Original author:Arthur Hayes, Founder of BitMEX

Original compilation: Biscuit, chain catcher

Original compilation: Biscuit, chain catcher

The content expressed below is the author's personal opinion and should not constitute the basis for investment decisions, nor should it be interpreted as a recommendation or suggestion for engaging in investment transactions.

We have very little control over why humans exist in this universe. As a civilization, we spend an inordinate amount of energy bringing calm and stagnation to a turbulent Earth. Just turning the temperature up and down in our homes and workplaces takes a lot of energy.

Because we instinctively understand that humans are but reeds blown by the wind, endowing individuals and institutions with immense power. Politicians tell us there is a plan, business leaders chart the course of the future, and we hope it will always be successful. But reality has thrown up unexpected conundrums time and time again, and the plans formulated by leaders often fall through the cracks. But what can we do, try again and again?

Just as civil society has shown calm, so must the money that powers civilization remain stable. Fiat currencies are designed to depreciate slowly over time. When referring to the purchasing power of fiat currencies in the past, humans cannot comprehend the loss of purchasing power over decades or centuries. We are conditioned to believe that dollars, euros, yen, etc. today will buy the same amount of energy tomorrow.

The actions of Bitcoin and the crypto movement it spawned are extremely pathetic. Satoshi Nakamoto was essentially a revolutionary, and the love and rage of crypto believers led to price fluctuations in Bitcoin relative to fiat currencies and beyond pure energy itself. While believers profess to accept such fluctuations with unwavering conviction, we are only human and sometimes give up on the gold standard. In times of trouble, stablecoins show us their sweet melody, but what many fail to appreciate is that they are simply incompatible with the financial world we hope to create.

Many people have asked me my opinion on stablecoins. The recent volatility surrounding Terra's USD stablecoin UST pegged to $1 prompted me to start a series of articles on stablecoins and central bank digital currencies (CDBC). These two concepts are related to the fundamental nature of the debt-based banking system that dominates the global financial system.This article will explore the broad category of blockchain stablecoins — including fiat-backed, over-collateralized crypto, algorithmic, and Bitcoin-backed stablecoins. While there is no proven solution yet, the last part of this article will deal with my current thinking:

A stablecoin based on Bitcoin and pegged to the US dollar is also an ERC-20 asset compatible with the Ethereum Virtual Machine (EVM), which is the best way to bring these two incompatible systems together.

"The Fremen have a proverb: 'God created Arrakis to train believers.' One cannot violate the word of God." - Paul Atreides, 'Dune'

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Fiat-backed stablecoinsI Still Can't Draw A LineAs in the previous article "

As explained in , banks are public utilities operating fiat values. They help individuals and organizations conduct business. Before the Bitcoin blockchain, banks were the only trusted intermediaries that could perform these functions. Even after Bitcoin, banks are still the most popular intermediaries, which makes some banks even act recklessly, because they think that the government can print money to bail out their actions.

Banks charge a very substantial tax on the time and fees it takes users to transfer value. With instant and near-free encrypted communication now available to us, there is no reason for us to continue paying so much and wasting so much time with traditional banks.

Bitcoin creates a competitive peer-to-peer payment system at a low cost in time and money. For many people, Bitcoin is highly volatile and is used to fiat currencies and energy (i.e. a barrel of oil) as benchmarks. To solve this problem, Tether created the first dollar-pegged stablecoin using the Omni smart contract protocol built on top of Bitcoin.

Tether created a new digital asset class on a public blockchain backed 1:1 by fiat assets held by banking institutions, what we now call fiat-backed stablecoins. After Tether (also known as USDT) and USDC, various other fiat-backed stablecoins have sprung up, and the fiat-custodial assets (AUC) held by each project have exploded as the pair tokens have grown. Currently, USDT and USDC have a combined statutory AUC of more than $100 billion.

