Enigma Ventures
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How To Avoid Crypto Ponzis

A top 10 coin that went to zero.

40 billion of market cap erased.

And a stablecoin that wasn’t so stable.

Before its plunge to oblivion, LUNA was the poster child for algorithmic (“algo”) stablecoins. It had everything going for it — notable institutional investors, a seemingly invincible alliance with well capitalized hedge funds, brilliant developers, and if you had used the Terra apps before, you would have known how beautiful and simple the UX was.

There were even real world use cases for UST. Something that previous algo stablecoins never had.

So wtf is a ponzi?

In hindsight, there are many calling LUNA an obvious ponzi and to be honest, I’ve spent quite abit of time wrapping my head around what constitutes a ponzi.

According to Wikipedia, a Ponzi scheme (/ˈpɒnzi/, Italian: [ˈpontsi]) is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors.

The most notorious crypto ponzi of all time

I prefer to think about this in terms of value and ecosystems:

Value Added > Value Removed = Growth Ecosystem (eg. Startups)

Value Added equal to Value Removed = Zero Sum Game (eg. Poker)

Value Added < Value Removed = Ponzi Ecosystem (eg. Pyramid schemes)

A ponzi happens when value output from the ecosystem is designed to be greater than value input to the ecosystem. A clear example which comes to mind is a pyramid scheme, where value addition is created by the fresh injection of capital from new joiners at the bottom of the pyramid, but this is quickly removed by those at the top of the food chain.

A ponzi is generally not sustainable because the pace of value removal is faster than that of value creation.

What was UST backed by?

Algo stablecoins are different from fully collateralized stablecoins such as Tether (USDT) and USD Coin (USDC) where their value comes from the full collateral set backing new issuances (ie. 1 real world USD added into reserves = 1 USDT output into the crypto world).

Collateralized stablecoins are deemed to be less capital efficient simply because the assets they are backed by, are just sitting in a vault and not optimized, for these have to retain a store of value (remember value has to come from somewhere).

Enter UST.

Where the entire ecosystem was designed to create value around:

  1. LUNA as a layer 1 chain
  2. UST adoption through uncorrelated use cases

This value would then accrue indirectly to UST via its flywheel burn mechanism.

Driving the UST use case is no easy feat. And TFL was seemingly conquering the user adoption problem. Strong partnerships with onramp payment systems and neobanks like Kash, Kado, Alice — were all promising platforms that looked set to spread the evangelism of UST.

But instead of user adoption happening naturally via a flywheel effect, it was driven albeit inorganically by Anchor 20% yields, and this led to indiscriminate minting of UST without actual use cases.

In fact, there were platforms being touted as “savings accounts” where you could earn 20% on your real world US dollars (in the current low yield environment this was heaven). On the backend these platforms were really just depositing UST into Anchor.

We all know how proper adoption takes time. So while use cases 3–6 was supposed to drive the ecosystem, what really happened was that use cases 1 and 2 (above) ended up being the main contributor to the growing UST market cap.

Credit: CoinGecko

The amount of UST skyrocketed from $3b to $18b in a short span of less than 6 months. And what was the majority of this UST being used for?

Well not much.

It was basically sitting in Anchor earning 20% yields.

And how do we know? If you’d take a look at the 24h volume of the top 3 stablecoins — this number ranges from ~10–50% of total market cap (eg. USDT at 54%). This implies that the money is sticky (ie. high money velocity). While UST 24h volume as a percentage of total market cap only ranged between 2–5% on a regular basis.

Credit: CoinGecko

So at some point the dilutive effect to LUNA’s ecosystem caused by minting of UST in a vacuum (use cases 1–2) overtook the accretive effect of use cases 3–6.

In an environment where Aave or Curve was paying out <5% variable yields, 20% stable yields did seem very attractive. Only problem was that this hot ball of UST was not very sticky and did little to bolster the use cases that it was originally designed for.

The Fall of UST

To be fair, Terraform Labs did try to inject more value back into the system by adopting a partial collateralized model via LFG and BTC reserves. The only issue was that it was too little too late.

As UST was essentially an IOU to savers, this led to severe asset-liability mismatches when the number ballooned indiscriminately. And so what happened was that when both investors (LUNA) and savers (UST) lost confidence, they all rushed for the same exit (ie. trying to sell both these assets at the same time), which led to the death spiral mechanism of LUNA going into hyperinflation trying to pay back all its debtors.

And unlike real world currency where countries enforce backstops through military might and capital controls (physical or otherwise), there are no such bottlenecks where crypto is concerned (otherwise no sane person would want to use your product).

Ponzinomics 101

“If you can’t identify where the yield is coming from, then you are the yield.”

In the crypto world where things are mostly unregulated and happening at warp speed; and where the lines between innovation and scams sometimes get blurred, it is important to always protect your bottom line.

Avoid hubris and and echo chambers — What worked at a market cap of $200 million may not work at a market cap of $10billion as the token scales. Many argued that while Do Kwon was a brilliant shipper, his arrogance was off-putting and created an army of drones (“Lunatics”) that fought off any well meaning advice/criticism for improving its business model.

De-risk accordingly when position sizes become too large — No one ever got rich through diversification, but no one went broke as well. If a position size has gotten too large and makes or break you, it might be time to revisit the weightage and be disciplined about it. Sure you may miss another 100x from there, but you live to fight another day.

Understand what you are buying — It was shocking to see how fast Luna’s price spiraled to zero in real time. And many who were not aware of the Luna’s hyperinflation mechanism (ie. death spiral) were caught with their pants down trying to bottom fish.

A decentralized economy needs decentralized money

A fully decentralized algo stablecoin remains one of the largest unsolved problem in the crypto space. Deemed by many to be unsolvable, LUNA is the latest tombstone to be added to the list.

I truly thought LUNA would be different as it had additional functionality as a Layer 1 protocol and real world use cases (compared to previous algo stablecoins that only fed off asset price reflexivity).

The entire ethos of crypto is about independence and decentralization — that was why Bitcoin was created in the wake of the Global Financial Crisis. So that asset holders would no longer be held hostage by irresponsible monetary policy. My belief is that this is still needed, but we need to be able to manage the volatility that comes with it. Crypto should be anti-fragile and survive the test of time (as with all money) and I look forward to the day that the crypto community solves this problem.

Until then, we will have to rely on fully collateralized and centralized stablecoins such as USDT and USDC, or partial collateralized ones such as DAI and Frax. For a cup half full is better than an empty one.

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Brandon C.

Brandon C.

Investor at Enigma Ventures. Web3 advocate. Tradfi-to-Defi. Thoughts on crypto, wealth and perspective.