Digital Alchemy: A Post-Analysis of the Recent Cryptocurrency Slump and UST Death Spiral (Lyn Alden)

Original link:

https://www.lynalden.com/digital-alchemy/

Throughout history, people have always tried to create something from nothing.

On the one hand, there are genuine scientific innovations. New developments allow us to develop more intensive energy sources, increasing productivity to improve the quality of life for most people.

They came from nothing, just made resources more abundant than before, and made it easier for people to get more resources. They organize matter, information, and human activity better than previous innovations. In other words, if you showed a caveman a smartphone, he'd think it was magical.

On the other hand, there are those who try to use methods like alchemy and perpetual motion machines, which misunderstand the science. Even a famously wise man like Newton spent time studying alchemy. This is an easy trap to fall into.

A large part of the cryptocurrency market is basically a modern version of alchemy. While there has been genuine innovation in this space, such as Bitcoin, fiat-backed stablecoins, and some experimental technologies, there has also been a great deal of speculation, pump and dump schemes, technical claims that obscure trade-offs and risks, and more.

This article is a post-mortem analysis of Terra's multi-billion dollar failure.

Learn about Bitcoin

“Before coming to the SEC, I had the privilege of researching, writing, and teaching at the intersection of finance and technology at MIT. This included courses in crypto-finance, blockchain technology, and currency.

In that job, I came to believe that despite all the false hype in the crypto space, Satoshi Nakamoto's innovations were real. Furthermore, it has been and may continue to be a catalyst for change in the financial and monetary sphere.

At its core, Satoshi Nakamoto was trying to create a private form of money without a central intermediary such as a central bank or commercial bank. "

-Gary Gensler, SEC Chairman, August 2021

Local payments have historically been a private and physical process. I give you cash, you give me goods. It is difficult to monitor or prevent such transactions.

But for many years, people relied on large central intermediaries (commercial banks and central banks) if they needed to pay over distance.

If I want to send money to my friend in Chicago, or specifically to another friend of mine in Tokyo, or to buy something from a merchant in those cities, I need to go through a major bank. I would tell my bank to wire their money to the bank one of many ways, and if it went international it would end up involving our country's central bank as well.

As an American, paying long distance through a central entity isn't a big deal for these kinds of destinations because they don't block my payments. However, they are expensive and slow.

However, for most of the world with restrictive monetary regimes and persistently high inflation (more than half of the world lives in an environment of authoritarianism and/or recurring double-digit inflation), there is a lack of alternatives has always been a limitation. For journalists, academics and analysts in developed markets, many of them are unaware of this due to the advantages of their environment.

The invention of Bitcoin changed this reliance on a central intermediary as it brought about the first reliable self-custodial peer-to-peer currency. Anyone with an internet connection can send liquid value to anyone with an internet connection in the world without relying on commercial banks or central banks. Nobody needs to hold their money for them, and they don't need to ask permission from any central entity to send value to others.

So it is perhaps not surprising that 19 of the 20 leading countries in the Chainalysis Cryptocurrency Adoption Index are developing countries. In general, people in these countries face lower levels of property rights, financial freedom, and inflation than most readers of this article:

Bitcoin became the fastest asset in history to hit $1 trillion in market capitalization, and has recovered from three 80%+ crashes and several 50%+ crashes to hit new highs:

Bitcoin holders have to live with volatility, technical risk, and other such things, but in a technical sense, Bitcoin offers something truly new, regardless of what ultimately happens to the network in the long run. Rather than relying on human decisions to reach consensus, the protocol uses energy and open-source code to build a publicly auditable global consensus ledger.

But after Bitcoin, there were 20,000 imitators.

Some of these increase node requirements, thus sacrificing decentralization, in order to increase transaction throughput (thus defeating the purpose of a blockchain).

Some of these reduce energy inputs and replace them with human governance inputs, which in turn reduces decentralization in various ways.

Some of them add additional complexity to enable more code expressiveness, which also increases node requirements and reduces their decentralization.

Basically, there is a theme here. Every new "innovation" from a competing project continually weakens the decentralization property.

