May 23, 2022
The Unstable Stable Coins
What Terra, Luna & The Crypto Crash Teach Us about Investing
The point is not to take the world’s opinion as a guiding star but to go one’s way in life and working unerringly, neither depressed by failure nor seduced by applause — Gustav Mahler
If you want to invest in a currency, invest in common sense for common sense is the most undervalued currency in the world today. The recent meltdown in the value of stable coins Terra and Luna and the crypto market in general just makes this conclusion more obvious as I explore in the essay below. Before I get into the lessons, allow me a quick detour as I explain the fundamentals of investing — some inalienable truths worth remembering.
Fundamentals of Investing
As with any skill worth learning, investing is part science and part judgement (art). At the very basic level, you have a finite amount of money (also known as your ‘savings’). Investing is lending that money out in the hopes that you will earn more money by investing than what it costed you in the past and what it can cost you in the future.
For example, let’s say you are a salaried person, you earn salary by ‘renting’ your time out to a corporation. Therefore, it cost you an education and continued efforts to earn salary. In addition, there is also a hidden cost to your efforts. That hidden cost is called opportunity cost. In simple terms, opportunity cost is the next best option you gave up by renting your time out to a corporation e.g. you could have used that time to earn money by writing or starting your own business.
If you simply put your money in a savings or checking account, you are lending money to the bank and the bank earns profits in turn by lending that money out through loans i.e. personal loans, mortgages, auto loans etc. The hidden cost of keeping your money in the bank is inflation. If you earn 0.5% interest on your bank account while inflation is at 2.5%, you are losing 2% every year. The same coffee you bought for $5 now costs you 2.5% more.
On the other hand, you would rather invest your money in an ‘asset’ that earns you more than the cost of that money (including hidden costs). Therefore, most investors invest in stocks and bonds. When you invest in a stock, you are lending money to the management of a company to do as they wish with it. The idea is that the management invests that money in projects that will earn profits in both the short and the long run. Those profits will be reflected either in the price of that stock or they will be paid out as dividends. Over a longer term (stocks can always fall), stocks should earn you 12–13% on an annual basis. Thus, you are now earning more than what you would with a savings bank account. Of course, higher earnings carry a higher risk. Some of these companies may not be managed well and you could end up losing money. The problem with investing in stocks is you could end up losing your initial investment which is not the case with bank accounts at least not until there is a ‘run’ on the bank.
Stocks, bonds, currency, commodities are all established assets that can be readily exchanged in the market. More importantly, there are metrics that provide you with indicators as to the relative worth of an asset (metrics exist for bonds, currencies, commodities etc.).
For example, there are metrics such as revenue growth, cash flow, Price to Earning (P/E) multiple, dividend payout in case of stocks. While these metrics are the science behind stock picking, investing is more about psychology than hard numbers. The reason is fairly simple — metrics tell you how the stock performed in the past. However, no one (including the management of a company) knows how the future will pan out. Therefore, you invest to the best of your judgement which may not always be right. You hope to be more right than wrong. The same logic applies to the management of the company — it cannot predict how forces beyond its control can impact the company. A new regulation can simply wipe out its profits.
The reason I explained a few basics about investing is metrics are hard to come by when you invest in cryptocurrencies and stablecoins. Investing in crypto assets is harder — you need to know how the technology is evolving to make an informed guess about what a cryptocurrency is worth. Therefore, there is a thin line between an educated guess and a gamble. Most investors, like you and me, cannot see that line.
If you feel uncomfortable or you feel that the opportunity cost of keeping track with emerging technologies is higher than the money you earn by investing in them, common sense dictates you lessen your exposure or better still avoid investing in cryptocurrencies altogether. There is no black and white when it comes to investing in crypto as with most things. Investing, in general, relies on evaluating probabilities of events happening i.e. shades of grey. Also, a Black Swan event like the pandemic is beyond our imagination. Therefore, tread carefully.
The Crypto Crash
A Stablecoin is a cryptocurrency backed by a reserve asset. The reserve asset could be a fiat currency i.e. US Dollar or assets such as gold, silver or another cryptocurrency. There are three types of stable coins i.e. Fiat collateralized, crypto collateralized and algorithmic stablecoins. The word ‘collateral’ means a security that you will get your money back. For example, a bank that provides and auto loan usually has a lien on the vehicle. If a borrower defaults, the bank can sell the car and recover whole or part of its loan.