Because of the lack of infrastructure in the bitcoin economy, our means of payment are still in dollars or other fiat currencies. Since the traditional way of sending and receiving fiat is very expensive and complicated, bypassing the bank payment system and sending fiat instantly at low cost is a very valuable thing. I'd rather be sending USDT or USDC to someone than use an expensive global fiat bank payment system.The fundamental problem with this type of stablecoin is that it requires willing banks to accept the fiat assets backing the token. Stablecoin transaction fees do not end up in the pockets of bankers, but there are costs for banks to hold these huge fiat assets.

Central banks have been known to disrupt the lending business model of commercial banks, making it impossible for them to agree to agreements with commercial banks to hold billions of dollars to achieve decentralization.

Fiat-backed stablecoins want to use a bank's storage facilities, but pay nothing for it. For me, this strategy will not survive. Billions may be fine, but expecting commercial banks to allow AUC for fiat-backed stablecoins in the trillions is impossible.Fiat-backed stablecoins are not going to be the payment solution that powers Web3 or a truly decentralized global economy. They cannot be a digital payment service that connects the physical world quickly, cheaply and securely. whenFed Bans Silvergate Bank From Partnering With Facebook's Diem Stablecoin

The next iteration of stablecoins are a family of projects that overcollateralize major cryptocurrencies in order to maintain a peg to fiat value.

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Overcollateralized Stablecoins

In short, these stablecoins allow participants to mint a pegged fiat token in exchange for crypto collateral, the most successful of which is MakerDAO.

MakerDAO has two currencies. Maker (MKR) is the token that governs the system. It is similar to a stake in a bank, but the bank aims to have more assets than liabilities. These assets are mainstream cryptocurrencies such as Bitcoin and Ethereum, and MakerDAO promised to create the dollar-pegged token DAI after receiving the encrypted assets.

1 DAI = 1 USD

Users can borrow DAI from MakerDAO with a certain amount of crypto collateral. Since the price of crypto collateral can drop in dollar value, Maker will programmatically liquidate the pledged collateral to satisfy the DAI loan. This is done on the Ethereum blockchain, and the operational process is very transparent. Therefore, the level price of Maker's liquidation can be calculated.

Here is a graph of the percentage deviation of DAI from its peg to $1, a reading of 0% means DAI is holding the peg perfectly. Maker has done a good job of maintaining the dollar peg.The system is very strong as it has survived the price crashes of Bitcoin and Ethereum several times, and its DAI token still maintains a value close to $1 on the open market.The downside of this system is that it is over-collateralized. It effectively removes liquidity from crypto capital markets in exchange for the stability of pegged fiat assets.

We all know that stagnation is expensive and volatility is free.
The f(x) of MakerDAO and other over-collateralized stablecoins: completely drains the ecosystem's liquidity and collateral. Maker token holders can choose to introduce risk into the business model by lending out idle collateral in exchange for greater income. However, this introduces credit risk into the system. Who are reliable borrowers paying positive interest rates on cryptocurrencies, and what collateral do they pledge? Is the collateral the original asset?
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Algorithmic Stablecoins

Algorithmic Stablecoins

The stated goal of these stablecoins is to create a pegged asset with less than 1:1 crypto or fiat collateral. Often the goal is to back the pegged stablecoin with assets other than “hard” collateral. Given that Terra is the current topic, I will use LUNA and UST as examples to explain the mechanics of algorithmic stablecoins.

LUNA is the governance token of the Terra ecosystem.

UST is a $1-pegged stablecoin whose "asset" is simply the LUNA tokens in circulation.

Here's how UST's peg to $1 works:Inflation:

If 1 UST = $1.01, then UST is overvalued to which it is pegged. In this case, the protocol allows LUNA holders to exchange 1 USD worth of LUNA for 1 UST. LUNA is burned or withdrawn from circulation, and UST is minted or put into circulation. Assuming 1 UST = 1.01 USD, the trader makes a profit of 0.01 USD. This drives LUNA price as its supply decreases.Deflation (where it is now):

If 1 UST = $0.99, then UST is undervalued relative to its peg. In this case, the protocol allows UST holders to exchange 1 UST for 1 USD worth of LUNA. Suppose you can buy 1 UST for 0.99 USD and exchange it for 1 USD of LUNA, you will make a profit of 0.01 USD. UST is burned and LUNA is minted. This causes the price of LUNA to fall as its supply increases on the way down. The biggest problem is that investors who now own newly minted LUNA will decide to sell it immediately instead of holding it in the hope that the price will increase. This is why LUNA is under constant selling pressure when UST is trading at a price that is substantially off its anchor.