Satoshi Nakamoto deliberately sacrificed most metrics in his Bitcoin design in order to achieve an automated, decentralized and auditable global transfer agent and registrar, nothing more. He combined existing technologies such as Merkle trees and proof-of-work algorithms, and then added difficulty adjustments to it. This combination is his innovation.

"PoW is not only useful, it is absolutely necessary. Without it, a trustless digital currency cannot function. You always need an anchor tied to the physical realm. Without this anchor, there cannot be a self-evident history of trust. Energy is our only reliance.

Proof of work = trust physics to determine what happened.

Proof of Stake = trust humans to determine what happened. "

-Gigi, author of 21 Lessons

Since then, developers have made several updates to Bitcoin through soft forks (backwards compatible opt-in upgrades), but the core design has not changed. It has an uptime of 99.98% since launch and 100% since March 2013.

Not even Fedwire, the Federal Reserve’s interbank settlement system, was up and running 100% during this period.

Most other cryptocurrencies are designed to add some features on top of decentralization, reliability, and security, and then advertise to investors that this is innovation.

And on the fringes, there are some innovations. For example, federated databases and compute layers are useful. But for the most part, there is a lot of misunderstanding about what Satoshi Nakamoto created and why.

These tradeoffs are rarely advertised to investors (and sometimes founders don't understand them), but instead are marketed as pure technical improvements. And that kind of advertising draws a lot of people, especially when combined with temporary financial incentives funded by venture capital.

Unlike the Bitcoin network, which does not have a central organization for marketing, most other projects have foundations or people that play a key role in the marketing and ongoing operations of the network.

Those who work in the Bitcoin ecosystem tend to be critical of these other protocols. From an external perspective, the entire cryptocurrency ecosystem may appear to be homogeneous, but within the industry, this is not the case. People who work on these so-called "altcoins" have a natural motivation to try to connect with Bitcoin while promoting how their token is better, and Bitcoin supporters have a natural motivation , pointing out all the risks and tradeoffs of these other cryptocurrencies in claiming innovation.

Satoshi Nakamoto launched this open source software and updated it in the first few years, he never pre-mined some bitcoins for himself, never spent the bitcoins he dug, and then disappeared, leaving Others continue with his project.

Since then, the network has relied on an itinerant group of open source developers with no leader. No one can push updates to users. When the price drops, there is no one to turn to, and no one to ask what they will do. Bitcoin never raised money, fails the Howey test, and is therefore not a security; in most cases, it is classified as a digital commodity.

In contrast, many other protocol developers made fortunes from their creation by giving themselves large amounts of pre-mined currency, and continued to operate their networks in a centralized manner while marketing in a decentralized manner they. Many of these projects/institutions raised capital, passed the Howey test, and thus had the characteristics of many securities.

If they're completely honest about their design, they're like startups, and we can analyze them that way. But in a practical sense, many of them are essentially unregistered securities, operating in a global gray area while billing themselves as decentralized networks until regulators figure out how to catch up.

This is not to say that all crypto is bad or devoid of technical contributions, but rather that the entire industry is riddled with scams, frauds, and well-intentioned but ultimately doomed projects that account for a certain percentage of those that have been created. Bitcoin left a huge trail in its path, and latecomers were happy to fill that trail and figure out how to make tons of money fast.

For the most part, Bitcoin is like the iPhone of the industry, and there are thousands of cheap knockoff phones with the Apple logo glued on them that are also marketed to people. Investors need to be very cautious if they choose to speculate on various cryptocurrency projects.

Several exchanges in the sector also fueled the bubble in search of quick profits. If something starts to gain momentum, including meme currencies like DOGE or SHIB that don't really have a future, they promote those currencies to users, which could attract retail investors to buy at the top of the bubble. In addition, many influencers on Youtube and TikTok are pumping up some small coins and using their audience as exit liquidity.

Terra: You are not a central bank

Terra is a cryptocurrency network based on an algorithmic stablecoin called TerraUSD or "UST" and uses its native token, Luna, as its base equity capital. A minting/burning mechanism relationship between the two is to keep the exchange rate stable.

