Bitcoin Killer: The Narrow Bank Stablecoin

Originally sent to VIXCONTANGO subscribers on February 6th, 2022

There has been a question I have been grappling with for the past couple of months with regards to stablecoins and I am sure that same question has been vexing the Fed as well: Are stablecoins going to kill off fractional reserve banking? Fed researchers issued a paper last week called “Stablecoins: Growth Potential and Impact on Banking” that discusses this problem and I found this paper very helpful in formulating my thinking on the subject. Note that the solution I propose here is very different from what the paper recommends and what the Fed currently thinks, but I think the approach I outline ultimately will win in the end.

Currently, there are 2 major stablecoins – USDC (USD Coin) issued by Circle and USDT issued by Tether. USDT has $78 billion in AUM while USDC has $50 billion. They are both big and quite widely used in the crypto ecosystem – USDT is primarily used a trade settlement asset on digital only exchanges like Binance while USDC is used as collateral in DeFi apps like Aave and Compound. However, the two coins have very different implementations behind the scenes. USDC essentially takes US dollars, puts them in a bank account and then issues 1 USDC for each $1 in the bank. In contrast, USDT takes your $1 and with it purchases securities (ie loans and notes) with short duration such as Treasuries and commercial paper. USDT is very similar to a money market fund while USDC is very similar to your savings account at a bank. Because USDT is backed by bonds, crypto traders prefer it as a settlement asset – if the crypto market tanks, traders would buy short term bonds as a hedge and that is what USDT is. Thus when you have crypto market stress, the paper finds that USDT actually rises in value. It acts as a VIX of sorts and the reason is because traders buy bonds when risk is off (it’s like buying AGG when SPY sells off). The Fed paper calls the USDC approach “two tiered intermediation” while the USDT approach “security holdings”. The Fed paper finds that those two designs aren’t really all that different from the current banking system. Putting money in USDC is the equivalent to parking money in a commercial bank while putting money in USDT is the equivalent of buying commercial paper and Treasuries. So the answer to the question whether current stablecoins like USDC or USDT will kill off fractional reserve banking is a resounding NO. But this is not all.

The paper also introduces a 3^rd theoretical stablecoin design called the “narrow bank” in which the stablecoin is backed by central bank reserves. This is very interesting and very powerful concept. There is no such narrow bank stablecoin at the moment, but Circle’s boss Jeremy Allaire is pushing very hard for regulators to turn USDC into a narrow bank stablecoin – ie for USDC to be backed by central bank reserves.

Generally speaking, the Fed is very leery of “narrow banks”. It doesn’t like them. In 2018 there was bank called “The Narrow Bank” (TNB) created by a former New York Fed Research Director James McAndrews which applied to become the first narrow bank in the US but was summarily rejected by the Fed. The purpose of The Narrow Bank was to serve non-bank financial institutions and provide them with direct access to the Fed’s central bank reserves. There is such a bank in Norway called “Safe Deposit Bank of Norway” used by high net worth individuals and institutions such as pension funds and sovereign wealth funds. Institutions want their money to be safe during market turmoil and there is nothing safer than central bank reserves in the modern banking system. Institutions know better than regular people that banks are fractional reserve institutions and lend out their deposits at minimum 8-1 ratio and therefore are risky – subject to a bank run. So if institutions put their money there, they know they aren’t guaranteed to get them back and to top it all off currently they are getting a bad rate of interest of 0%. Note that big balances at banks also aren’t FDIC insured. While retail deposits are insured, institutional deposits aren’t. So there is a whole lot of risk and no yield and institutions don’t like that setup one bit. For the non-bank financial institutions, James McAndrews was their man at trying to create this unique financial product in the USA, but it didn’t happen. Why?

Because the Fed doesn’t want to kill off fractional reserve banking. I discussed in my “Stablecoins vs CBDC” article how fractional reserve banking was Medici’s main invention and how it produced more economic growth than otherwise and the Fed isn’t about kill that banking invention/golden goose. If you have a Narrow Bank in existence, the Fed envisions that in times of economic trouble people will run to the narrow bank because central bank reserves are the ultimate safety and thus abandon commercial banks for good. All the deposits will become central bank reserves and banks will go caput. When that happens, banks obviously won’t lend and the economy will collapse. Fractional reserve banking disappears. Unlike China, in the US the Fed doesn’t believe that the central bank should become a centralized lender – that amounts to a communist takeover and central planning. There is pretty wide agreement that lending decisions need to be decentralized in order to avoid the fate of the Soviet Union. In fact, if there is one thing that people agree on unanimously in the US is that there are too few banks in the US in the aftermath of the Financial Crisis and that the big banks have grown too big and too centralized and need to be broken up. For that reason, the Fed is not going to approve a narrow bank that will compete directly with existing commercial banks (don’t forget the Fed partially represents the banks). For the same exact reason, the Fed is really leery of turning USDC into a narrow bank stablecoin and so far has resisted Jeremy Allaire’s overtures.

