Original compilation: TechFlow Intern
Original compilation: TechFlow Intern
Throughout history, people have tried to create something from nothing.
On the one hand, there are genuine scientific innovations—new developments that allow us to harness more intensive energy sources and increase productivity, thereby improving the quality of life for most people.
They created something from nothing, they made access to resources faster than ever, easier to grab more resources, better organized material, information and human activity. In other words, if you let a caveman look at your smartphone, he'd think it was magic.
On the other hand, there are people experimenting with alchemy and perpetual motion - methods that mislead science. Even someone as smart as Isaac Newton spent a lot of time studying alchemy. This is an easy trap to fall into.
Much of the cryptocurrency market is basically a modern version of alchemy. While there has been real innovation in the space, such as Bitcoin, fiat-collateralized stablecoins, and many technological experiments, there has also been a great deal of speculation, pump and dump schemes, and technical claims that confuse projects’ trade-offs and risk controls.
first level title
Harness Bitcoin
Local payments have historically been a private and physical process. I give you physical cash, you give me goods. This type of transaction is difficult to monitor or block.
But for many years, if people needed to send payments further afield, they relied on large central intermediaries (commercial banks and central banks).
If I want to send money to my friend in Chicago, or another friend of mine in Tokyo, or buy something from a merchant in those cities, I need to go through a major bank. I tell the bank and send money to them in various ways, and if it is going across the country, it will eventually involve our country's central bank.
As an American, remote payments through centralized entities are not a big deal for those destinations because they don't block my payments, but the problem is that they are expensive and slow.
But for most of the world with restrictive monetary regimes and persistently high inflation (more than half of the world lives in an environment of authoritarianism and/or recurring double-digit inflation), the lack of alternatives has been limiting . This may not be apparent to journalists, academics and analysts in developed markets, many of whom are unaware of this form of privilege.
The invention of Bitcoin changed this reliance on centralized intermediaries as it brought about the first trusted self-custodial peer-to-peer currency. Anyone with Internet access can send liquid value to other Internet users in the world without relying on commercial banks or central banks. Nobody holds money for them, and they don't have to ask permission from any centralized entity to send that value to someone else.
Looking at Chainalysis, it is not surprising that 19 of the 20 leading countries in the Crypto Adoption Index are developing countries.In general, people in these countries have lower levels of property rights, lower levels of financial freedom, and higher levels of monetary inflation than most readers of this article can handle:
Bitcoin became the fastest asset in history to reach a $1 trillion market capitalization, and has recovered from three 80%+ crashes and several 50%+ crashes to hit new highs:
Bitcoin holders have to live with volatility, technical risk and other such things, but what it offers is really innovative in a technical sense. Rather than relying on human decision-making to reach consensus, the protocol uses energy and open-source code to build a publicly auditable global consensus ledger.
But after Bitcoin, there were 20,000 imitators.
Some of these increase node requirements, thus sacrificing decentralization, in order to increase transaction throughput (thereby defeating the purpose of blockchain).
Some of them drop the proof-of-work mechanism and replace it with a proof-of-stake consensus mechanism, which again reduces decentralization.
Some of them take extra complexity to achieve more code functionality, which also increases node requirements and reduces decentralization.
Basically there's always going to be a theme here. With each new "innovation" of competing projects, decentralization is constantly being thrown aside.
Satoshi Nakamoto deliberately sacrificed most of the metrics in Bitcoin's design for an automated, decentralized, and auditable global transfer agent and registrar, nothing more. He combined existing technologies such as Merkle trees and proof-of-work algorithms, and then added difficulty adjustments to the combination. This combination is his innovation.
Since then, developers have updated Bitcoin several times through soft forks (backward compatible upgrades), but the core design has remained the same. It has had 99.98% uptime since inception and 100% uptime since March 2013.
Not even Fedwire, the Federal Reserve's interbank settlement system, has had 100% uptime during this period.
Most other cryptocurrency designs take back some of the decentralization, reliability, and security to add more features and then pitch it to investors as an innovation.
There is indeed some innovation here. For example, it may be useful to federate the database and compute layers. But for the most part, the space is filled with misconceptions about what Satoshi created and why.
These trade-offs are rarely advertised to investors, instead being marketed as pure technical improvements. This kind of advertising attracts a lot of people, especially when combined with temporary financial incentives funded by VCs.
Unlike the Bitcoin network, which has no central organization for marketing it, most of these projects have central foundations or personnel that play a key role in the marketing and ongoing operation of the network.
Those working in the Bitcoin ecosystem are often critical of these other protocols.From an external perspective, the entire "crypto" ecosystem may appear homogeneous, but within the industry this is not the case. People who work on these so-called "altcoins" have a natural incentive to try to connect with Bitcoin, but it's to better market their coin, while Bitcoin supporters have a natural incentive at this time to point out all the risks and trade-offs of these purportedly innovative projects.
