As of the time of writing, if you go to the website for the Terra project, you’ll see this introduction: “Terra is a public blockchain protocol deploying a suite of algorithmic decentralized stablecoins which underpin a thriving ecosystem that brings DeFi to the masses.” Since this will likely be deleted soon, here is a screenshot for posterity:
Sounds exciting and, pardon the pun, cryptic. What is a blockchain, what are algorithmic decentralized stablecoins, and what is DeFi?
Defining these three terms uncovers why Luna failed, and it also shows why, eventually, all cryptocurrencies will fail.
Let’s start with the blockchain, which has been defined multiple times in multiple ways by now, but let’s do it again: a normal accounting system at a financial institution contains a database that is centrally stored by one institution, like a bank or a payment processor, with a variety of security protocols and backups designed to guarantee the accuracy of its records. We trust that institution to ensure the accuracy of its records, and if it fails there are legal and financial consequences for the institution, so it has a motive for keeping those records as accurate as possible.
Blockchains have been leveraged to create a record-keeping system that does not require trust in that central institution. While this was not its original use case, blockchain has been modified for this end in a very simple but extremely inefficient way.
The best way to understand this is to imagine you are in a club with 20 people and you all share collectibles—say beanie babies. Everyone wants to share and exchange their beanie babies with each other but retain ownership of them—so you make a spreadsheet of who owns which beanie babies that can be used as a record for anytime in the future when anyone wants to get their own toys out of the group.
There’s just one problem: none of you in the club trust one another, so all 20 people want to host the spreadsheet. This is impossible, so everyone needs to have copies of the spreadsheet that will instantly sync with each other.
Now, you could do this with Google Sheets very easily—but imagine this group is super paranoid, and everyone is terrified that Google will try to steal your beanie babies. So you can’t trust Google Sheets to keep a reliable record.
In this situation, you want an encryption protocol that ensures that every single one of the 20 spreadsheets automatically updates when one person updates one version, and each change is recorded and traceable. Blockchains make this possible by automatically updating the spreadsheets.
As you can imagine, this involves significantly greater computing power than the centralized solution, which is why blockchains are heavily criticized for being wasteful.
Nonetheless, it is decentralized, thus satisfying the paranoia of the club members. And in this way we’ve explained not only the “public blockchain protocol” part of Terra’s self-promotion, but also the “decentralized” part of “algorithmic decentralized stablecoins” and the “De” in “DeFi”—since DeFi stands for “decentralized finance”.
A clue to how bad Luna was is also appearing: there is a lot of repetition of the same basic concept of decentralization here, with little explanation of why it needs decentralization in the first place.
But let’s go back to algorithmic stablecoins—what are those? Stablecoins are cryptocurrencies that are pegged to a currency, almost always the U.S. dollar that, ironically, cryptocurrency has long been touted as ultimately replacing. An algorithmic decentralized stablecoin is one that uses algorithmic buying and selling of assets to maintain a peg to a currency. The assets come in from investors who are promised an interest rate on their investments by selling cash for Terra—and since that interest rate was as high as 75% at points, a lot of speculators were enticed by the thought of a massive yield on their investment.
However, that interest rate is variable, meaning that lower demand for Terra will lower the interest rate. Before the crash, there was a large movement of people selling Terra, which resulted in lower potential returns and more selling—then when people saw the slide in the value of Terra, they stopped caring about the yield and just wanted to sell as fast as possible. Thus the coin went to zero.
TerraUSA CEO and creator Do Kwon responded to this by tweeting: “I understand the last 72 hours have been extremely tough on all of you—know that I am resolved to work with every one of you to weather this crisis, and we will build our way out of this.” Later he linked to a proposal linked by an anonymous forum user called “FatMan” on how they would recover. Put simply, the proposal is incoherent.
Thus we see the end of a very speculative and poorly constructed project whose aims and goals were never clear and whose promises were extremely extravagant implode—in much the way as beanie babies, tulips, and other mania bubbles have ended before. Robert Shiller’s Irrational Exuberance is over 20 years old and details perfectly the psychology and the financial mechanisms behind bubbles like this; it is one of the reasons Shiller won the Noble Prize in Economics nearly a decade ago.
Are other cryptocurrency projects doomed to the same fate? With so many crypto projects out there, one must resort to the cliche that crypto enthusiasts have touted for years: you must do your own research. But it seems quite clear now that, unlike before Terra’s failure, that research will face much more skepticism and incredulity; using the word “decentralized” multiple times in marketing materials just won’t cut it anymore.