However, I think the Fed researchers and the Fed are thinking about this all wrong. There is critical omission here: there is already a narrow bank in existence currently and its name is CASH. Bank notes (or cash) are direct liability of the central bank – in other words they are themselves central bank reserves. So if an individual wants the ultimate safety, he can put a ton of cash in his basement. In fact, in Europe many wealth advisors have contemplated storing mountains of euro bills in bank safes as opposed to holding them as commercial bank deposits.

Still there is a critical difference between cash and central bank reserves. Cash has a permanent interest rate of 0%. Reserves on the other hand are a yield products – the Fed pays the IEOR rate on central bank reserves. Paying a positive rate on reserves is really a policy decision and different central banks have different approaches. In Japan the rate on central bank reserves is set to zero regardless of what the rate in the interbank market is (which in Europe and Japan has been mostly negative over the past decade). There is really no reason for the Fed to be paying positive IEOR rate because there is no solvency or liquidity risk for central bank reserves. They are the safest asset in the banking system. Many liberals in the US staunchly object to a positive IEOR rate and for good reason. BTW, the IEOR rate was renamed to IORB rate (interest rate on reserve balances) in 2021 and there is a new series for it at the FRED. IEOR series has been discontinued.

If the Fed simply creates a new special rate only for narrow bank reserves and sets it to zero, then a narrow bank stablecoin solution all of sudden becomes not only feasible but also desirable. Why? Because the Fed goes back in time to the pre-Financial Crisis financial system while simultaneously preserving the stability innovations introduced in its aftermath.

Before the Financial Crisis, the US had a normal financial system in which people who wanted a stable currency could put their money in cash. If they wanted to take risk, they put the money in a commercial bank deposit and would get 4-5%. They were compensated for the risk they were taking with the fractional reserve banking system and simultaneously they were not compensated for being in a safe central bank reserve instrument like cash. Everybody was happy – if people felt the economy and the banking system was in trouble, they could store cash under the mattress like Tony Soprano. If they thought the economy was doing well, they could go and take risk and put their money in a bank account and get paid 4-5%. However, our constantly virtue signaling government was not happy that drug dealers like Pablo Escobar had billions in cash and they wanted to put an end to cash and its use in money laundering and drug trafficking activity. From about 1985 on, the US government stopped printing cash. As a result, people were forced to put money in commercial banks. Commercial bank deposits vs cash ratio kept increasing from a historically normal, fairly stable 1-8 ratio to 1-10 to 1-15 and culminated at 1-20 ratio right ahead of the Financial Crisis in 2007. In other words, by refusing to print cash, the Fed massively leveraged the financial system over a period of 2 decades and the system ultimately collapsed from the accumulated leverage. Then Bernanke was forced to print cash in 2008 like a maniac but instead of printing cash, he printed central bank reserves and put them in the US banks. Obviously, the US government didn’t want to print cash that would end up in the hands of the likes of Pablo Escobar and so it printed reserves which can be very tightly controlled.

The problem with reserves though was that banks no longer wanted to lend. Bernanke himself killed the fractional reserve banking system. BTW the IEOR rate was 10 bps higher than the Fed Rate. Banks would rather keep the money at the Fed and get the IEOR rate instead of take risk and lend it in the economy. So the Fed’s worries about issuing a narrow bank stablecoin stem directly from Bernanke’s mistakes. But the Bernanke mistake wasn’t so much that he issued reserves and reduced leverage in the system, but that the IEOR rate was basically the same or higher than the Fed rate. You can’t have the commercial bank rate (Fed rate) be the same reserve rate (IEOR). IEOR has to be lower than the Fed rate in order to encourage people to take risk in the commercial banking system. It is just a fact that central bank reserves are of lower risk than commercial bank deposits and that needs to be reflected with a differential in those rates. You can’t have the difference between these two rates being 10 basis points. The spread between these rates needs to be 200 to 400 bps (2% to 4%).

If you implement USDC as a narrow bank stablecoin and set the narrow bank reserve rate to 0%, the Fed will accomplish everything that it wants to accomplish. USDC becomes the digital equivalent to cash. Institutions can go to USDC for safety and just hold it on the blockchain when they need to. But if they want to make money on their USDC and get positive interest, they need to lend it out in the economy (for example give it to Celsius or a commercial bank like Chase). The Fed can get away from the policy of Fed rate suppression that it has had over the past decade and banks can again offer 4% interest rates. If the Fed wants to stimulate the economy, it can issue new reserves in the form of USDC and have it directly distributed to retail. If retail can’t spend it and wants to save it, it puts it in a bank and the bank puts it to work. By having a differential rate between narrow bank rate and the Fed rate, the Fed will greatly incentivize an increase in commercial bank deposits. You end up with a dramatically bigger commercial banking system which is simultaneously safer than the pre-2008 system.