The more UST is used in commerce in the Web3 decentralized economy, the more valuable LUNA becomes. This minting and burning mechanism is very useful on the way up. But if UST is unable to reverse its downward trend, a death spiral may begin with indefinite minting of LUNA in an attempt to get UST back to its peg.All algorithmic stablecoins have some sort of mint/burn interplay between the governance token and the pegged stablecoin. All of these protocols have one common problem:

How to increase people's confidence to restore the peg when the pegged stablecoin is trading below the fiat peg.

Almost all algorithmic stablecoins have failed due to the death spiral phenomenon. If the price of the Governance Token falls, then the Governance Token asset backing the anchor token is deemed untrustworthy by the market. At that point, participants start dumping their pegged tokens and governance tokens. Once the spiral starts, it is very expensive and difficult to restore people's confidence in the market.

The death spiral is no joke, it's a game of confidence based on the debt-based banking system. However, the game has no government that can force users to use the system.

In theory, profit seekers should be willing to preserve algorithmic protocols despite the fall in collateral to reap huge profits on governance tokens created out of thin air. But that's just an assumption.

Here is a chart of the percentage deviation of UST from its peg to $1. Like MakerDAO, 0% means the peg is rock solid. As you can see, everything was fine until the UST unanchored.

In theory, this model is like a part of a bank that can scale to meet the demands of a decentralized Web3 economy, but requires near-perfect design and execution.

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Bitcoin-backed stablecoins

The only laudable goal of stablecoins is to allow tokens pegged to fiat currencies to be issued on public blockchains. This has practical uses until the arrival of real bitcoin economics. So let's try to make the most of a fundamentally flawed premise.

The most primitive cryptographic collateral is Bitcoin. How can we turn a 1:1 dollar-to-value bitcoin into a hard-to-break dollar-pegged stablecoin?

Various top cryptocurrency derivatives exchanges offer inverse perpetual swaps and futures contracts. The underlying of these derivatives contracts is BTC/USD, but BTC is used as margin. This means that profits, losses and margins are denominated in Bitcoin, while quotes are denominated in USD.

I'll hold your hand while we do some math - I know it's hard on your TikTok-damaged head.

Each derivatives contract is worth $1 in Bitcoin at any price.

Contract Value Bitcoin Value = [$1 / BTC Price] * Contract Quantity

If BTC/USD is 1 USD, the contract is worth 1 BTC. If BTC/USD is $10, the contract is worth 0.1 BTC.

Now let's create $100 using a combination of BTC and a short derivatives contract.

Assume BTC/USD = 100 USD.

At a BTC/USD price of $100, what are 100 contracts or $100 worth of BTC?

[$1/$100] * $100 = 1 Bitcoin

Intuitively, this should make sense.

100 synthetic dollars: 1 BTC + 100 short derivatives contracts

If the price of Bitcoin goes to infinity, the value of the short derivatives contract in terms of Bitcoin approaches the limit of 0. Let's demonstrate this with a larger but less than infinite BTC/USD price.

Suppose the price of Bitcoin rises to $200.

What is the value of our derivatives contracts?

[$1/$200] * $100 = 0.5 Bitcoin

Therefore, our unrealized loss is 0.5 BTC. If we subtract the unrealized 0.5 BTC loss from our 1 BTC pledged collateral, we now have a net balance of 0.5 BTC. But at the new BTC/USD price of $200, 0.5 BTC is still equal to $100. So even if the price of Bitcoin rises and causes an unrealized loss on our derivatives position, we still have $100 in synthetic dollars. In fact, it is mathematically impossible for this position to be liquidated upwards.

The first fundamental flaw of the system occurs when the price of BTC/USD approaches 0. As the price approaches zero, the contract value becomes greater than all the bitcoins that will exist - making it impossible for the short seller to pay you back in bitcoins.