It bills itself as decentralized, but ultimately isn't:

At its peak, Luna had a market cap of $40 billion, while TerraUSD was close to $20 billion. VCs and retail investors in the encryption industry invested heavily. Now most of them have been wiped out, UST has been dismantled, and Luna is almost zero. This mostly took place from May 7th to May 12th and remains a legend to this day.

When the Terra ecosystem was small, I basically ignored it. I've been following various crypto projects, and once they're in the top 20 or so by market cap, I get a sense of what they're doing, but there's only so much I can keep track of.

By mid-March 2022, the Luna Foundation Guard is established and they start buying Bitcoin, which provides another line of defense for Luna's token stake. From then on, I started to dig deeper into their ecosystem and analyze the risks.

Many in the Bitcoin ecosystem have been sounding the alarm about Terra for months. Industry professionals such as Brad Mills of Castle Island Ventures, Nic Carter, Cory Klippsten of Swan Bitcoin, many of whom I've listed here, have publicly criticized it. Especially Cory Klippsten, who loudly and repeatedly warns people of this.

I analyzed the situation, read some of the criticisms of the project, and then went and read the objections from Luna bulls on why these risks were deemed unwarranted. My point is that the risks are fairly clear and precise. This is not really a technological risk; it is an economic risk based on unstable economic design and unsustainable fiscal incentives.

Instead of rewriting my entire analysis, I share below what I wrote to my research subscribers on April 3, 2022:

Luna Defense Guard's Bitcoin Accumulation

The recent Bitcoin price breakthrough may have been due to the purchase of more than $1.3 billion worth of Bitcoin by the Luna Foundation Guard, which plans to purchase $3 billion in Bitcoin as a reserve and eventually increase that reserve to more than $10 billion.

The mechanism between LUNA and UST is like a central bank trying to motivate market participants to conduct open market operations. However, if the price of LUNA cannot keep up with the growth of UST's market cap, then over time, UST will be less and less backed by LUNA. This has been a general trend since late 2021, when demand for UST started to take off. At this point, it still has more than 200% support, but is falling fast.

Terra is now the second largest DeFi ecosystem based on total value locked:

Image source: DeFi Llama

So what is the problem?

The huge demand for UST is almost entirely driven by unsustainable high-yield financial opportunities, just like other DeFi ecosystems. In Terra’s Anchor protocol, investors have been able to earn nearly 20% yields on UST thanks to various arbitrage opportunities, and that looks to be starting to dry up. If this venture-backed yield opportunity dries up, demand for UST could fall. If UST demand shrinks, it could lead to a negative feedback loop and cause liquidity problems for UST and LUNA, also known as a "death spiral", where a large amount of capital withdraws from the Terra ecosystem, causing the price of LUNA to collapse and eventually UST decoupling. If that happens, it will be functionally very similar to an emerging market currency crisis.

Unlike Bitcoin, which does not have a centralized foundation, most smart contract blockchains have specific for-profit or non-profit organizations that serve as their central promotion and development centers. Terra has Terraform labs. Solana has the Solana Foundation. Ethereum has the Ethereum Foundation. Avalanche has Ava Labs. These are generally founder/VC-backed entities with specific leaders and employees trying to promote and grow their ecosystem, and they typically use pre-mine tokens as start-up capital.

Terraform Labs and other parties have raised funds to form the Luna Foundation Guard, which will serve as a second layer of defense for the UST/USD algorithm peg, rather than the peg being entirely dependent on LUNA.

Think of it this way, it's similar to a country's sovereign reserve. In good times, emerging markets can use accumulated trade surpluses or foreign exchange sales to increase their reserves of foreign exchange assets, such as gold, dollars or euros. Then, if the country later experiences a recession and a currency crisis, it can defend the value of its currency by selling some of the foreign reserves it previously held, and use the proceeds of those sales to buy back some units of its currency from those who sold it .