Censorship of any narrow bank stablecoin (like potentially USDC) has to be significantly more decentralized than a central bank digital currency. Censorship of CBDC is essentially a bureaucrat in the government. We know these bureaucrat positions go to ideologues so that is a tremendously dangerous setup and undesirable. Instead, censorship of the stablecoin has to reside with the stablecoin issuer (for example Circle) and the entities that custody your stablecoin such as banks or crypto exchanges (Coinbase). This is more similar to how the current banking system works. The Fed doesn’t censor cash or bank accounts. Banks do that. The only new addition to the censorship structure here is the narrow bank stablecoin issuer (Circle) because people can use self-custody wallets and then the only way to censor is through the stablecoin issuer. Basically the US government has to ask Circle to censor USDC while the Fed really is not involved at all because censorship decisions are inherently political and the Fed needs to stay out of that. I think this is a much more familiar and better setup. It is intuitive and people will accept it very quickly.

I completely disagree with the Fed paper conclusion that a narrow bank stablecoin will have a negative effect on commercial bank deposits. I think the exact opposite – it will increase them dramatically because it offers consumers a choice. They can pick the safety of central bank reserves for 0% yield or they can decide when to put those safe reserves to work in the economy for positive yield. On the other hand, a stablecoin like USDC which is backed by commercial bank deposits or USDT backed by securities is simply a return to the Pre-2008 financial system that led to the financial crisis. There is no cash equivalent instrument in that system and in times of trouble institutions will abandon USDC for non-sovereign safe havens like Bitcoin and Gold. The reason why Gold rose ahead of the Financial Crisis and after the Financial Crisis is because people were looking for a safe haven and there wasn’t enough cash to go around. So they were forced into Gold. If a narrow bank stablecoin is available, many people will choose that first over Gold or Bitcoin depending on their individual situation. That is why I call the narrow bank stablecoin a “Bitcoin killer”. If it was available, institutions would seek safety in central bank reserves via a narrow bank stablecoin first before they turn to non-sovereign scarce assets like Bitcoin or Gold. If the Fed wants to kill Bitcoin and put it on a downside trajectory like it did Gold in the 80s, it needs to have a narrow bank stablecoin (digital cash) in its arsenal. Commercial bank stablecoins (current USDC) or security holding stablecoins (USDT) are not going to be perceived as good safe havens in times of economic distress just like banks weren’t in 2008. It wasn’t until the Fed deleveraged the banking system in 2011 that Gold’s rise stopped. With a narrow bank stablecoin the Fed can keep the system as deleveraged as pre-Pablo Escobar.

A banking system with 0% narrow bank stablecoins and positive Fed rates is naturally self-governing. If the economy goes into recession and the deposits go from commercial bank to stablecoin, the overall rate in the economy goes down. Let’s say 10% of the money is in stablecoins earning 0% and 90% is in the commercial banking system earning 4%. The aggregate rate is 3.6%. If depositors move to 20% stablecoin/80% commercial because of recession, and the rates are unchanged the aggregate rate is now 3.2% without the Fed cutting rates. This type of system would make Fed rates far more stable and predictable and the Fed can really only reduce rates in a really big recession. By keeping commercial bank rates at 4%, institutions will be much more incentivized to keep their money in the banking system and take risk. The current system where you lower rates in the commercial bank system to 0% is simply not an acceptable proposition – investors don’t get paid for the risk that the fractional banking system poses.

If the Fed doesn’t approve of the narrow bank stablecoin design, it will face stiff competition from Europe and China. Putin and Jinping just signed a 30-year gas deal between Russia and China that will be settled in Euros worth about $120 billion. Euro stablecoins aren’t a big deal yet, but will be in the future. Europe can certainly try a narrow bank stablecoin or an equivalent CBDC type design. China already has its CBDC and I don’t know if you have noticed but China’s rates are nearly 4%. That is because its CBDC can act like safe haven for Chinese citizens and that allows the PBOC to keep rates on commercial deposits high. The Chinese know that America’s cashless financial system failed and that is why they told Hank Paulson “there is nothing you can teach us”. America’s financial system has been in decline for the past decade and the only way out is to reintroduce cash back into the system in the form of a narrow bank stablecoin. The Fed needs to allow the economy to risk manage itself. Removing cash impaired the economy natural risk management adjustments. Digital cash/narrow bank stablecoin is the solution going forward.

An introduction of narrow bank stablecoin here would enable the Fed to raise Fed rates to 4% and thus allow it to battle inflation with better credibility. Right now markets aren’t convinced the Fed can raise rates to 2.5% because it would trigger a bunch of defaults in the high yield market. But if there was a narrow bank stablecoin option for institutions, they can diversify away from Treasuries and high yield debt today, build out their portfolio with safe central bank reserve 0% yielding instrument and call it a day. Federal debt just passed $30 trillion. That means that there is about $3 trillion (10%) potential demand for a narrow bank stablecoin. The Fed can convert big portion of its central bank reserves to narrow bank stablecoins and call it a day. USDC and Circle in my view are the clear cut leaders that would profit from this type of transition. Allaire understands this whole situation and has been pushing for Circle to adopt a narrow bank design. And I think we are not far from the moment when he is going to get that charter. Watch for USDC market cap to explode in the coming year. Circle currently offers 4% yield on USDC because USDC is basically a commercial bank deposit at the moment. When it switches to a narrow bank stablecoin USDC will lose the yield but gain the world.

