc., so it can be some combination of expensive, slow, and illegal.
To solve this problem, and continue their speed-run of the history of financial fraud, crypto’s brilliant grift engineers invented the “stablecoin.“ In theory, this is a crypto coin whose value is equal (or “pegged”) to a government currency. That way instead of dragging your bloody skeleton out of the river through all the voracious crypto piranhas and regulators, you can just trade your volatile beanies for these happy stable beanies, where they sit being quietly equal to vile fiat dollars while you snooze.
Nice. So how do you make a coin that’s always worth a dollar?
The obvious way to make a stablecoin would be to get a whole lot of dollars in a pile, lock them up, and issue one stable beanie per dollar. So the tokens are just a database entry that says “this represents one dollar, which I definitely have.” That’s also what “actual U.S. dollars” are now, so this is pretty uncontroversial. The second biggest stablecoin is called USDC, and it claims to be “fully backed by cash and short-dated U.S. government obligations, so that it is always redeemable 1:1 for U.S. dollars.” I.e. more or less “a big pile of real money,” without getting into the hairy question of what even is money, anyway.
That seems expensive though
There’s about $50 billion worth of USDC out there, so backing it all with real money is expensive as heck.What if instead of “a big pile of money,” you could back a stablecoin with “a big pile of other stuff that’s kind of like money?” That’s the approach of Tether, which is the biggest stablecoin, with over $80 billion circulating. Tether is backed by real money in the sense that when you ask what it’s backed by they say “real money” and when you request that they show you the money they say “lol no.”
Last October Bloomberg’s Zeke Faux went looking for Tether’s backing and found a former child actor from “The Mighty Ducks” and a clown car full of chaos. According to Tether itself, its backing is mostly short-term commercial loans. If you ask them to tell you who those loans were made to, they say “lol no.” Speculation has it that the loans must be to Chinese property developers (of “facing an unprecedented liquidity squeeze” and “deemed to be in default after a run of missed payments late last year” fame), because the sheer volume of commercial loans involved can’t be found anywhere else. Everyone seems to agree that the size of Tether at this point represents an existential threat to not just the crypto market but the actual economy, as Liz Lopatto explained last summer.Astonishingly, this isn’t even the funny part yet.
What if I want to make a stablecoin but all I have are hopes and dreams?
If you don’t have real money, or even pretend money, a third and final way to create a stablecoin is: the art of illusion!
TerraUSD is an “algorithmic stablecoin,” where the much-abused word “algorithmic” here means “bullshit.” It is the third largest stablecoin in existence, with almost 18 billion tokens in circulation. The way it works is this: a developer named Do Kwon made two new crypto tokens. One is called Terra, and Kwon said “those are each worth one dollar.” The other is called Luna, and the value of Luna is allowed to float, so it’s worth whatever someone wants to pay for it. The two tokens can be converted into each other, so if Luna is worth $30, you can destroy one Luna and get 30 Terra (which are supposed to be worth $1 each). And if Terra was worth less than a dollar, you could destroy 30 Terra to create 1 Luna at a discount, which also will decrease the supply of Terra and make it more valuable, via good old supply and demand, eventually pulling it back up to $1.
Have you spotted the problem yet? If you have: lol, right? If not: I promise you have, you just think it can’t possibly be that stupid. Regrettably, it is that stupid. Many other people have noticed the problem with this system, which Matt Levine explained very well today:
The basic thing that makes Terra valuable is confidence in it. The essential source of this confidence is ... just sort of recursive social belief? If you think that everyone else will treat Terra as worth a dollar, then you will treat it as worth a dollar, and you won’t sell it for $0.90 in a panic, which means that it won’t go down to $0.90, etc. But if you think that everyone else will treat Terra as worth zero, then you will dump it as fast as you can at whatever price you can get, which means that it will go down below $0.90, etc.
The law of supply and demand only works when there is both supply and demand. If I offer you a gallon of poison for a dollar, and you say “no thanks, I don’t want any poison!” and then I drink half the gallon and say “now there’s only half a gallon, better act fast!” and you say “well, I still don’t want any poison,” then I haven’t managed to make my poison any more valuable and I have also died horribly.
So Do Kwon said “well if you’re not convinced of the long-term value of the beanie I made up, what if I also back the whole thing with a different beanie that someone else made up?” So he formed a nonprofit that used Luna tokens to buy Bitcoin to act as a pile of kind-of money to back his stable-ish coin, in case of emergency. The “Luna Foundation Guard” (or LFG, an acronym which I can only imagine was chosen first) accumulated Bitcoin worth, as of yesterday’s terrible Bitcoin price, about $1.3 billion.
All of this actually worked for a while, mostly because Luna isn’t just the backing token for Terra, you can do other things with it. One of the main things you can do with it is deposit it in something called the “Anchor Protocol,” which is a box you can lock your beanies in that pays 20% yield on them annually. Last month, Coin Desk’s David Z. Morris pointed out that:
Anchor provides 20% APY on locked deposits, but that rate isn’t profitable for the system: The current APR being offered to borrowers is just 11.81%. A lender is only sustainable if it collects more interest on its loans than it pays out to deposits.
