Good Evening [%first_name |Dear Reader%],

Welcome to this week’s edition of Tokenised.

If you’ve been tracking the headlines, you know these past few days and weeks have not been kind to the crypto sector. The start of a new interest rate upcycle has resulted in investors pulling out of riskier assets, and many of the world’s most popular crypto assets have seen their values plunge.

But what about stablecoins? Pegged to real-world currencies, these were supposed to be the ‘safe’ crypto investments. Have they lived up to their claims?

The short answer is no.

Let’s dive in. 

Unstable pipedream: Terra’s unravelling puts the spotlight on crypto’s ‘safe’ tokens

If you’ve ever been to a casino, you know you can’t bet regular cash at a craps table. 

Instead, casinos require patrons to swap their money for chips (or tokens) and make their bets with them instead. Typically, this is done for two reasons: to make it easy to track money flowing in and out, and to create a mental separation between the gambler and their money. Because they’re just colourful chips after all, right? 

Anyway, casinos tend to be tightly regulated and rarely run into a situation where the money deposited by patrons doesn’t tally with the tokens in circulation. With the crypto casino, however, the chips can play out a little differently. 

For one thing, crypto’s casino chips have a nice comforting name—stablecoins—and they are supposed to be pegged to the value of currencies, like the US Dollar. And just like casino tokens, stablecoins facilitate a user’s participation in various bets they might want to make in the crypto markets, including some of the riskiest—like betting on yields from decentralised finance (DeFi) assets, or trading in futures and options on crypto assets. 

For instance, DeFi projects like Compound allow users to lend and borrow money stablecoins like USD Coin and Tether, and the liquidity providers earn interest on the money they deposit. Just like how banks offer interest to people who deposit money with them. 

While the likes of Tether and USD Coin are among the largest stablecoins, they are also ‘centralised’ in nature. What that means is that the organisations behind them take in money from depositors, give them tokens in return, and consequently invest the cash in safe, liquid financial assets. Like government debt or well-rated commercial debt. 

But one concern (and a big one, as far as the crypto universe goes) was that the organisations maintaining such tokens could become a chokepoint if regulators started tightening the noose on them. Or, maybe they could be asked to police certain types of transactions, or even refuse to provide services to people that the dominant regulator, in all likelihood the United States, was uncomfortable with. 

These fears gave rise to ambitious experiments. One approach was to create stablecoins that were not backed by any real assets, but instead dependent on a pure arbitrage mechanism to maintain their peg to the US Dollar. In short, the mechanism guarantees that for a pair of tokens—like TerraUSD (the stablecoin) and Luna (whose price is determined by supply and demand)—the stablecoin can always be exchanged for US$1 worth of Luna. 

For instance, if Luna is trading for US$2, one TerraUSD token could be swapped for 0.5 Luna, and vice-versa. And this would work just fine, as long as people believed Luna was worth something or the projects being built using it were worth something. 

But if that faith is shaken, it can all spiral quickly out of control. Both tokens would see mass selling, which would make it impossible for Terra to stay anchored to the US$1 mark. 

Which is exactly what happened last week with TerraUSD, the most popular of such arbitrage-driven tokens.

That these tokens may need to be defended against sudden volatility was known, which was why the Luna Foundation Guard (LFG) existed in the first place. This was an entity whose job was to defend the token’s peg to the dollar, and it had accumulated a reserve of funds for just that purpose. 

The basic idea was that, in case there was downward pressure, the LFG would infuse these reserve funds to prop up the token’s value. 

Solid idea. Just one problem. 

The LFG’s defence fund consisted of, surprise surprise, more crypto assets. And since Terra’s death spiral was triggered when crypto assets were already tanking in value, the ‘Guard’ did little to defend TerraUSD. All told, LFG went from holding US$3.1 billion in reserve assets to under US$90 million in about a week. All of that capital was supposedly deployed to help prop up the algorithmic buck, but it still collapsed. 

TerraUSD’s dive to the bottom has put pressure on other similar experiments. DEI, another algorithmic stablecoin, lost its peg to the US dollar on Monday and is currently trading at about 60 cents.

[Source: CoinMarketCap]

Not to belabour a point here, but I’d say that trying to create a stable asset backed by volatile assets has proven to be about as bad an idea as it sounds. The rout of algorithmic stablecoins even briefly shook Tether, the largest stablecoin by market capitalisation, and the more ‘centralised’ token briefly lost its peg to the dollar by about 5%. 

Data compiled by Glassnode also indicated that Tether’s capitalisation has contracted by US$7 billion since the sell-off began. Some Tether investors have cashed out of the token and rotated into USD Coin, which is considered a safer asset because, unlike Tether, it has been more forthcoming about the safe assets its token is backed by. Tether is already the subject of multiple concerns over which assets supposedly back the stablecoin, which currently has a market cap of US$74 billion. 

All said and done, here’s why I am highlighting this. As TerraUSD and Luna show, in a market notorious for volatility, a loss of faith can quickly turn into a crisis of confidence, and eventually, mass redemptions—basically the crypto equivalent of a run on a money market fund. 

And the biggest risks may come from anywhere—even tokens that are supposed to be so stable, they actually have it in their name.

Crispy bytes

• Bitcoin has no future as a payments network, according to Sam Bankman-Fried, the chief executive of crypto exchange FTX. [Financial Times]
• Coinbase is slowing down its hiring plans after a market downturn hammered its stock price and the prices of crypto-assets. [CNBC]
• India’s central bank has reiterated its concerns about crypto-assets causing a dollarisation of the country’s economy which would harm sovereign interests. [Livemint]
• Crypto-asset regulation is likely to be discussed at a meeting of the G7’s financial chiefs this week in Germany, according to the chief of France’s central bank. [Reuters]
• Most retail investors who have put money into crypto-assets don’t fully understand what they bought or the risks that come with it, according to an official at England’s central bank. [Bloomberg]
• India’s markets regulator has proposed putting a ban on celebrity endorsements for crypto assets. [Moneycontrol]

What caught my eye this week

[Source: Nayibtracker.com]

Yesterday, El Salvador played host to financial regulators from 44 countries to discuss items like digital banking, financial inclusion, and of course, bitcoin. 

Ever since the country’s president started day-trading the crypto asset with taxpayer money, El Salvador’s financial conditions have only worsened. Their crypto investment has lost ~35% of its value, according to data from Nayibtracker, a website tracking the country’s bitcoin holdings. But that doesn’t seem to deter the president from continuing to evangelise the token. 

“Bitcoin was supposed to save the country from economic stagnation, but instead, it’s causing harm because no one really uses it and the government keeps spending money to buy more of it,” Fernando Mejía, a young graphic designer in San Salvador, told The Wall Street Journal. 

Rising public debt, looming bond repayments, and the visible failure of its crypto moonshot seem to indicate hard times ahead for El Salvador. With the IMF unlikely to bailout the country if it defaults on its sovereign debt, a change of fortunes might just require a change of leadership. 

That’s all for this week’s edition. If you have any overarching thoughts (or even nitpicky ones) about this newsletter, please do write to me at [email protected].

I’ll see you again next week. Take care! 

Regards,

Jaspreet Kalra