This is math.

Suppose the price of bitcoin falls to $1.

What is the value of our derivatives contracts?

[$1 / $1] * $100 = 100 bitcoins

Our unrealized gain is 99 BTC. If we add the unrealized gain to the initial 1 BTC collateral, we come up with a total balance of 100 BTC. At a price of $1100, Bitcoin is equivalent to $100. So our $100 synthetic peg is still in effect. However, notice how a 99% drop in the price of Bitcoin increases the contract's Bitcoin value by 100 times. This is the definition of negative convexity and shows how this peg is broken when the price of Bitcoin approaches 0.

The reason I'm ignoring this scenario is that if Bitcoin goes to zero, the entire system ceases to exist. At that point, there will no longer be a public blockchain capable of transferring value, as miners will not expend pure energy maintaining a system where native tokens are worthless. If you're concerned that this is a real possibility, just keep using the fiat banking rails -- no need to try something that might be cheaper and faster.

Now, we have to introduce some centralization, which brings a whole host of other problems to this design. The only place where these inverse contracts are traded large enough to accommodate a Bitcoin-backed stablecoin that can serve the current ecosystem is on a centralized exchange (CEX).

The first point of centralization is the creation and redemption process.

Creative process:
Send BTC to the foundation.
The Foundation pledges BTC on one or more CEXs and sells inverse derivatives contracts to create sUSD, the synthetic dollar.
The foundation issued a sUSD token based on a public blockchain. For ease of use, I recommend creating an ERC-20 asset.

In order to trade these derivatives, the Foundation must create an account on one or more CEXs. The BTC collateral is not kept in the foundation, but now in the CEX itself.

Redemption process:
Send sUSD to the foundation.
The foundation buys back one or more short reverse derivative contracts of CEX, and then destroys sUSD.
There are two problems with this process. First, the CEX (for whatever reason) may not be able to return all the BTC collateral entrusted to it. Second, CEXs must charge losers a deposit. As far as this project is concerned, when the price of BTC falls, the derivatives of this project are profitable. If the price falls too far, too fast, CEX will not have enough long margin to pay. This is where the various socialization loss mechanisms come in. TL;DR, we cannot assume that if the BTC price falls, the project will receive all due BTC profits.

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The foundation needs to raise funds for the development of the project. The greatest need for capital is a general fund that covers exchange counterparty risk. Governance tokens must initially be sold in exchange for Bitcoin. This bitcoin is used exclusively in the event that the CEX does not pay out as expected. Obviously the fund is not inexhaustible, but it would give credence to the belief that the $1 peg can be maintained if CEX returns are lower than they should be.

• The next step is to determine how the protocol will earn revenue. There are two sources of income:

• The protocol will charge a fee for each creation and redemption.

The protocol will gain a natural positive basis for derivatives contracts and underlying spot values. let me explain.

The stated policy of the Federal Reserve (and most other major central banks) is to inflate their currency by 2% per year. In fact, the dollar has lost more than 90% of its purchasing power when pegged to the CPI basket since 1913 (the year the Fed was founded).

BTC has a fixed supply. As the denominator (USD) grows in value, the numerator (BTC) stays the same. This means that we should always assign a higher value to the future value of the BTC/USD exchange rate than the spot value. So fundamentally, the contango (futures price > spot) or funding rate (perpetual swaps) should be positive - meaning income for those shorting these inverse derivative contracts.

One could argue that US Treasuries have a positive nominal yield and there are no risk-free instruments that are nominally priced in Bitcoin — so it is incorrect to assume that the dollar will depreciate relative to Bitcoin in the long run. While this is true, as I and many others have written, negative real interest rates (i.e., when the nominal risk-free treasury bill rate falls below the rate of GDP growth) are the only mathematical way for the US to nominally repay debt holders.

Another option is to increase the population growth rate above 2% per year, which would require couples to collectively avoid contraception and other methods of family planning. According to the US Census Bureau, the population growth rate in 2021 is 0.1%. If you exclude immigrants, the tax rate will be negative.