A transition of USDC to a narrow bank stablecoin is also key to my short Bitcoin thesis at the moment. The moment the Fed opens central bank reserves to the public via USDC, much of the safety bid in Bitcoin will disappear and Bitcoin will collapse rather dramatically. Don’t forget the Fed will be simultaneously making its reserve scarcer via QT. I don’t know how long it will take for this transition to happen but once there is consensus at the Fed to go down the narrow bank route for official USD stablecoins, these guys will move very quickly. And USDC already there, ready to capitalize.

Reference Articles

Stablecoins: Growth Potential and Impact on Banking

Fed’s CBDC Paper

The Narrow Bank

The Skinny on the Narrow Bank

Lunageddon

Originally sent to VIXCONTANGO subscribers on May 11th, 2022

The long awaited collapse (by many) of the UST algorithmic stablecoin has finally arrived. I call this event Lunageddon in reference to the 2018 Volmageddon when XIV (short VIX ETN) lost all of its value overnight. In this case, the Terra token LUNA went from about $80 at the start of May to currently trading at less than $2. Ouch. LUNA got XIVed. What happened here?

UST is an algorithmic stablecoin backed by the LUNA token. So long as LUNA has value and there is fresh new money coming in to create new UST, the code can maintain the peg. However, if there is more UST in circulation than the market cap of LUNA you could have a crisis of confidence because there is nothing backing the UST. That leads to a run on the bank ie run on the collateral. If you have a situation where people are dumping LUNA while creating new UST that would put the supply/demand dynamic of the two assets significantly out of whack. That’s exactly what is happening here. UST has been doing well over the past 2 years but they were bull market years – UST was fairly small coin and LUNA market cap was always ahead of the UST usage. This year we got the perfect storm conditions that could lead to a collapse of LUNA. The crypto bull market ended which in turn would lead people to dump LUNA. At the same time, what people do in bear markets is put money in US dollars to earn interest. That dramatically increased interest in UST this year increasing its market cap from about $8 billion to $16 billion. Terra’s Anchor lender offered the largest dollar yields out there with 20%. The yield was large enough to attract big flows. All of sudden the Terra system was awash with dollars seeking high yield. Which is fine if people were also buying the LUNA token. But because it is a bear market and interest rates are going up, big institutions were dumping LUNA. Seeing this confidence problem, Do Kwon (Terra’s creator) created a treasury which started buying Bitcoin and he committed to using the incoming dollars to buy Bitcoin which would hopefully end the run on LUNA. For a while that move worked, but then Bitcoin started crashing as well and we got a situation where all the collateral backing UST was losing value. At some point LUNA market cap dropped below the UST market cap and the peg was lost. UST trades currently at 60 cents. They have been trying to restore the peg for a couple of days to no avail. We’ll see if they recover the peg, but basically LUNA shareholders are paying for the restoration of the peg and if they run out of cash they may not be able to restore the peg. UST is being sold here as people try to get some of their money back. When UST is being burned then more LUNA is being minted (added to the market) and that is leading to massive collapse in the LUNA price as you are adding more LUNA in a seller’s market. Yesterday, a consortium led by Sam Bankman Fried and Novogratz tried to raise $1 billion to rescue the situation but it didn’t work out leading to further collapse of LUNA today.

This is by far the most high profile blowup in crypto industry history in my opinion. LUNA was a $40 billion coin at the start of April which then collapsed to a current $2 billion market cap by early May. We have a $38 billion loss here. UST itself had $16 billion market cap and now is less than $8 billion. If you add them together, we are talking about $42 billion in losses for somebody in the past couple of months. This is a blowup that is about 10 times bigger than the Long Term Capital Management (LTCM) in 1998. The bailout then was only about $3.6 billion dollars. Lunageddon is roughly equivalent to the Bear Stearns collapse. Bear Stearns had capital of about $65 billion when it collapsed in 2008. The bailout given to Bear by the Fed was about $25 billion. I know it is crazy to compare Terra with a 100-year old investment bank in Bear Stearns but there is a lot of money sloshing around in crypto these days. Crypto is the new investment banking. I think the hedge fund that is going to lose the most amount of money here is Mike Novogratz. He is a big holder of LUNA and its highest profile promoter and this collapse to $2 is painful. This, by the way, is yet another high profile blowup by Novogratz in crypto. If you remember, Novogratz previous debacle was EOS in 2018. Solunavax was a big trade in late 2021 and all those crypto hedge funds like 3 Arrows Capital and Galaxy Digital are getting killed here. Terra is at $2 (high of $120), Solana is now at $51 (high of $250), Avalanche is now $31 (high of $140). Lots of value is being destroyed here. Keep in mind that Sam Bankman-Fried has started hanging out with Bill Clinton and other former Epstein clients, financing woke Democratic candidates all over America and I am pretty sure crypto’s more conservative users don’t really want to invest in the SBF related tokens anymore – the most notable of which are Terra and Solana. Go woke, go broke.

