“The Terra Protocol will be one of the largest holders of BTC. Saylor beware.”
— Do Kwon
The making of a reserve currency
Earlier this week, I asked the hypothetical question, “If you were in charge of a country, how would you incentivize people to use your currency?”
Today, I have a different but related hypothetical. “If you wanted to create a decentralized, crypto reserve currency, how would you do it?”
At first it seems like the answer would be very different. In crypto land, you don’t have armies, oil, booming economies or legislative power to lock in demand.
But the more I think about it, the more similar the problem becomes. Because just like a reserve currency in the real world, a decentralized reserve currency needs two things:
Demand for your currency
Reserves that back it
The question is, which of the two do you go after first? Luckily, both strategies are being tried in crypto today.
Let’s say you decide to start with reserves. If you successfully accumulate $10 billion in assets and issue a currency against it, people might start to use it, right?
For my uninitiated non-ohmies out there, this is basically what Olympus DAO was trying to do.
To massively oversimplify a very complex scheme, Olympus tried to get people to deposit collateral (reserves) by issuing them a token (reserve currency).
They incentivized people to deposit their collateral by offering an insanely high APY to people that staked their OHM, which would, over time, dilute that value of an OHM token down to $1 (ish).
The idea was that by the time OHM wound up at a value that could be used as a currency, the token would be backed by a treasury the size of El Dorado. That pile of assets would give users confidence in the strength of the token as a currency.
There were lots of reasons this didn’t end up working out, but in my view, the primary one was that the ohmies neglected the demand side of the equation.
100,000% APYs don’t exactly scream “I’m a currency!” and they did not successfully create any demand in the crypto ecosystem to use OHM for transactions.
Money, as people in our industry love to say, is a story. As it turns out, telling the story of why something is a currency is very, very important.
Especially if you don’t have a military to nudge people in the right direction.
So if reserves aren’t the right way to go, then your only other option is to start with demand. So how do you do it?
That’s the question most people would ask. But you, dear reader, are a student of financial history.
You know that there is a rich history, from Alipay and Taobao to PayPal’s legendary relationship with eBay, of bootstrapping through payment networks.
And as it turns out, you, my informed and deeply intelligent Blockworks reader, are not the only one who understood payments. Do Kwon and Daniel Shin, the co-founders of Terra, knew this as well.
And that’s exactly what Terra did with UST.
In June of 2019, Terra announced its first partnership with South Korean mobile payments app CHAI. Soon, that turned into the Terra Alliance, with 15 Asian e-commerce giants doing $25 billion in annualized transaction volume spread across 45 million users.
At the time, thanks to their partnerships, Terra had the third-highest amount of transactions of any blockchain. Not a bad set-up in which to launch a stablecoin.
And finally, to secure demand, Terra launched Anchor, a savings protocol that offered 19.5% yield for depositors. Anchor has since become the single most important source of demand for UST.
Creating demand for UST helped tell a simple but powerful story: UST is currency.
It is still in its early days, but it looks like starting with demand was the correct strategy as far as algo stables go.
Now that Terra has successfully manufactured demand, they have to solve the next part of the equation: reserves.
You could argue that even from the beginning, Terra’s suite of stables were backed by demand for payments through its e-commerce partnerships.
But this is a currency, and currencies need something more solid than that. Terra didn’t have the option of armies or economies, so they came up with LUNA.
LUNA is Terra’s native token. It’s used for staking, governance, and most importantly, collateralization of UST.
LUNA’s dynamic supply and native burn (read: swap) mechanism perform two key features:
LUNA acts as a source of reserves
The ability to maintain the peg through arbitrage
This was a good first step, but ultimately it’s not enough. LUNA has exploded in value over the last 12 months, but cryptoassets have been known to go down 90% and stay there.
Not exactly the ideal collateral to back your new decentralized currency. If only there was a completely decentralized, digital bearer asset that Terra could somehow leverage…
Enter the Luna Foundation Guard (LFG). LFG is many things, but to me, the most important way to view it is as a vehicle for raising BTC reserves to collateralize UST.
Back in February, LFG announced a $1 billion raise in BTC through an OTC sale of LUNA led by Three Arrows Capital, Jump Capital and many others.
That’s just the start though. Based on tweets from Do Kwon, it looks like LFG has bigger goals.
The way BTC is raised today primarily comes down to the most important pool of stables on Curve between UST, DAI and USDC. The pool’s ratio is consistently under pressure due to strong demand for UST on Ethereum.
LFG’s approach has been to burn (read: swap) massive amounts of LUNA for UST, sell UST into the pool for DAI and USDC, and use the proceeds to buy more bitcoin.
I mean…this is nuts! Besides being the most interesting conceptual thing happening in crypto right now (in my opinion), Do is publicly announcing multiple billion dollar bitcoin buys.
Eat your heart out, Michael Saylor.
If you have been in crypto for any length of time, you’ve heard “the institutions are coming” more times than your parents have told you they’re proud of you.
The narrative for bitcoin has always been that eventually the institutions will FOMO in. Wall of demand, decreasing supply, that old chestnut.
What I LOVE about this development is that this is simply another example of a lesson I continue to learn about this ecosystem: Crypto doesn’t need TradFi to succeed.
Crypto is perhaps the most pure form of disruption that I will see in my lifetime. Institutions do not accept disruption. They get disrupted by it.
I think given the benefit of retrospect, it will be obvious that central banks won’t buy bitcoin. Instead, I think crypto will give us novel institutions and networks that replace our broken central banks.
Interestingly, if Terra is able to successfully collateralize UST with bitcoin, that construction looks strikingly similar to the gold-backed Bretton Woods monetary system.
The kicker is that Terra is not a country and would thus not be subject to the same tensions of the Triffin dilemma that the US was.
Finally, there is a regulatory reason why decentralized stablecoins are attractive as well. As Jim Bianco noted on Empire earlier this month, there may be a ceiling on how large USD-backed stables like USDC can get.
The reason why is because regulators fear a “run on USDC,” which is backed by (among other things) commercial paper.
Regulators view dollar-backed stable-coins like money market funds.
Let’s say USDC eventually grows to a $500 billion market cap backed by corporate debt. If USDC owners ever wanted to “get out,” a flood of redemptions might ensue causing USDC to sell their assets and cause a systemic risk to the financial system.
Hence, regulators will (most likely) not allow them to grow as large as their decentralized counterparts.
The future looks bright for Terra, but there are still some open questions.
Anchor’s 19.5% APY is more of a meme than a sustainable source of yield. Terra will most likely need to find another solution for generating demand for UST.
As exciting as LFG is, it is an off-chain organization run with opaque governance. For the truly decentralized, algo stable this space deserves, we need to find a way to get this on-chain.
Spreading UST successfully into other ecosystems. Today xAnchor was launched, which brings Anchor to the Avalanche ecosystem. It’s a clever design powered by Wormhole, but tbd how this all ends up working out.
Ultimately, Terra’s success will be based on the ability to successfully scale demand while attracting quality reserves.
Today, Michael Saylor’s $5+ billion buy is up there as one of the ballsiest buys in crypto history.
But the show ain’t over till it’s over, and Do basically just announced a $10 billion market buy, financed by LUNA at ATHs while BTC is at cyclical lows.
Who knows? When the dust is settled, it could all end in tears or mark the single greatest accumulation move of all time.