Fiat collateralized stablecoins are usually backed by a fiat currency although they can be backed by gold, silver etc. For example, one unit of crypto will be backed (collateralized) by a unit of US dollar. Reserves of fiat currency are maintained by independent custodians and regularly audited. Tether USD and True USD are examples of stablecoins backed by the US dollar.
Crypto collateralized stablecoins are backed by other cryptocurrencies. This type of stablecoin is riskier than the fiat collateralized stablecoin since the cryptocurrency held as collateral itself is subject to volatility. Often, crypto collateralized stablecoins have more collateral than the value of the stablecoin. As per investopedia, MakerDAO’s Dai (DAI) stablecoin is pegged to the U.S. dollar but backed by Ethereum (ETH) and other cryptocurrencies worth 150% of the DAI stablecoin in circulation.
The riskiest type of stablecoin is an algorithmic stablecoin. An algorithm (preset computer program) controls the supply of the stablecoin maintaining its peg against the US dollar. Terra and Luna — the crypto currencies responsible for crashing the crypto market are examples of algorithmic stablecoins. It is easy to understand, therefore, that if you don’t know how the algorithm works, steer clear of this type of stablecoin. In the event, the stablecoin loses its value, you may not get your money back. That is precisely what happened with Terra and Luna.
Do Kwon and Daniel Shin (also known as Shin Hyun-sung) co-founded Terraform Labs in Seoul, South Korea in 2018. In 2019, Terraform labs issued its first cryptocurrency token. Terra is a blockchain that functions as a payment system. The business rationale for creating Terraform labs is the creation of a stablecoin to be used in the growing DeFi (Decentralized Finance) universe. Terraform Labs raised more than $200 million from venture capitalists and investors, Even as critics questioned the business model, Terraform labs’ valuation grew to more than $40 billion enticing wealthy investors, day traders and entrepreneurs to invest in it — early stages of a crypto tulip mania. Of course, this conclusion seems obvious only in hindsight.
There are many apps (approximately 114) developed on the Terra blockchain that serve many functions cross DeFi, Web 3.0 and Non-Fungible Tokens (NFT’s). One of the most popular app was the Anchor protocol which provided yields of upto 19% to users for lending (staking) their cryptocurrencies.
The Terra blockchain is unique in that it is designed to maintain the stablecoin (UST) peg through a complex model called a “burn and mint equilibrium”. Burning in simple terms is selling while minting is creating/buying. This method uses a two-token system, whereby one token (UST or Terra) was supposed to remain stable (UST) while the other token (LUNA) was meant to absorb volatility. The golden rule was that 1 UST can always be exchanged for $1 worth of Luna.
If Terra’s supply outstrips demand, its price would fall below $1 say 99 cents. In order to bring the price to $1 again, Terra (UST) would be exchanged for Luna and traders would gain 1%. As more traders sell Terra (pool contraction), its supply would be brought back to equal its demand. Likewise, if the price of Terra goes above $1 say $1.05 — it would mean the demand for Terra is higher than its supply. Therefore, to increase supply, traders would mint (buy) Terra and profit by $0.05 by selling Luna. This would increase supply of Terra (pool expansion) and bring it back to match its demand.
The idea was that Luna would be backed by a reserve asset — Bitcoin in this case. The Luna Foundation Guard was created to protect the peg. It purchased roughly $2.3 billion worth of Bitcoin with plans to increase reserves upto $10 billion. If UST falls below $1, Bitcoin reserves would be sold and additional UST bought to bring the value back to $1 and vice versa.
Terra’s blockchain issued the Luna token. At one point, Luna traded for $82 which meant 1 Luna could be exchanged for 82 Terra. In order to incent users to mint more Terra and burn Luna , the Anchor Protocol offer an insane interest rate of 19.5% for staking i.e. investing your money in Terra.
The situation was fine until an unforeseen event forced users to sell Luna crashing its price. Whether the selling was due to liquidity pressure (investors withdrawing money) because of rate hikes by the Fed or a well co-ordinated hack is up for debate. The selling began on May 7 and resulted in roughly $2 billion of UST taken out of the Anchor Protocol. This resulted in its price crashing to 20 cents. Now, you might say — its pegged to Luna. The problem is that only $100 million of Terra can be exchanged for Luna in a day. If investors burn more than $100 million of Terra, Terra loses its peg. Luna holders had it worse with the distress selling. Luna’s price crashed to less than a penny. Collectively, $40 billion was wiped off in the crash with many investors losing a ton of money. Sophisticated hedge funds had already withdrawn their investments.
