Three Things #19: May 29, 2022
Terra special issue
Unless you’ve been living under a rock for the past few weeks, or are just deeply uninterested in crypto shenanigans (for which you could be forgiven), you must be aware of the collapse of the Terra project and the aftershocks it sent throughout the crypto ecosystem. While the damage seems to have been relatively contained and high quality projects and coins such as Bitcoin weren’t too severely impacted, it’s still early days and the repercussions will continue to play out over the coming weeks and months. To put things in perspective, the Terra collapse destroyed around 25x as much value as the DAO Hack of 2016, an event which continues to cast its shadow over the Ethereum ecosystem six years on.
I won’t attempt to recount everything that’s transpired. Terra is a fairly complex project and I won’t attempt to explain it here due to limited space and the fact that others have already done so better than I could; if you’re not already familiar with it (or, heck, even if you are), I recommend reading this overview by Matt Levine. Instead, I thought it would be interesting to do some high-level analysis and try to look at the situation from multiple perspectives.
Thing #1: Thesis
(Note: I’m going to be intentionally blunt and one-sided in this section. If you’re upset or offended, I encourage you to read the following sections as well.)
Terra was bound to fail from the get-go. It was a hubristic, arrogant, “memetic phenomenon” built on lies and overly aggressive marketing, covering up a lack of technical innovation (it’s a fork of Cosmos), bad economic design, bad governance, and ponzinomics. Its “algorithmic” design belied the fact that, in practice, maintaining stability in extreme situations required manual intervention of a central bank-like mechanism known as the “Luna Foundation Guard” effectively controlled by one person. In the event, the system’s governors didn’t respond appropriately and the mechanism totally failed to defend the stablecoin’s value. In a pattern that’s become depressingly familiar in the space, the project’s investors peddled reputation and influence to the tune of billions of dollars, then pumped and dumped on unsophisticated retail investors—some investors were stung by the crash, but many had likely already taken massive profits by then.
Terra’s primary motivating force wasn’t a technology, nor a driving mission, but rather a cult of personality coupled with economics that were deeply flawed and fundamentally unsustainable. It would be easy to write off everyone who was sold on this dream, everyone who drank the hopium kool aid, as gullible, unsuspecting dupes more interested in number go up than in serious technical, economic, or ecosystem development, except that that group included no small number of serious investors and professionals who should’ve known better.
In retrospect, there were several fatal flaws. The idea to maintain the USD peg of the stablecoin by minting an unbounded amount of Luna never made any sense and could never have survived in extremis. By the same token, the decision to tie the security of the network itself, i.e., the value of the Luna token used in staking, which has no intrinsic value, to the economics of the stablecoin was also bound to fail. These are two lessons that we as a community must learn from what happened and must never forget. But they were also eminently foreseeable, and indeed a few contrarians who saw through the hype did point them out ahead of time.
It would’ve been bad enough if the damage of the collapse had been limited to the Terra ecosystem. As it was, because of Terra’s doomed scheme to sell billions of dollars worth of bitcoin to defend the UST peg, bitcoin and other legitimate projects got dragged through the mud. Once again, we have to explain to uninformed friends and colleagues that, no, this market crash has absolutely nothing to do with bitcoin fundamentals.
Thing #2: Antithesis
There are many scams and garbage projects in the crypto space. Terra was not a scam and it wasn’t a garbage project. It’s an experiment that failed. Not all experiments succeed and we can learn a lot from failure. What’s more, the risks were clear from the beginning and investors who lost money in the debacle have no one but themselves to blame.
One of the most important types of experiment to run is experimenting with the design of stablecoins. At this point, the value of stablecoins to crypto diehards and newcomers alike is obvious. Alongside NFTs and DAOs, they are one of the “Big Three” most useful, and most used, applications in the crypto ecosystem. There’s a limited number of ways to design a stablecoin. The most popular, USDT and USDC, are fiat asset-backed: in both cases a company holds (in theory) an equivalent amount of fiat-denominated assets and allows people to deposit these assets and mint more tokens, or redeem tokens for the assets. This design is functional and relatively safe but it’s suboptimal for two reasons. For one, it’s capital inefficient, since the set of assets that are stable and liquid enough to act as collateral, such as treasuries, is limited, meaning that the collateralized capital cannot be deployed in more interesting ways (i.e., it can’t be invested in riskier, less liquid assets). For another, it’s inherently centralized and relies on the traditional financial and legal systems, and as such isn’t particularly interesting or innovative from a cryptocurrency perspective.
An alternative model that, in theory, addresses both of these concerns is an algorithmic, partially crypto-backed stablecoin. Of these, UST was by far the largest, and the project’s backers intended that it would become even larger, and would over time challenge the dominance of the centralized, fiat-backed tokens such as USDT and USDC. Other algorithmic stablecoins, such as DAI and Frax, are more sustainable and achieve varying degrees of decentralization, but also less capital efficient, and have thus far failed to scale to the level of the fiat-backed coins. Algorithmic stablecoins are essential to achieving a truly decentralized, permissionless, censorship-resistant internet of money. Centralized, fiat-backed stablecoins can be frozen or seized when governments or law enforcement intervene and thus fail to satisfy these important properties. As a novel attempt to create a decentralized, algorithmic stablecoin, the UST experiment was thus worth trying, even if it resulted in failure.