Long Bitcoin vs short inverse derivatives contracts should deliver positive returns year after year. Therefore, the greater the circulation of sUSD, the more Bitcoin is in custody compared to shorting derivatives contracts, resulting in a substantial stream of compounded interest income. This provides a large pool of funds for governance token holders.

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perfection is impossible

There is no way to create a fiat-pegged stablecoin on a public blockchain without many compromises. It is up to users of the relevant solutions to determine whether the compromise is worth the goal of making fiat currencies faster and cheaper on public blockchains than on bank-controlled centralized payment networks.Of the four options presented, I like bitcoin and derivatives-backed stablecoins the most, followed by overcollateralized crypto-backed stablecoins. However, each of these solutions secures cryptocurrencies in large pools. As I said in ", the problem is that these public networks require assets to move between parties in order to incur transaction fees that pay for network maintenance. Holding is toxic in the long run. So let’s not be complacent, but keep working hard to create a farm-to-table Bitcoin economy.

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Will Terra/UST survive?Terra is currently in the deepest part of a death spiral. Read this article from founder Do Kwontweet thread

, what is currently happening is completely by design. The protocol is working and the fact that people are surprised by what is happening means they are not reading the white paper properly. Luna-tics also haven't looked hard enough into questioning where Anchor's 20% UST yield came from.

Even if LUNA and UST survive this event, in the long run some genius protocol changes would have to be made to increase the market's confidence that LUNA's market cap will always exceed UST's float. I don't know how to do this. That's why I only know LARP. This fundamental question has been highlighted by many - check out this article by Dr. Clementsarticlearticle

for a more detailed discussion.

Here is a chart of [UST Market Cap – LUNA Market Cap]. When this value < $0, the system is healthy. An upward spike means that the UST must be destroyed and a LUNA issued to re-pegg the UST to it.

Another victim was a group of investors who yelled "Yay, yay, hooray!" Because of their enthusiasm for Terra, so for DeFi. Now those investors will be busy repairing their balance sheets instead of buying Bitcoin and Ethereum as they resume their downward trajectory.

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adjourn

The debacle is not over yet...

During a proper crash, the market will seek out indiscriminate sellers and force them to sell. This week's plunge was exacerbated by being forced to sell all Luna Foundation bitcoins to defend the UST:USD peg. As usual, they still failed to defend the hook. And this is the reason why all the anchoring fails in the face of the entropy of the universe.

I dutifully sold $30,000 of Bitcoin and $2,500 of June puts. I haven't changed my structurally long crypto positions even though they are losing "value" in fiat currency terms. If anything, I'm evaluating the various altcoins I own and adding exposure.

I didn't expect the market to move through these levels so quickly. The collapse came less than a week after the Fed raised interest rates by an expected 50 basis points. This market cannot cope with rising nominal interest rates. It astounds me that anyone can believe that long-term risky assets at all-time high price multiples will not succumb to rising nominal interest rates.

US April CPI rose 8.3% YoY, lower than the previous 8.5% YoY. 8.3% is still too hot to handle and the Fed in firefighter mode cannot give up its unrealistic pursuit of fighting inflation. A 50bps rate hike is expected in June, which will continue to undermine long-term risk assets.

Crypto capital markets must now determine who is over-exposed to anything related to Terra. Any service offering above-average earnings that is seen to have had any exposure to this kind of melodrama will experience a rapid exodus. Given that most people have never read how any of these protocols actually work in a distress situation, this will be an exercise in selling first, reading later. This will continue to weigh on all cryptoassets as all investors lose confidence and prefer to cling to the safety rug and hold fiat cash.

After the bloodletting is over, the crypto capital market must have time to recover. Therefore, trying to understand reasonable price targets is foolish. But I will say that, given my macro view of the inevitability of eventual money printing, I will close my eyes and trust the Lord.

So, I'm a buyer of Bitcoin at $20,000 and Ethereum at $1,300. These levels roughly correspond to the all-time highs for each asset during the 2017/18 bull market.