So Anchor’s business model is to lend out deposits at a loss, which is subsidized by a reserve fund that makes up the fictional 20% yield that depositors are promised. And the value of this Ponzi scheme was the main thing backing the TerraUSD stablecoin.
Now all the pieces are in place. If you look at it a certain way, what Do Kwon actually created was a computer game where the right set of moves, performed with the right leverage, will force him to sell you more than a billion dollars worth of Bitcoin at a deep discount. Maybe it’s just a coincidence, but it sure seems like someone else noticed that, and took advantage of the ongoing Bitcoin crash and a general flight from risky assets to try their luck.
First, if you can simultaneously drive Luna and TerraUSD down, you can trigger a death spiral. Matt Levine again:
If one Terra goes down to $0.90, the arbitrage mechanism — you exchange one Terra for $1 worth of Luna, and then sell your Luna into the market for $1 — just doesn’t work. You exchange one Terra for $1 of Luna, but confidence in Luna is also falling, and the market is being flooded with Luna as people try to do this arbitrage. So the $1 worth of Luna you received is no longer worth $1, and then the next person who redeems Terra gets even more Luna and has to sell even more of them, which drives the price down more, which increases the amount of Luna being issued, etc., in a “death spiral.” There is no particular floor on this process, and it can go until everything is worth zero.
In The Wall St. Journal, Caitlin Ostroff and Alexander Osipovich described what happened to TerraUSD in the last few days:
The break in the peg, which began over the weekend, started with a series of large withdrawals of TerraUSD from Anchor Protocol…
In tandem with the big withdrawals, TerraUSD was also being sold for other stablecoins backed by traditional assets through various liquidity pools that contribute to the stability of the peg, as well as through cryptocurrency exchanges.
The death spiral drove the notionally dollar-pegged value of TerraUSD down to $0.69 (nice) yesterday, before the Luna Foundation Guard "emptied its treasury wallet of all of its bitcoin, about 42,530 bitcoin, or $1.3 billion,” according to Jacquelyn Melinek at TechCrunch. What LFG did was “loan” all that bitcoin to “market makers” to “significantly strengthen the liquidity around the UST peg.” What those finance words mean is: Do Kwon handed $1.3 billion worth of Bitcoin to some pals to buy Luna with, in order to prop up the price temporarily, in the hopes that everyone will forget that it’s a gallon of poison backed by hopes and dreams.
At the moment, the Terra stablecoin is worth $0.90, about where it’s been all day. That is definitely not a dollar! You simply can’t make any use of a U.S. dollar stablecoin that’s only worth ninety cents, and a whole day spent hovering at a useless 90 cents smells like “market makers” propping up the market with all that Bitcoin that LFG gave them. Indeed trading volume today has been about five times larger than it normally was before yesterday’s collapse started, and Coinbase reports that the trading activity is “80% buy.” It seems like UST will have to settle pretty soon at one of its two equilibrium values, which are either one dollar or zero dollars. I can’t wait to find out which it is!
So what does it all mean?
Even though it’s the third largest stablecoin, if Terra and Luna collapse completely it probably won’t matter to the actual economy, because none of it has any real connection to the actual economy. Someone may get a lot richer if they did construct a straw big enough to drink the Luna Foundation Guard’s $1.3 billion milkshake. Joe Weisenthal remembered that noted crypto skeptic Sam Bankman-Fried just went on Odd Lots last month and said this:
What's your take on the rise of either algorithmic or partially algorithmic partially backed stable coins. One of the most interesting phenomenon happening right now is the rise of Luna and UST and Luna has this Treasury Reserve consisting of a lot of Bitcoin, which seems a little dicey, but some people say any idea of like an algorithmically-backed stable coin is a perpetual motion machine. It's only a matter of time before it fails. Do you believe there can be like a truly sort of like decentralized stable coin? What do you make of these projects?
I think they're really cool. I do have some sympathy to the perpetual motion machine crowd here. They can serve some useful purposes, but if you do zoom out, right, and you say, this is a stable coin, backed by volatile assets, what's gonna happen in a big market move. Right? Like, you know how this plays out.
“Like, you know how this plays out.” And if you don’t know how this plays out, or you think crypto’s fraudgineers invented this kind of thing, last year Josh Giersch compared this whole scheme to the time in 2008 when “the Icelandic central bank said ‘EURISK is now pegged at 150. We will maintain the peg by growing and shrinking the ISK money supply to hold it around 150 ISK to the EUR. Do not test us.’” Did that go well?
Here’s the worst thing I saw yesterday:
Today’s Song: Maisie Peters, “Cate's Brother”
~ all my tabs gone ~
Well I was just gonna explain real quick why the UST crash was funny, and it got completely out of hand. If you learned something, maybe subscribe? Or share this post, that helps a lot too. Normal Tabs resume tomorrow!
I did the math and it costs: $50 billion.
If it’s not already clear, I relied heavily on both Liz Lopatto’s reporting and also her patiently explaining to me how the hell an algorithmic stablecoin works in chat yesterday. Any errors here are my own, but to the extent I understand any of this, she deserves the credit.