Big news in the land of cryptocurrency. A pair of crypto coins—TerraUSD and Luna—recently crashed from a $60 billion market cap to, essentially, zero. These two coins were intrinsically tied together. Ironically, one of them (TerraUSD) was a so-called “stablecoin.”
From “stable” to zero. Call me crazy, but I prefer my stable currency to be stable.
Everyone (including some of you) has been asking: how did these coins work, and how did this crash happen
It’s too hard to explain in crypto language, but easier using metaphors. So I’m going to invite you to JesseLand, my made-up theme park that explains how TerraUSD and Luna worked (and crashed).
Welcome to JesseLand!
I’m starting a theme park called JesseLand. I’m going to provide the infrastructure of the park. The land. The electricity. The bathrooms.
But I’ve got a unique business model. Outside vendors are going to build and operate their own attractions in my park. One guy is going to build a big roller coaster. He’ll rent the land from me and run the coaster as his own business. His sister is going to start a frozen lemonade stand. She’ll rent from me, but set her own lemonade prices.
As long vendors want to come to JesseLand and add more features to the park, I’ll provide the land and infrastructure to support them.
You can’t use normal money inside the park. Instead, we’ll use our own currency – just like you might use game tokens in an arcade (and yes – we have 4 different arcades in JesseLand!).
There are two forms of “currency” in JesseLand: Ride Tickets and JesseBucks.
The value of a Ride Ticket is determined by the free market. All the big stuff in the park requires Ride Tickets. How badly do fun-loving guests want to ride the rides? Their demand sets the price of a Ride Ticket. Each vendor can set their own business’s price in Ride Tickets.
JesseBucks do two things. First, guests can purchase smaller stuff around the park using JesseBucks. But more importantly, JesseBucks are part of an artificial “exchange rate.” I want to ensure that a JesseBuck is always equal to (roughly) one U.S. dollar. JesseBucks are the “stable” currency inside of the park, whereas Ride Tickets will fluctuate with outside demand.
To be clear, you can’t pay for anything inside the park with U.S. dollars. You can only use JesseBucks and Ride Tickets. Why? Simply because I said so! Even the vendors and operators in the park pay me in JesseBucks and Ride Tickets. That’s JesseLand’s currency!
But obviously, the rest of the world is using U.S. dollars. That’s why we have ATMs outside the park that permit exchanges:
- Ride Tickets can be bought with U.S dollars, at a price set by supply and demand.
- One JesseBuck can be exchanged for $1.00 worth of Ride Tickets
- One Ride Ticket can be exchanged for its U.S. dollar equivalent of JesseBucks.
Here’s a quick example to ensure you follow. It’s a popular weekend and fun-lovers are willing to pay $20 for a Ride Ticket. That means that:
- 1 Ride Ticket can be bought/sold for $20 USD, or
- 1 Ride Ticket can be bought/sold for 20 JesseBucks, or
- 1 JesseBuck can be exchanged for 0.05 Ride Tickets
I’d prefer not to have JesseBucks disappear out my gates. And I prefer to hold U.S. dollars in my coffers. That’s why I’m going to set up the Bank of JesseLand. You can create an account with me and deposit all of your JesseBucks with me. I will pay you interest to do so (in JesseBucks). Say, 19% per year.
You now have lots of incentives to participate in JesseLand’s economy.
- You can convert dollars to Ride Tickets and rent space in JesseLand. You can run your business here!
- You can convert dollars to Ride Tickets and pay other people to go on their rides.
- You can convert Ride Tickets to JesseBucks to pay for smaller services in JesseLand.
- You can convert Ride Tickets to JesseBucks and earn 19% interest on them.
Towards the end of the day, some of the fun-lovers convert their JesseBucks back into U.S. dollars. Long lines can form at the ATMs. People are in a hurry. Some of them will make deals with others in line, “Hey – I’ll give you all my JesseBucks for 98 cents each.”
A smart arbitrageur can take advantage. This is another great incentive.
They’ll buy JesseBucks at $0.98 (say, 20 for $19.60), then convert those JesseBucks to Ride Ticket. They’ll sell the Ride Ticket at market value ($20), and turn a quick profit. This “JesseBuck arbitrage” will happen whenever supply and demand are out of whack. It ensures that JesseBucks are “pegged” to $1.00 and the full ecosystem is stable.
It’s an economic marvel. This thing works!
What’s The Catch?
Everything about my economic ecosystem is perfectly reasonable, except for three parts.
First, the 19% interest on JesseBucks assumes that JesseLand is growing at more than 19% per year. This isn’t the worst foundation to build on. But I’ll have to lower that interest rate as soon as the park’s growth slows down.
Unless, of course, I intentionally operate at a loss (for a while, at least) to attract vendors and new park customers. If I’m creating my own currency, it’s quite easy to operate at a loss (see: crypto, U.S. government, etc.)
The second problem is ensuring that Ride Tickets have a real value.
