Happy Friday!
Short note this week on bear markets. I’m not crazy enough to call whether or not the S&P 500 will dip further, so this piece’s objective is to hypothesize what one might look like if it were to happen. As always, reach out if you’d like a copy.
This week’s big news was Terra, Luna, and the potential risk algorithmic stablecoins pose to the greater crypto world. Since that statement makes no sense to 99% of the planet, I’ll try to explain what’s going on in English.
Let’s say that my anarchistic proclivities fostered by Nietzsche, Tolstoy, Kaczynski, and other thought leaders in the space inspired me to launch a new cryptocurrency called “tinocoin.” This is to become the gold standard (pun intended) for anonymous transactions free from central bank authority.
If that sounds familiar, it’s because it’s pretty much the same pitch for bitcoin. But the problem with bitcoin and other cryptocurrencies is that they are way too volatile to act as a real-world currency.
For example, let’s say a local coffee shop accepts bitcoin. The exchange rate could take a double-digit swing from when they hand the latte to the customer to when they convert that bitcoin to USD.
Since bitcoin is unstable, I want tinocoin to be stable by making it worth $1 at all times. This is called a “peg,” and there are three ways to accomplish this task:
- Fiat-Collateralized: Send me $1, and I will issue one tinocoin. This option ensures that every tinocoin can be mapped to every dollar. This is how the USD worked before the government dropped the gold standard long ago.
- Crypto-Collateralized: The same idea, except instead of backing each tinocoin with one dollar, it would be backed by some other cryptocurrency. Since crypto is very volatile, I need to overcollateralize to be safe. For example, I could back each tinocoin with $2 of bitcoin. Now, tinocoin is 200% collateralized, so if bitcoin dropped by 25%, there’s still enough collateral remaining to back the value of tinocoin.
- Non-collateralized: This is when it gets fun. I could just not collateralize tinocoin at all. This is how the U.S. Dollar works – it’s only backed by the full faith of the U.S. government. Here, I could adjust the supply of tinocoins to keep one tinocoin pegged to one dollar. If demand gets too high, create more coins until the increased supply pushes the price back to its peg of $1. If demand falls, eliminate some of the coins to drive the price back up. Don’t get too spooked, but this isn’t much different than how most central banks operate.
Option #1 is going to take too long. Besides, there are already a handful of fiat-collateralized stablecoins like Tether. Option #2 isn’t ideal either because I’d have to contribute cash, bitcoin, or whatever else is being used to collateralize for every tinocoin minted.
But option #3 is juuuuuuuuust right. Follow me here…
No matter which option I choose, one of the foundational tenets of any currency is network effects – the more people use the currency, the more valuable and important it becomes.
Now, I could simply hire social media influencers to Instagram pics of them paying for bottles of Ace of Spaces at Liv with tinocoin. The hype could increase adoption, but that will get really expensive fast.
Or I could employ second-level thinking by paying people tinocoin to own tinocoin. Here’s how that works:
- For every tinocoin you buy, you’ll earn a 20% interest rate (compared to 0.04% at a bank).
- The interest will not be paid in dollars but rather in tinocoin.
- As more Millennials and bored apes buy more tinocoin, network effects begin to set in.
To be clear, no lightbulbs should be going off right now. Nor should you feel like an idiot for missing the logic in this plan because there is none. Tinocoin is not a currency but rather a vanity project to generate hype and readership for this blog.
Oh… and it’s also a Ponzi scheme.
Let’s say Mark owns 10,000 tinocoins that pay a 20% yield. A year later, Stacy buys 20,000 tinocoins, which is right around the time when Mark decides to exchange his tinocoins back to dollars at the 1:1 peg. He needs his $10,000 back plus $2,000 interest to do this. Take a wild guess where that comes from.
If you guessed Stacy, then take a victory lap. This is a textbook definition of a Ponzi scheme, and these usually don’t end well for those last out the door.
There’s another problem. Tinocoin isn’t backed by collateral, so it only has value if people perceive it as having value. What if, one day, not everyone thinks one tinocoin is worth $1?
If people start selling tinocoin, I must defend this peg against the dollar. Without collateral, this could death spiral fast.
Side note… Dollars aren’t backed by collateral either, but the difference between tinocoin and USD is that people have been using USD for decades to become the world’s reserve currency. And despite what the news may warn our clients, the trust and applicability of USD in global finance aren’t going to death spiral anytime soon.
Terra is an algorithmic stablecoin (option #3), and it garnered a lot of media attention this week. The mechanics of how it works differs from tinocoin in that it uses another made-up coin called Luna to defend its peg utilizing an algorithm. How this works doesn’t matter, but if you’re interested, Matt Levine has been all over this subject lately.
Anyway, Terra almost death spiraled this week, which isn’t supposed to happen according to its founder (aka the “King of the Lunatics”), but it almost did. Billions were lost, and the concern was that it could create contagion across crypto markets.
The thinking is that if Terra can death spiral, people no longer perceive it as having value. The perception of value is the only source of value for bitcoin and most other cryptocurrencies, so people freaked out.
I’m skeptical that a Terra/Luna failure could cause widespread contagion. There’s too much smart venture capital backing the prophets who have created this industry, so it’s probably too big to fail.
But the lesson here is that Terra, bitcoin, and tinocoin aren’t much different than art, gold, or Pokémon cards. They are only valuable because people perceive them as having value. None generate revenue, earnings, cash flow, and/or dividends, so keep that in mind when you allocate to them.
To be clear, there’s nothing inherently wrong with investing in crypto. I’m the proud owner of more than one dog coin (I’m almost certain one is a rug pull). Just try to keep it in moderation because you never know if people will wake up and view them differently one day.
Enjoy the weekend…
Mike on Markets 