A simple picture of the Terra ecosystem
In my previous article, I talked about Bezzle, a fancy name for paper gains, and reflexivity, two important concepts to understand what’s going on in Terra. I also talked about all the alleged sources of demand for UST. The main conclusion was that the only sources of demand for UST and LUNA were pure speculation and Anchor, an unsustainable lending protocol offering an annual yield of 19,5% on UST deposits. However, I didn’t talk about how all that pieces fit together to make the Terra ecosystem a ticking bomb. In this article, I will present a simple illustration of the mechanics of the Terra ecosystem, where to look for signs of stress and I will finish by arguing that Do Kwon and prominent figures of the ecosystem are perfectly aware of this unsustainability and yet they choose to conceal the risks to investors.
An illustration of Terra
Let’s break down this scheme step by step.
First, we have the real economy, where real goods and services are produced. In our example, some people decide to take some of their hard earned money and invest it on the Terra ecosystem. For investors in the Terra ecosystem to gain as a whole, some value needs to be produced within the ecosystem. Otherwise, it is a zero sum game. Past investors can only win at the expense of new investors, which will be the ultimate bagholders. Sadly, as I explained in my previous article, Terra is a zero sum game system, the only use of Terra is (1) speculating on the price of LUNA, (2) depositing UST on Anchor to earn a 19,5% annual yield or, potentially if you use leverage, more than a 100% APY.
However, many other cryptocurrencies are also purely speculative in nature. What is so special about Terra? The difference is that, in Terra, Venture Capitalist and Terraform labs have sold to the public that it is an amazing system that enables ‘decentralised’ ‘stablecoins’. As we will see down below the only merit of Terra is creating a highly reflexive system that, as long as there are more money flowing into the system than money flowing out of the system, it creates a huge illusion of wealth, outcompeting in that way most of the other scammy crypto projects. This wealth is, however, just a fragile illusion.
Let’s talk first about LUNA. As we have seen before when I talked about Bezzle, the value of LUNA is determined by supply and demand at a given point in time. Supply and demand forces operate at the margin, that is, only a very small fraction of LUNA change hands. The fact that all holders of LUNA value their portfolios using this latest price means that, if there are more dollars flowing into the system than dollars flowing out, an additional dollar can increase the total value that LUNA holders perceive they have by much more than one dollar. Imagine that there is 1 additional dollar of demand and supply remains constant, in order to convince someone to sell you his LUNA, you will have to bid up the price a bit. Let’s say that this increases the price 0,01$, if there are 1 million LUNAS in circulation the ‘value’ of the total amount of LUNA has increased by 10.000$! This is of course not a realistic example but I hope you get my point. Additionally, the holding mentality in cryptocurrencies investors exacerbate this dynamic by making supply and demand more inelastic. Therefore, the total value of LUNA, represented by the circle in the upper right of the box can fluctuate wildly based on the forces of supply and demand.
Now, here it comes the most important part of this article, fundamental to understand the Terra scam. Terra allows you to burn $1 worth of fluctuating LUNA in exchange for 1 ‘fixed value’ UST. By using the LUNA burn mechanism you can transform LUNA into ‘dollars’ without negatively affecting LUNA supply and demand! If you were to change your LUNA for real USD, that would put downward pressure on LUNA price. Not anymore. You are transforming Bezzle into ‘real money’. UST are of course not real dollars and this mechanism is just a hoax, the Bezzle nature of UST will come to light when the peg inevitably breaks permanently. We can think of the UST on the system as dollar deposits on a bank, while there is confidence in the bank everything seems ok. However, as people start exchanging their deposits (UST) for real dollars the peg starts to suffer, ultimately producing a bank run. The only thing that backs UST is faith, arbitrageurs and LUNA, a cryptocurrency whose only value comes from being able to mint UST with it (Do you realise how everything is self-referencing in the Terra ecosystem?).
How will all this unfold?
We have said that when things go well and additional dollars are coming into the system, they have a disproportionate effect on the total value of the system. This generates a positive reflexivity trend that, for a while, makes the dollars flowing out of the system less than the dollars flowing into the system. FOMO kicks in causing new investors to come or existing holders to double down their bets. However, this trend will be unavoidably exhausted, as the amount of new investors starts going down. On the other hand, the influx of dollars out of the system is less volatile. Who is taking real dollars out of the system? Investors taking gains, people working on the Terra ecosystem cashing out to pay their bills or receivers of the numerous incentives that Terra gives to promote the use of UST and LUNA, like the recent sponsorship of Washington Nationals. I argue that, over the last month, dollars flowing out of the system already outpace dollars flowing into the system (when I wrote my first article LUNA marketcap was $30B, now it is $23B, $7B have already vanished). Therefore what we are witnessing right now is a soft downward reflexive trend that will get stronger and will end up with the collapse of UST and LUNA as the stress keeps pilling up
Let’s see where we can see how that stress evolves.