There were two things Terraform Labs never considered — creation of a backstop if massive selling pressure overwhelms the system logic and the fact that Terraform Labs doesn’t have the same power as the Federal Reserve that can print more money should the need arise since it is the government.
Terraform Labs set out to create an algorithmic decentralized stablecoin. It aimed to create a stable, decentralized crypto currency. It was supposed to be decentralized and stable — which Bitcoin and Ether are not. Most stablecoins such as Tether are centralized in that they are backed by US dollars.
Terra ended up casting a long shadow of doubt on stablecoins, invited regulatory attention and cost a lot of money to a lot of investors.
Key Lessons From Terra, Luna and The Crypto Crash
First, invest in things you understand. To be honest, I bought Bitcoin for sentimental reasons. To me, Bitcoin gave birth to the blockchain although reverse is true as well. The power of Bitcoin lies in its power as an idea that has transformed the world of financial services in general. Therefore, I wanted to own a piece of history. In other words, I invested in Bitcoin to be a part of history and not for monetary gain. I bought just a little bit of Bitcoin understanding fully well its value can go to zero.If Bitcoin appreciates in value, it is simply a bonus. Theoretically, it could plunge to zero if the world stops attributing any value to it although that outcome is unlikely but possible.
I also invested in Ethereum because it serves as the foundation for modern Decentralized Finance or DeFI. As long as the developer community continues to build on the Ethereum blockchain, Ether will have value as a currency in that universe. The closest to the third coin I have come to invest in is Solana. Therefore, in all three cases — I have reasons to justify my investment and I am ready to stomach the losses. Beyond these three currencies, I admit I don’t understand the rest of the crypto coins. Therefore, I steer clear of investing in any of them. I wasn’t aware of Terra or Luna until the news of its collapse spread across mainstream media including this article in the New York Times titled ‘How a Trash-Talking Crypto Founder Caused a $40 Billion Crash’
Second, The media tends to highlight the world falling apart as its good for business. It also highlights the abnormal success of billionaires to inspire you into thinking you could do the same. What we often tend to forget is that in a market, if one side wins — the other side loses. It is not a pure zero sum game rather a balance between buyers and sellers. For every billionaire making millions, there are thousands of small investors that lose thousands or tens of thousands of dollars — a warning that is not repeated with equal frequency as the shining mega billionairesi n the media. Investing in cryptocurrencies becomes a ponzi scheme. The smart investors get in early and create hype that ultimately creates a Fear of Missing Out (FOMO) effect with the small, retail investor community. Small investors often buy at the peak of hysteria. When its time to sell, there are no takers and the cryptocurrency is worthless — likely the case with investors who got caught in the Terra Luna downturn. A good, general rule of thumb in investing is if the media is hyping a boom e.g. in Non Fungible Tokens, in virtual properties on the Metaverse or in cryptos you don’t understand, it is highly likely that you are sitting at or near the peak of a bubble. You will pay a high price to get in only to discover the hype to fizzle out later. The only exception is if you truly understand the technology and where the market is headed. Don’t invest in a crypto if that crypto is a topic of conversation in your neighborhood kitty parties.
Third, understand the basics of a business. For example, if you walk into a Starbucks — it is easy to see your friends, neighbors enjoying the experience. It is easy to surmise that the business has a future based on what you experience first hand without relying on second hand data. In addition, you have metrics (the company’s financial performance) that tell you the management of the company has successfully navigating the external environment and built a healthy foundation.
Common sense, therefore, dictates you extend the same simple logic to investing in the crypto world.
Your ability to understand the business, to be reasonably confident of its success, should guide your investment decisions and not what the world is doing or talking about. The world could be portraying a tulip to be worth a million bucks. Hype doesn’t make assets valuable. Try to figure out an assets’ intrinsic value.
Fourth, remember that billionaires and sophisticated investors have a different playbook and play by a different set of rules. Common investors, like you and me, could do well to stick to the basics. However, this safe approach does not mean we stay away from risky assets. It just means we don’t bet the farm or we stay away from risk we don’t fully comprehend.
In sum, common sense is undervalued. If you are an avid gym rat, you know that the key to a healthy body is a healthy core (gut). In sum, develop your own instinct and remember to keep your emotions at bay while investing. Your own emotions can get the better of you. If there’s one message I can leave you with, it is this : Stick to the basics!!