Terra’s Bitcoin Bet to Restore Confidence in The Peg

Originally sent to VIXCONTANGO subscribers on March 14th, 2022

The biggest story in crypto right now is the Terra (LUNA) ecosystem which seems to be benefiting immensely after the sanctions on Russia. TerraUSD (UST) is the top algo stablecoin and its market cap has ballooned to close to $15 billion with $5 billion added just this year alone. At the start of 2021, UST had about $150 million in AUM so this has been an incredible rise over the past 15 months from basically nothing to a $15 billion coin and a Top 15 ranking. After the massive sanctions on Russia, UST is becoming crypto’s uncensored and unsanctioned US dollar equivalent and I guess money is flowing there because of that. I am guessing some of that money is Russian sanctioned money.

The main lender in the Terra ecosystem is the Anchor protocol (ANC) which offers 20% return on UST. My guess is this high yield is a reason for crypto natives to flock there in this bearish crypto environment where prices are getting cut in half. I have seen many of the Bitcoin guys talk about Terra lately and my guess is some of the inflows are Bitcoin whales.

In September of 2021, Terra made some changes to the protocol, the biggest of which was implementing IBC (inter-blockchain communication) and then hooking up to the Cosmos Hub (ATOM) and then becoming available on the Osmosis DEX (OSMO). That liquidity gave big boost to ATOM and OSMO and setup crypto only truly decentralized DEX system. They also made the protocol faster. But the biggest change Terraform Labs made was addressing the stability of the UST peg. UST is backed by LUNA and to address the fact that LUNA can become undesirable in a downturn and thus force UST to break the peg, the Terra foundation decided that they will add Bitcoin (BTC) as an additional reserve for UST. The original amount was $1 billion and since then Do Kwon has said that they will be buying up to $10 billion of Bitcoin to back up UST so that there is no question about the stability of the UST peg. Now UST is backed by LUNA and BTC and the Luna Foundation Group (LFB) is becoming one of the biggest buyers of Bitcoin out there. Now when people buy UST, they effectively also buy Bitcoin. That has been a very successful move and has endeared Bitcoin maxis to Terra. LUNA currently has about $35 billion in market cap and based on FDV has become the 3^rd biggest coin after Bitcoin and Ethereum with almost $80 billion in FDV. Unsanctioned US dollars like UST is a big business and may become one of the biggest practical applications of crypto.

How does Anchor get its 20% return? Anchor is a decentralized lending protocol similar to AAVE. Lenders can post money there and borrowers can borrow it and pay high interest usually up to 10%. So where does the other 10% of interest come from? It comes from backing of the Anchor token (ANC) which is backed by staked LUNA and staked Ethereum (ETH). LUNA gives about 10% in staking rewards and Ethereum about 5%. So the Anchor protocol gets these staking rewards and gives it back to the users. In other words, the 20% rate is backed by both lending and staking activities. There is uncertainty about this 20% rate in Anchor and many people expect that rate to go down in the future particularly if more and more people flock to UST and Anchor and fight over a limited amount of generated rewards. Anchor has seen an explosion of TVL and is now about $13B in TVL after starting the year at around 8B. Terra’s TVL is now near its all-time high at $25B and is now the 2^nd biggest chain by TVL. Incredible growth for LUNA TVL in what is a rough year for crypto. Anchor is planning to introduce staked Solana (SOL), staked Avalanche (AVAX) and staked Cosmos (ATOM) as reserve for the Anchor rewards in the future which will endear UST to SOL, AVAX and ATOM holders.

Everything so far sounds good for UST and Anchor in terms of the coin being backed by the best Layer 1 tokens in crypto and Bitcoin but I have serious problem with how centralized Terra is. The Terra foundation is in South Korea and is the holder of the reserves backing UST. So if you buy UST, you buy Bitcoin for the Terra foundation. The Terra foundation can get shut down by South Korea which at the moment is an US ally. Or Do Kwon and his partners can just walk out for whatever reason because they are threatened by somebody or just want to bolt with $10 billion in Bitcoin. I am not comfortable with how centralized the ownership of Terra is either – it is all the team and VCs. There was no community ownership at inception like most other coins like Bitcoin, Ethereum, etc. This level of ownership centralization bothers me and has prevented me from investing in LUNA. I just don’t want to be at the mercy of whales who want to dump on me. I am fine with UST being used as a trade settlement currency where you use it for short periods of time but I will not use it to park in a lender like Anchor or AAVE and make yield over the long term. I am just not comfortable with long term holding of UST. I will keep watching it but at this point I am not there yet.