JesseLand has to be so special that it convinces people to accept and value our currencies. After all, there’s no rational reason why using U.S. dollars all over the park wouldn’t work. As soon as the perception of value is lost, JesseLand is hosed.
Imagine the State Inspector came in and said, “Wait…you have independent operators running all your roller coasters? What kind of cockamamie circus is this? SHUT HER DOWN!“
Ride Tickets instantly become semi-worthless (at least until JesseLand reopens). The value of a Ride Ticket will plummet. ATM conversions will still happen, though. So when the park does reopen, everyone will be flooded with Ride Tickets. It will be Ride Ticket hyperinflation!
And the third potential problem involves JesseLand’s ability to exchange Ride Tickets back into dollars. At the end of the day, everyone in JesseLand is going back to their real lives to use real U.S. dollars. They need to have confidence that I can exchange the U.S. dollars they need. If there’s a sniff of a liquidity issue, there will be a “run on the bank,” destroying the value of Ride Tickets and JesseBucks alike.
Problem #1 is fixable. But Problems #2 and #3 are powder kegs waiting for a spark.
This is TerraLunaLand
Back to real life. Actually, can you call this crypto problem “real life?” I’m not sure.
Let’s go to “TerraLunaLand,” the unique cryptocurrency blockchain that promised software developers a place to create their own projects using TerraUSD and Luna as currencies. It’s just like JesseLand, but on the blockchain.
TerraUSD was a stablecoin pegged to the U.S. dollar, like my JesseBuck. Luna varied in price based on market demand, like a “Ride Ticket.” Both currencies could be used to create projects or support others’ projects on the Terra/Luna blockchain, like my theme park vendors. A few billion dollars worth of Bitcoin was used as collateral (to prevent liquidity concerns), ensuring everything worked at the “ATM.”
TerraUSD and Luna ran headfirst into the two major problems I outlined in JesseLand.
First, there was a liquidity crisis. The details on this are murky, but some people are pointing the finger at Wall Street manipulation. Large outside accounts (from Wall Street firms?) were able to “squeeze” TerraUSD and Luna (and their Bitcoin collateral) to the point where TerraUSD—the “stable” coin—de-pegged from the U.S. dollar. Not by one or two cents (which can get arbitraged away), but by 15 or 20 cents.
This more-than-temporary de-peg devastated confidence in TerraUSD’s stability, and the “run on the bank” was on.
Investors fled for the exit. And remember, “the market is like a large theater with a small door.” The small door is ok during normal times. But when everyone clamors for the exit during a “fire,” there’s only one way to budge the line: lower your price. Investors sold their TerraUSD and Luna for lower and lower prices, further fanning the panicky flames.
TerraUSD and Luna are up in smoke.
This market cap destruction leads to important questions. Namely, “Why did Luna have any value in the first place?”
With JesseLand’s Ride Tickets, their value is their utility within the park. You’ll pay for cool experiences. There’s demand there. So a Ride Ticket has a real value in U.S. dollars.
But what was Luna’s “real value?” According to Bloomberg’s Matt Levine, everything about the Terra/Luna ecosystem makes logical sense, except for Luna having any real value. That part, says Levine, “is insane.”
Crypto fans point out that the value is a permissionless decentralized system with no intermediaries that operates 24/7. Yes – that’s really cool. But how do TerraUSD and Luna provide that system in a different way than, say, Bitcoin or Ethereum?
The keystone of TerraLunaLand—the idea that Luna had real value—crumbled. And when the keystone fails, the structure folds like a house of cards.
In other words, what are the “roller coasters” and “lemonade stands” in TerraLunaLand, and why should any of us pay for them? The past two weeks have revealed the complete lack of faith in TerraLunaLand’s value proposition.
Perhaps the only “real” value proposition was the 19% yield on TerraUSD (just like the Bank of JesseLand). And that yield was solely propped up by new investor money entering the Terra/Luna ecosystem. This is the textbook definition of how a Ponzi scheme works.
So this begs an even bigger question. What are the “roller coasters” and “lemonade stands” in all of cryptocurrency, and why should we pay for them?
A currency is only as good as the faith placed in it by those who use it. This is true for U.S. dollars and for Bitcoin. U.S. dollars are widely accepted by actual roller coasters and lemonade stands (and everything else we buy and use).
But can the same be said for Bitcoin? For Ethereum? For NFTs? I’m far less confident. With TerraUSD and Luna, we saw $60 billion disappear in a week. Could investor sentiment dissolve similarly for more popular cryptocurrencies? If you answer no, I’d push you: why not? Are they propped up by utility? Or by new investor dollars entering the ecosystem?
Considering the number of real government currencies that have failed, can we expect far-easier-to-create digital currencies to stand the test of time? I’m not sure.
It’s easy to realize TerraLunaLand’s folly in hindsight. Can we not ask similar questions about other cryptocurrencies with foresight?