The $10 Billion Bitcoin Bet On Stablecoins

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To investors,

Algorithmic stablecoins elicit intellectual curiosity from people across disciplines. Whether you are coming from the technology industry, finance, or academia, creating a digital currency that holds stable value without being pegged to another asset is a fascinating problem. The value of this type of asset is obvious, but no one has been able to figure it out.

In November, Ryan Clements published a paper tilted Built to Fail: The Inherent Fragility of Algorithmic Stablecoins, where he argued:

“Algorithmic stablecoins are inherently fragile. These uncollateralized digital assets, which attempt to peg the price of a reference asset using financial engineering, algorithms, and market incentives, are not stable at all but exist in a state of perpetual vulnerability. Iterations to date have struggled to maintain a stable peg, and some have failed catastrophically. This Article argues that algorithmic stablecoins are fundamentally flawed because they rely on three factors which history has shown to be impossible to control.

First, they require a support level of demand for operational stability. Second, they rely on independent actors with market incentives to perform price-stabilizing arbitrage. Finally, they require reliable price information at all times. None of these factors are certain, and all of them have proven to be historically tenuous in the context of financial crises or periods of extreme volatility.”

This is important context because there is an experiment underway in crypto that is worth paying attention to.

Terra is undergoing a transition from a dollar-pegged stablecoin to a bitcoin-backed stablecoin. There is a lot to unpack here, so let’s start from the top. Terra is described as a public blockchain protocol deploying a suite of algorithmic decentralized stablecoins which underpin a thriving ecosystem that brings DeFi to the masses. The stablecoin at the heart of this ecosystem, TerraUSD (known as UST), sits at more than $15 billion in market cap.

This is the fourth largest stablecoin in the market behind Tether, USDC, and BinanceUSD. Based on a recent conversation with members of the Terra community, there is approximately $100 million to $200 million of new demand for UST per day. Not only is UST large, but it is growing quickly too.

The other asset that you need to know about is LUNA. This is the native staking token to the Terra ecosystem. The purpose for LUNA is to absorb the price volatility of the fiat-pegged stablecoins, along with use in governance, mining, and staking. A simple framework to evaluate LUNA with is that “the more Terra is used, the more LUNA is worth.”

So here is how UST gets created today — if someone wants UST, they have to burn LUNA. For every $1 of UST that the person seeks, they have to burn $1 of LUNA. This burn mechanism is similar to a stock buyback. It contracts the supply of LUNA and is used as mechanism to keep UST pegged to the US dollar at the preset value of $1.

This is obviously not a simple mechanism though and the complexity can create significant challenges. Many of these challenges were highlighted in Ryan Clements paper that we talked about at the start of this letter.

So what is Terra going to do differently with UST moving forward? They are going to back UST with bitcoin.

There is approximately $3 billion in bitcoin, Tether, and LUNA sitting in the Luna Foundation reserves today. They are slowly converting the majority of this into bitcoin. As for new issuance, the Terra team will refrain from having market participants burn 100% of their LUNA when they seek UST.

Instead, Terra may burn 60% of the LUNA and use 40% to purchase bitcoin. Here is an example — I want $10 of UST. Instead of burning $10 of LUNA, I may have $6 of LUNA burned and $4 would be used to purchase bitcoin. This dual strategy begins to slowly add a bitcoin-backing to the UST stablecoin that is in circulation.

The math shows that UST won’t be 100% backed by bitcoin initially. The idea is that over time, bitcoin’s price will continue to rise and will eventually pull in-line with the outstanding value of UST. There is a strong likelihood that the bitcoin-backing will actually exceed the UST value over a long enough timeline.

So what are the ramifications of this decision by Terra?

First, Terra is becoming a persistent buyer of bitcoin. They are slowly purchasing $3 billion of bitcoin from the Luna Foundation reserves. This is being done via aggressive buying on price dips. Terra will then be a daily, persistent buyer of bitcoin based on the new issuance mechanism that I just described. You can think of Terra as new demand for bitcoin that will be measured in tens of millions of dollars per day to start.

Second, Terra is highlighting the opportunity for bitcoin-backed assets. Terra’s Do Kwon has discussed at length his belief that bitcoin is pristine collateral. It is the hardest, most decentralized asset in the world. The move to back UST with bitcoin creates a symbiotic relationship, which allows UST to have confidence that the asset is backed by the most superior collateral.

Third, bitcoin gets a credible layer two in Terra, one of the largest smart contract platforms in the world. There is a lot of conversation around what bitcoin can and can not do, but now it is becoming obvious that bitcoin’s role as pristine collateral opens a world of possibilities.

Now this evolution of Terra, and bitcoin’s role as collateral, doesn’t come without risk. The team at Terra has identified the biggest risk being a successful bridge between bitcoin and their ecosystem. The security model for bridging bitcoin to a large system with lots of users is still unproven. Many people will point to wrapped bitcoin as a successful answer, but the process of wrapping bitcoin in its current form eliminates the decentralized elements of bitcoin, so this isn’t a true bridge from bitcoin to a decentralized ecosystem.

Lastly, Terra is pioneering an idea of bitcoin-backed currencies that bitcoiners have long discussed. If you think of the US dollar, there has been no underlying commodity backing the currency once we went off the gold standard. The gold bugs think we will return to the gold standard, but that seems hard to fathom. Some bitcoiners believe we will use bitcoin as the next global reserve currency, including bitcoin denominated goods and services, bitcoin as the only currency, and failure of all existing fiat currencies.

While the bitcoiners may or may not be right about hyperbitcoinization, it is easy to see a world where fiat currencies continue to exist but they are simply backed by bitcoin. This would be a replication of the gold standard, but using digital gold instead of the analog version.

Regardless of how this situation unfolds, Terra’s move to back UST with bitcoin is worth paying attention to. There are lots of risk, but if they successfully pull this off then they will be creating a playbook for other stablecoins and/or central banks to follow. Bitcoin is a decentralized, digital currency that has successfully achieved the properties necessary to serve as superior collateral.

As more people recognize this achievement, I would anticipate many other assets to adopt the bitcoin standard. Bitcoin-backed assets are coming. It just may not be in the form that you previously thought. Hope each of you has a great day. Talk to everyone tomorrow.

NOTE: If you’re interested in helping Terra create better bitcoin bridges, they are taking applications and proposals at agora.terra.money

-Pomp

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THE RUNDOWN:

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Regulatory Uncertainty a Recurring Theme at London’s Token2049: Regulatory uncertainty kept coming up at London’s Token2049 conference on Thursday. Speaking via Zoom, Galaxy Digital CEO Mike Novogratz said U.S. Securities and Exchange Commission Chair Gary Gensler was smart and committed but questioned the scope of the regulator’s purview where crypto is concerned. “Gensler wants to be the sheriff of crypto, but he doesn’t have full authority because of the newness of our industry,” Novogratz told the crowd in London. Read more.

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