The fact that many retail investors, including more conservative investors looking for stablecoin yields, were hurt by the Terra collapse is tragic. However, looking at the big picture and the long term, it was actually positive for serious projects. While it has definitely caused a retrenchment and a market correction, deflating the value of not only shitcoins and DeFi casinos but also legitimate projects, that correction was overdue anyway and good projects will persevere. It’s good that the capital, talent, and attention that Terra commanded will ultimately flow to better, more deserving, more sustainable projects. It’s positive that high APYs will come down, and that everyday investors will be more careful and more aware of the risks associated with ponzinomics. Ultimately, the sustainable, slow-burn projects that are playing the long game will win. Hopefully, investors will be more careful of overconfident, hubristic, sweet-tongued personality cult figures shilling snake oil, and will take the time to understand the fundamentals of what makes a blockchain and its ecosystem healthy.
We’re probably at the start of a protracted crypto winter, but winters are for builders and there is much building that needs to be done. We’ll emerge from this winter much, much stronger and wiser, just as we did from the last one, and it will be a sight to behold once this winter ends.
Thing #3: Synthesis
It’s interesting to consider why Terra grew so quickly and was so successful (until it wasn’t). As described above, it wasn’t because of a groundbreaking new technology, nor because of a purposeful, unifying mission: “powering the innovation of money” is vague, generic, and dumb. To the extent that the project had a purpose, it appears to have been growth itself, along with a DeFi ecosystem powered by the UST stablecoin. Lots of other blockchains offer this and more, with less of the hubristic jingoism that was Terra’s trademark. What is it about Terra that attracted so many people?
It’s tempting to say that it was precisely that hubristic jingoism, but I don’t think it’s that simple. The excitement and energy of the Terra ecosystem—the speed and extent of its meteoric growth, in spite of ample competition—are testament to the way in which it attracted a real community of builders and users, and addressed real problems for its users. Until the fall, it was one of the most vibrant, active, healthiest ecosystems in crypto. The fact that it was a castle of sand built on bad economics doesn’t take anything away from the success of the community. We’d be wise not to throw the baby out with the “bad economics” bathwater and recognize and appreciate the things that Terra got right.
For one thing, Terra is an open source project and it was built using reliable technology. The network itself performed well even under great stress: blocks were still created, transactions were still processed, and the network itself didn’t fail. (The failure was rather a human failure.) For another, there is a genuine desire to experiment with more novel stablecoin designs, and people seem to like the idea of network fees being denominated in a stablecoin as it’s more intuitive.
What’s more, the extent of the crypto banking infrastructure built on top of Terra, UST, and the Anchor protocol, with its guaranteed 20% APY, demonstrates the desire globally for an alternative to a legacy banking and financial system that’s inefficient, overregulated, balkanized, and as a result burdened by applications with terrible UX.
Finally, there seems to be appetite for independent networks other than Ethereum, based on technology other than EVM, that offer higher throughput and lower fees, and are less focused on technology and more on community. I was not personally active in the Terra ecosystem, but I’ve seen firsthand in similar ecosystems that this sense of community—the sense of affinity and a common identity borne of shared values and a shared struggle—is a powerful force that can be harnessed for good or for ill. If it’s not based on something sustainable, however, such as novel technology paired with purpose, it’s bound to implode.
True scam artists are those who peddle simple solutions to complex problems. The crypto ecosystem exists to solve a set of complex social, technical, and economic problems, and the solutions to precisely none of these problems will be straightforward. Stablecoins are undoubtedly part of the solution for the reasons discussed above, but the design space has not yet been fully explored. With the failure of Terra, as an ecosystem we’re able to effectively zone off part of this design space, post signs reading, “There be dragons,” and move on. Ultimately it’s up to us to learn the necessary lessons and boldly keep moving forward.
While some of the building blocks that Terra built on, such as the Cosmos SDK and DPoS, are relatively mature and battle tested, and in the event performed pretty well, other building blocks are far less mature. These include the network’s economic model. As we continue to experiment, over time, more mature, trustworthy, battle tested economic models, including for stablecoins, and other building blocks will continue to emerge. This is true at the genesis of any new paradigm shift. It takes time to figure things out, and over time, reliable standards emerge. We’re in the very earliest phases of this process playing out in DeFi and cryptoeconomics. While it’s true that projects like Terra make life harder in the short term for legitimate, sustainable projects, by tarnishing the reputation of the entire crypto space, over the long term the trend is positive. The best projects will survive and thrive, and we will learn to build more resilient projects and communities.
What’s the most important lesson we can draw from Terra’s failure? Look for authenticity. It’s impossible to describe, but you know it when you see it. Authentic leaders inspire amazing projects and communities, and authentic projects and communities create the most sustainable value over the long term. If it sounds too good to be true, it almost certainly is. Seek out projects that make sense to you and resonate with you personally: in other words, projects that pass the “gut check.” Resist “memetic phenomena” with overly aggressive influencer and social media marketing.
By the same token, let’s not slow down and let’s not stop innovating. More regulation is not the answer. The answer is education and personal responsibility.