Maybe the market forecasts that South Korea will not be in the US sphere of influence in the future after moves by China in the Pacific this year and thus UST really represents a US dollar with Chinese censorship rules that are outside the scope of US jurisdiction. For some people that might be exactly what they are looking for – let’s say Russian oligarchs. It seems that hedge funds are using Terra here. Terra has the highest TVL per follower of over $60,000 in TVL per follower. This stat has doubled and tripled over the past 6 months. These are big money – definitely whales or hedge funds. So big folks are using it and trusting its censorship rules. My guess if Russian oligarchs think that UST will have Chinese censorship rules they will feel comfortable parking their sanctioned money there. Certainly the spike in UST usage coincides with the Russian sanctions. Despite all of that I am not comfortable with parking money in UST and making 20% in Anchor. I’d rather still get 7% at Celsius in USDC.

On a side note, yes, the Celsius rate got lowered because there is less margin trading in crypto now that it has cooled off. Obviously, if I want to get 8% on my USD, I can do 90% in USDC at Celsius and 10% in UST at Anchor and that maybe acceptable risk to some but not to me. The Terra system is just very complicated with a lot of moving parts and dependencies and I need more time to get used to it.

The Terra Conundrum

Originally sent to VIXCONTANGO subscribers on December 6th, 2021

The hottest L1 token during this crypto drawdown has been Terra (LUNA). LUNA has gone up +30% over the past week as everything else has dropped. Terra’s TVL has grown to 14.4B during the pullback and has eclipsed both Solana and Avalanche in TVL which prior to this crypto drop were been the hottest L1s this fall. Now Terra is only 3 billion away from flipping Binance (BNB) for 2^nd place behind Ethereum in TVL. These are pretty incredible developments for this Cosmos chain. In Tendermint protocols the number of validators is fixed and Ethereum degens don’t like that very much (“the chain is centralized”). Terra has 130 validators. Terra is also the only functional WASM chain out there and thus the only non-EVM chain with smart contracts. That alone is a very worthy accomplishment, but still its TVL growth has been surprising because it is clearly not Ethereum money powering it. Terra has a big backer in crypto hedge funder Mike Novogratz, but still that doesn’t explain everything that has happened recently.

Terra development is led by Do Kwon who is emerging a new top figure in crypto. Do Kwon was formerly a software engineer at Microsoft and Apple and studied computer science at Stanford University. He is South Korean and lives in Seoul. Prior to crypto he had a WiFi mesh network startup. He is about 30 years old. Do Kwon was served a subpoena by the SEC at a Messari crypto conference called Mainnet in Miami earlier in the year. Kwon has sued the SEC back for “improperly issue subpoenas” and “failure to keep confidential an investigation into the Mirror Protocol”.

Here is my conundrum with Terra: I am not surprised at all that the SEC is going hard after it. Terra’s main product is TerraUSD (UST) which is an algorithmic US dollar stablecoin backed by LUNA. UST is a synthetic dollar – it is not real. There are no dollars deposits backing UST at all. It is unlike USDT and USDC which both have backing with real dollars and real assets. Despite it being a fake US Dollar, UST has grown dramatically over the past 2-3 months from about 2-3 billion in market cap to $8 billion. This makes UST by far the biggest USD algo stablecoin. All of the TVL on Terra is from the lending protocol Anchor which basically enables lending in UST where Do Kwon is offering 20% yields on UST.

The problem that I have with Terra and that the US government has with Terra is that it is creating unauthorized liabilities for the US state. Effectively, on a very small scale Terra is printing its own counterfeit money. In addition, in the Mirror protocol Kwon is doing the same thing with synthetic stocks. He is creating unauthorized Apple shares, Tesla shares and so forth. These are shares that aren’t backed by anything other than the LUNA token. That was the reason for the SEC subpoena by the way. The US dollars Terra is printing are also backed by the token LUNA which in turn is bought with other currencies. So effectively, through code Do Kwon has been able to become an alchemist and conjure up Gold out of Lead – create US dollars out of the Korean won. Its US dollar coin UST is essentially backed by every other currency in the world via the LUNA token except the US dollar itself.

The chief attraction of the UST abroad is that it is censorship resistant. In other words, the US government can’t order a company to shut down certain addresses like it can with Circle’s USDC. For example, Iran can trade with Iraq using the UST and get the stability of the US dollar without the sanctions. In the crypto community, censorship resistance is paramount and they all want a censorship resistant US dollar. However I have always viewed that as an impossibility. It may not be a technical one but it is a legal one. A fake dollar is a fake dollar. It’s not created by the US and therefore it is not its liability. If you hold US dollars you implicitly import the censorship rules of the country that issues it. There is no such thing as censorship resistant US dollar. But Do Kwon has created one and so far he is succeeding in getting it accepted on the market. Getting $8 billion of UST in circulation out there is a big success.