On the one hand, Terra buying a large amount of Bitcoin is good for Bitcoin. LFG can buy USDC or USDT as a reserve, and can buy ETH as a reserve. They could have bought a combination of these assets as reserves. But instead, they bought Bitcoin as a reserve because they believed it was the best reserve for holding permanent, decentralized, pristine collateral with minimal counterparty risk. This further confirms the claim that Bitcoin is the best digital reserve asset. Now, the bigger the Terra ecosystem gets, the bigger their demand for bitcoin reserves will be. Eventually, they intend to add small amounts of other tokens as reserves as they expand to other platforms. For example, to the extent they expand the use of UST into Solana's ecosystem, they hope to bring some SOL into their reserves. Their stated expectation is for BTC to become the primary reserve asset alongside LUNA, with less allocation to other coins.

On the other hand, this also creates future risks for the price of Bitcoin. If Terra ran into problems and was forced to sell a lot of bitcoin to defend its peg to UST, it would hurt the price of bitcoin, just as their current purchases are good for the price. Terra's unsustainable anchor protocol of 20% yield led to a lot of UST demand, and with this new reserve practice of Terra, UST demand now leads to BTC demand. This could be considered an indirect, artificial or unsustainable source of demand for Bitcoin that should eventually dry up. Active bitcoin traders should keep an eye on Terra's LUNA and BTC reserves relative to UST market cap, because if it starts to collapse and they are forced to defend the UST peg, we could see a quick selloff of tens of thousands of bitcoins. I'm not saying that's going to happen, but it's a new factor to monitor.

-Lyn Alden, April 3rd 2022

Then I continued to monitor and the level of risk assessment continued to increase. Here is a passage from my May 1 report:

Luna notes

As an update a month later, UST's market cap has increased while LUNA's has decreased, so things are getting worse for staking:

This is different from the mortgage method of DAI. This is an algorithmic stablecoin, not a crypto-collateralized stablecoin. However, the market value of LUNA is an important variable for the long-term integrity of UST.

Their Bitcoin and AVAX reserves are less than 10% of their total collateral, so even taking those reserve assets into account, the ratio is somewhat lower.

Meanwhile, reserves at Anchor, which provides artificially high yields for UST, fell 40% in April. This decline represents high yields for many stakers. Ultimately, the founders either need to pump more money into it, or the yield must stabilize at market rates, which may reduce demand for UST.

Image credit: Mirror Tracker

We're at a stage where it's worth keeping a close eye on Terra's peg to UST in the coming months. As LUNA depreciates, the amount of collateral LUNA offers to algorithmically back the UST peg also decreases. This might be saved by a general rally in cryptocurrencies for a while, but I'll keep an eye on it here anyway.

In a worst-case scenario, UST begins to depeg and Luna Defense Guard is forced to sell some or all of its $1.6 billion in Bitcoin into an already weakened market in order to defend UST's peg. I think the way it works is that UST holders will be able to redeem Bitcoin, at which point many of them will choose to close their positions and go back to cash. At that point, the Terra network will be severely damaged, and the price of Bitcoin may take a noticeable hit.

In this case, I'd be buying bitcoin, but if/when it happens, it could be confusing. It could even mark the bottom of the cycle, with massive forced liquidations similar to Q4 2018 or Q1 2020. I'm not saying this will necessarily happen during this cycle, but I'm observing it so often now that it's risky enough.

Overall, the only investable asset I see across the digital asset ecosystem is Bitcoin, but even Bitcoin is best paired with some cash to rebalance in this challenging macro environment and reduce volatility. When I analyze the industry, I classify it as speculation (best case), or basically a Ponzi scheme (worst case), depending on the specific asset in question. So most of my DeFi and NFT reports look like this:

-Lyn Alden, May 1st 2022

While I was growing concerned that it would happen, I didn't expect Terra to crash a week after the second report was published. This sort of thing can go on for a long time if there's a lot of big money backing it like Terra, so I don't know exactly when or how it's going to fail.

Image credit: Coin Market Cap

They didn't even have time to set up an automated bitcoin redemption mechanism, so LFG manually pooled its bitcoin reserves to lend to market makers in an attempt to defend the failed UST peg.