What we can see and what we cannot see.
One of the most cool things of the blockchain world is that we can easily monitor numerous metrics. In our case, the most important thing to watch are UST supply, UST supply changes and LUNA price. Because LUNA is supposed to back UST, the lower the LUNA marketcap, the less power it has to back UST. I highly doubt that right know LUNA could withstand a significant supply contraction in UST (e.g 2B) but if the LUNA marketcap drops below UST marketcap that will be clearly the case. Right now LUNA marketcap is about 2x UST marketcap, less than a month ago it was 3x. If bitcoin crashes again significantly, the chances of the marketcap of LUNA dropping below the marketcap of UST are high.
The supply of UST and its changes can be monitored in Terra Analytics. During the May crash last year UST peg broke and supply of UST contracted by a merely 5%. Now there are 5x more UST. A new 5% contraction will put 5x more pressure on the price of LUNA.
Anchor dashboard offers another set of interesting metrics you can monitor. The gab between borrowing and deposits are a particular interesting one. Note the sharp drop in deposits after the MIM and Sifu fiasco last week. That caused a temporarily depeg of UST for a few hours. The speed at which the yield reserve is depleted is another thing to watch. Today, a proposal for increasing the yield reserve with 450M UST has been approved. This UST will come from burning LUNA using the previously mentioned mechanism. You can see my previous article for a more in depth discussion of Anchor.
This is what can see.
What we can’t see is Terra VC and whales operations. They surely run arbitrage bots that buy UST when it depegs and sell them when the peg recovers. However, their gunpowder is limited. Remember that there are 11,2B UST (in the near future 11,6B). Just $1B of real money is a lot of money and I highly doubt they would be willing to risk that amount of money, specially when arbitraging the peg is not a safe bet. To arbitrage the peg, they must buy UST with real dollars while the peg is broken and, as long as UST peg is broken, their inventory of UST keeps growing. If the peg never recovers they will be the bagholders. On the other hand, if the peg recovers, they must start unloading their UST into the market, putting again downward pressure on demand. Note how the bigger the capital they have to put to maintain the peg the bigger the amount of UST they will have to dump into the market when the peg recovers, putting again downward pressure in the peg.
My guess is that they have at most a few hundred millions ready to support the peg and there are billions of UST out there!
Do Kwon knows about all this
If you follow Terra community, there is little doubt that he is the cult leader of Terra. You will hear how smart he is, how big his plans for Terra are and how lucky we all are for having him working for the future of ‘decentralised’ stablecoins (did you know that about half of the supply of LUNA went to founders and VC, that doesn’t seem too decentralised).
I honestly think Do Kwon is a very smart guy. And precisely because of that I’m certain he is perfectly aware of how unsustainable the Terra ecosystem is. My guess is that he is playing the fake it until you make it game. Of course to do that you have to constantly lie about risks. I already commented in my previous article what a joke the simulations on the Terra whitepaper are.
Do you want proof Do Kwon knows? Let’s see proof. In June 2021 Titan, a stablecoin project similar to Terra collapsed. People were naturally worried that Terra might suffer the same fate. Do Kwon wrote a Twitter thread about how different Terra is from Titan. Let’s see some highlights from that thread.
Here he recognises that the main problem of Titan was recursive holding incentives. That is precisely what Terra is! The only reason for the demand of UST is that you can earn 19,5% yield on Anchor payable in UST. Do Kwon is perfectly aware of the recursive nature of Anchor, yet he choose to bluntly lie in his next tweets. Of course you can not let people think Terra is by any means recursive!
And here it comes another tweet making fake claims. I’ve talked about Chai in my previous article and I keep telling this to people on the Terra ecosystem: please send my a link where Chai explicitly states that they use Terra as the backend for all their transactions (and no, vague press releases don’t count as proof). Until then, I will keep claiming that all Terra shillers are misleading people in a really disgusting way.
If you liked this article you can follow me on twitter @TulipoJM. I will keep talking about Terra until the house of cards collapses.