I will not be surprised at all if the US government comes even harder on Kwon because of that. I am actually surprised the US government hasn’t been more involved and in particular Janet Yellen. I think one reason is that UST was fairly small this summer but in recent weeks UST has grown a lot and certainly merits closer attention. $10 billion in synthetic USD is not chump change. That is a lot of money. Mike Novogratz is a big sponsor of Do Kwon so I won’t be surprised if the US government goes after him. LUNA is not listed on any US based exchanges like Coinbase and Kraken so the US government can’t really hit it here. Trading in LUNA and UST is entirely abroad but I have a feeling that US government is going to get creative in shutting this down. I expect them to get the South Korean government involved. Crypto is fun and games, but once you start creating counterfeit US dollars, I think things get more serious. Bitcoin or Ethereum have never claimed to be something else (US dollars) but UST does.

On the other hand if the US government is unable to shut UST down, I think UST is going to become huge. Many people holding USDT will move to UST. LUNA price is a play on the popularity of UST. The bigger UST is in market cap, the higher LUNA will go. LUNA’s run maybe alluding to that. I personally am not touching LUNA with a 10 foot pole here. If the US crackdown on it fails, I will take a look, but ahead of the crackdown I am not touching it. If UST succeeds, Do Kwon is basically taking down the US treasury. America’s geopolitical enemies then effectively can devalue the US dollar by using UST. All they have to do is pour money into LUNA and they can turn their shitty currencies into US dollars and in turn devalue the US dollar. If you get more US dollars in circulation you trigger inflation in America and around the world. This whole thing can easily unleash a Pandora’s box of problems.

I honestly can’t believe this is happening. Do Kwon is playing a very dangerous game here. Don’t be surprised if you hear news about him jumping off a building in an unexplained suicide attempt. If he was messing with Putin, that probably would have happened already.

Terra (LUNA)

Originally sent to VIXCONTANGO subscribers on August 21, 2021

Terra is emerging as the 2^nd largest Proof-of-Authority (POA) chain after Binance Smart Chain (BNB) with a $12 billion market cap. It has Galaxy Digital’s Novogratz as a major investor so I figured I look into it and try to understand what is happening there. I did some research last year, but I didn’t see a whole lot. Terra was one of many algorithmic stablecoin providers that were launched over the last couple of years and you know my opinion about algo stablecoins – I don’t like them. It’s also a Tendermint chain. There a lot of Tendermint chains that have gone nowhere. Everybody can spin up a Tendermint chain. That’s the whole point. What is notable is that Terra has 130 validators which is the most decentralized Tendermint chain that I know of. It also appears that Terra’s main product – the TerraUSD (UST) algo stablecoin – is taking off this year. UST has reached a $2 billion market cap and today is the 5^th biggest US dollar stablecoin after Tether (USDT) 64B, USD Coin (USDC) 28B, Binance USD (BUSD) 12B and Maker’s Dai (DAI) 5B. UST started the year at less than $100 million market cap and $100 million algo stablecoins are dime a dozen. Something led to its rapid adoption over the last 6 months.

The way algo stablecoins work, they always come with 2 tokens – one token is the stablecoin and then 2^nd token is the “reserve” currency. The 2^nd token goes up in value if the stablecoin is used by more and more people and vice versa – if the market cap goes down then the reserve coin goes down. For example, with Frax, FRAX is the stablecoin pegged to the US dollar while Frax Shares (FXS) is the reserve coin. In Terra’s case, its own token LUNA is the reserve coin while UST is the stablecoin. The diagram below that describes the stable coin-reserve coin interactions is from Cardano’s Djed stablecoin documentation, but generally speaking all stablecoins more or less work the same way. There is a smart contract in the middle that manages the central reserve of the stablecoin and buys and sells the reserve coin to maintain the peg depending on real-time demand for the stablecoin. The reserve coins get staked and have limited supply and their value forms the base upon which the stablecoin can be pegged to $1. Reserve coins can be Ethereum (ETH), Bitcoin (BTC) or anything of value but usually it is coin of the protocol maker. Obviously one issue with all algo stablecoins is that if people lose faith in crypto markets, they dump the stablecoin, which in turn leads to a rapid decline in the price of the reserve coin and then reserve algorithm depends on whales showing up and buying the reserve coin to maintain the peg. If nobody shows up, the reserve collapses in value, the peg can’t be maintained and the stablecoin starts to trade for pennies on the dollar. There is an algo stablecoin called Basis Dollar (BSD) which trades for 2 cents to this day. It is very important for algo stablecoins that the reserve coin keeps its value. If it doesn’t, like in May and July, these things can collapse. Now that the crypto markets are going up, many of these algo stablecoins that had broken pegs in July have been able to restore their peg. But those pegs will only work while the crypto market is going up. That’s probably one reason why UST market cap is going up now as well. If crypto is in a bull market, the algo stablecoins are a safer bet. Obviously we shouldn’t ignore that the entire stablecoin market has gone up 20-30 times this year so it’s not surprising that some of the algo experiments are getting traction. Also the word on the street it is that Terra stablecoin algorithm is really good and UST has never broken the peg, even during the May selloff. That maybe a reason why now UST is becoming the stablecoin of choice for algo stablecoin fans.