LFG's Bitcoin multi-signature address was exhausted, and a large amount of it flowed into the exchange. It’s unclear what the full chain of custody for its Bitcoin looks like, but blockchain analytics firm Elliptic has tracked Binance and Gemini:

There is evidence that this was a well-funded attack that affected the timing of the Terra/Luna breakout; a large entity was apparently shorting Bitcoin and carried out an attack on the UST peg. For macro investors, it's like Soros shorting the Bank of England.

Blaming the attackers is not the point, know that if something in the market can be successfully hacked, it will eventually be successfully hacked. Algorithmic stablecoins have a terrible record of failures, and this is by far the biggest. Since most of their adjustment mechanisms are public, an attacker can know all the specific attack methods.

The impact of Terra's crash began to spread to the entire digital asset ecosystem. Many VCs have exposure to Luna. Thousands of altcoins have been shed in blood. All kinds of fund pools were scared out of their wits. This is a time of broad reassessment of the entire ecosystem to separate the good from the bad. But most of them are worthless.

Bitcoin itself continued to function without any permanent damage other than a drop in price, while the Terra ecosystem took a coup de grace, hurting the broader cryptocurrency industry somewhat from a regulatory, reputational and liquidity standpoint .

Summarize

I remain structurally bullish on Bitcoin as part of a portfolio, especially with repeated purchases over time to take advantage of volatility.

While there are risks to this view, I think 2022 will be seen as a good time for investors to accumulate capital on a 3-5 year time horizon, similar to the capitulation crashes of 2020, 2018 and 2015 .

Image credit: Look Into Bitcoin

While there are other good blockchains out there, I personally don't find one with a risk/reward ratio worth investing in. Investors should be very cautious about speculating on any crypto token other than Bitcoin, if they do so at all. Even with Bitcoin, investors must maintain an appropriate position size relative to its volatility and cyber risk assessment.

In my opinion, the ongoing monetization of Bitcoin is similar to a bodybuilder's cycle of gaining muscle and losing fat. Bodybuilders focus on cycles of gaining muscle and losing fat so that after many cycles, they build up a lot of muscle while avoiding fat buildup.

During a bull market, the price of Bitcoin rises but faces dilution from thousands of new projects, like building muscle and fat simultaneously in a massive creation cycle. When liquidity is plentiful, anyone with an idea can get funding and can attract investors with a promising story. Outside capital flows into Bitcoin, but then it starts getting distracted by these shiny new objects and starts diluting into all these other things.

Then during bear markets, liquidity flows out. The price of Bitcoin has taken a hit, but thousands of altcoins have been hit far harder. Excessive debt is destroyed, pegs are broken, Ponzi schemes are exposed, and fragile networks fall apart. Muscle growth stops and even shrinks, but importantly, a significant amount of unproductive fat is burned so that the next growth cycle can begin anew.

Bitcoin’s network effects and investment thesis have remained the same with each new cycle, while most other projects have stalled, abandoned by developers and investors. Bitcoin made higher highs in four different major cycles, each with higher levels of adoption and development, while most altcoins only survived a cycle or two.

Even many of the most famous coins ended up stalling. For example, if we look at the top 10 currencies near the end of the 2017 bull market, each of them underperformed Bitcoin in the subsequent bear and bull markets. Ethereum, BCH, XRP, LTC, ADA, MIOTA, DASH, NEM, and XMR all reached lower highs in BTC terms during the 2021 bull market compared to the 2017 bull market.

Image credit: Coin Market Cap

If we look back at the 2013 bull run, it was basically the same; people today haven't even heard of the top 10 currencies. On this list, only Ripple set a higher Bitcoin price high in 2017 than it did in 2013, but then failed to do so in the 2021 cycle. None of the other coins experienced another round of larger gains in bitcoin terms.

Image credit: Coin Market Cap

I think this pattern will continue; in the 2021 bull market, there is a good chance that most of the cryptocurrency darlings have seen all-time highs in Bitcoin terms. Maybe one or two will go on to gain more heights at some point, but most won't.

That doesn't mean Bitcoin is risk-free, but it has by far the best track record in this space and is a currency designed for a specific purpose. Block by block, it will continue to function as expected over time.