Terra has also become a little bigger than just a stablecoin provider. During its latest version “Columbus” released in August, Terra gained smart contract ability using WASM. WASM is the technology that Polkadot is supporting that also Ethereum will support in ETH 2.0. WASM is short for Web Assembly and this is an open web standard supported by everybody from Microsoft to Google on down. In other words, developers can write smart contracts in Rust and Go – two new languages that are gaining popularity among application developers – compile them down to WASM and deploy them to Terra. Terra is now the 4th Layer 1 chain that can run smart contracts after Ethereum (ETH), Binance Smart Chain (BNB) and Solana (SOL). Inside the POA sector (BNB, ATOM, LUNA), Terra is clearly the most decentralized with 130 validators and has the most advanced smart contract tech with Rust and WASM. BNB at this point is last year’s version. It appears that with Terra and Solana, Rust has become the 2^nd most dominant smart contract language so far after Solidity (BSC, Ethereum and Avalanche). All in all, Terra seems to be the state of the art smart contract chain in the POA sector.

Over the past month, Terra has had 2 major smart contract apps deployed on it – Mirror Protocol and Anchor. Mirror (MIR) is similar to Synthetix (SNX) in Ethereum – it provides synthetic assets such as stocks or commodities. However, like the stablecoin UST there is no actual stocks or commodities collateral backing them. They are backed by LUNA and I am guessing the algorithm used in UST is reused to peg those. You just need an oracle to provide a price for an asset and then algo will peg to the price. So long as TVL (total value locked) is growing LUNA price will grow and these synthetic assets will work. Anchor (ANC) is a lending protocol similar to AAVE. People can put UST there or LUNA and get yield. MIR has $1.7 billion TVL which is quite large. ANC has $3.5 billion which is also quite large. So it seems between UST, MIR and ANC we have a total of $7 billion TVL in the Terra ecosystem. Not a bad start.

Competitively, I don’t think the emergence of Terra changes anything for Binance Smart Chain (BNB) or any of the other top POS chains like Cardano (ADA), Solana (SOL), Polkadot (DOT), etc. Each one has their own set of users and its own target market and users aren’t going to be jumping from one ecosystem to the other. While Terra is a clearly a very nice option, it is still a POA chain and POA will be always be lower valued than POS in the long run simply because POS tech is superior and more secure. I think there is a massive amount of Wall Street money coming and chasing everything POS and POA, so I don’t think over the next year any of these competitive considerations will matter. All L1s will be going up. In Binance’s case, CZ has an amazing mouse trap (I will be writing about Binance next) and it is very unlikely that his Chinese user base goes anywhere else. Binance users will be hanging on Binance Smart Chain and won’t be going anywhere. Cardano has its own set of users. Solana its own set. It’s a big world and there is space for everybody right now. If Terra only captures the South Korean market, it will do just fine. Terra’s core developers are in South Korea. I personally don’t like the Terra product mix – all of these synthetic assets and stablecoins in my opinion aren’t scalable. Institutions would rather hold actual digital US dollars than a synthetic dollar. They would rather hold tokenized stocks and commodities than synthetic stocks and commodities. While Terra may be a month or two early to market with WASM smart contracts I don’t think that gives it any long term advantage given its product selection. Maybe that will change, but I don’t see how Terra affects anything else.

LUNA is definitely a viable bet and if you want to bet on it, I don’t think that is a place where you will lose money over the next 6 months to a year. $12 billion is still a fairly low market cap and that can clearly go up for a functional smart contract chain that has institutional fans like Mike Novogratz. However, in the long run I don’t think Terra beats out Solana, Polkadot or Cardano in total market cap. I think those will be dramatically bigger chains simply because they pack so many more features and have bigger communities. For some period of time, however, Terra could provide superior percentage returns due to its lower market cap starting point and implied reserve coin leverage. If crypto markets top out and turn down, LUNA is one of the first tokens you need to sell because everything in the ecosystem depends on it and if TVL leaves the ecosystem, LUNA as a reserve coin will lose value fast. You definitely have to keep that in mind and make sure you don’t overstay your welcome in it. LUNA can lose -80% in a matter of days given that it is the reserve coin for all of the synthetics in its system. You have to think of it as a highly leveraged play on Terra ecosystem TVL. Very small moves in TVL can have big percentage impact on LUNA. If you’ve noticed over the past year, Cardano has very low volatility compared to other chains. Why? Because it is not used as a reserve asset. With LUNA you have to expect the opposite – higher volatility compared to other chains because it is a reserve asset. The more USDC and actual collateral is used on a given L1, the lower the volatility of its token. The more the token is used as reserve for synthetics, the higher its volatility.