Satoshi Nakamoto launched open-source software, which was updated for a few years at the beginning, never pre-mined bitcoins for himself, never spent the bitcoins that had been mined, and then disappeared, letting others continue his project.
Since then, the network has relied on itinerant open source developers, with no leader. No one can push network updates to users. And nobody does anything when prices fall. Bitcoin has never raised money, failed the security Howey test, and therefore is not a security, it is classified as a digital commodity in most cases.
In contrast, many other protocol developers have gotten rich off of leaving a lot of premine tokens behind and continue to operate their networks in a centralized fashion while marketing them as decentralized. Many of these tokens/organizations raised capital, pass the security Howey test, and thus have many of the characteristics of securities.
If the protocol developers were completely honest about their design, this would be like a startup, we can analyze it that way. But in practical terms, many of them are essentially unregistered securities, operating in a global gray area until regulators figure it out, while promoting themselves as decentralized networks.
That’s not to say that all crypto projects are bad or devoid of technical contributions, but rather that the industry is full of scams, frauds, and ultimately doomed, albeit friendly, projects that make up nearly all of the projects created. Bitcoin has left a huge trail in its path that sharks are happy to fill and figure out how to make big bucks fast.
For the most part, like Bitcoin is the iPhone of the industry, there are thousands of cheap knockoff phones being sold with the iPhone logo on them. Investors need to be very cautious if they choose to speculate in various crypto projects.
first level title
Terra - "A Central Bank That Doesn't Exist"
Terra is a cryptocurrency network based on a stablecoin called the UST algorithm and uses its native token LUNA as equity capital. The create/destroy mechanism relationship between the two is designed to keep the peg stable.
It bills itself as decentralized, but it's not:
At its peak, Luna had a market cap of $40 billion, while UST was close to $20 billion. It has received a lot of investment from many crypto VCs and retail investors. But now most of them are dead, UST is decoupled, and LUNA is zero. This event took place from May 7th to May 12th and is still ongoing.
The Terra ecosystem is still young and I ignore it. I follow various cryptocurrency projects, and once they hit the top 20 or so by market cap, I'll go and see what those projects are doing, but there's only so much I can keep track of.
By mid-March 2022, the Luna Foundation Guard was formed to ensure the Terra ecosystem was functioning, and LFG began buying Bitcoin, intended as another line of defense for its token stake. That's when I started digging into the Terra ecosystem to analyze risks.
Many in the Bitcoin ecosystem have been warning about Terra for months. Industry professionals including the likes of Brad Mills, Castle Island Ventures' Nic Carter, Swan Bitcoin's Cory Klippsten, and more than I can name here have all been openly critical. Especially Cory Klippsten loudly and repeatedly warning people.
I analyzed the reality, read some of the criticisms of the project, and then read the rebuttal arguments from the people at Luna Bulls about why these risks were deemed unwarranted. My point is that the risks are very clear. This is not really a technical risk. This is an economic risk based on unstable economic design and unsustainable financial incentives.
secondary title
“Luna Defense Guard Bitcoin Accumulation
The recent Bitcoin price breakthrough may have been due to the purchase of more than $1.3 billion worth of Bitcoin by the Luna Foundation Guard, which plans to purchase $3 billion in Bitcoin as a reserve and eventually increase that reserve to more than $10 billion.
Terra is a proof-of-stake smart contract cryptocurrency based on algorithmic stablecoins, specifically the US dollar stablecoin UST surrounding its ecology. Unlike USDT or USDC, which are custodial stablecoins (centralized entities that hold fiat dollars as assets and issue redeemable stablecoin tokens representing those assets), UST is an algorithmic stablecoin. This means it approximates the value of the dollar, but does not hold dollars. "
The way it works is that LUNA acts as a volatility offset for UST. If UST exceeds $1, there is an arbitrage opportunity to burn LUNA and create more UST. If UST falls below $1, there is an arbitrage opportunity to create LUNA and destroy UST. UST should stay around $1 while LUNA is allowed to fluctuate. Over time, the more UST is demanded, the higher the market cap of UST and LUNA should be. It's like a central bank trying to incentivize market participants to conduct open market operations.
But if the price of LUNA fails to keep up with the expansion of UST's market cap, UST may become less and less "backed" by LUNA over time. This is the general trend we've been seeing since late 2021 when UST demand started to take off. Currently, it still has an approval rating of more than 200%, but the decline is rapid.
Terra is now the second largest ecosystem in DeFi based on total value locked:
The huge demand for UST is almost entirely driven by unsustainably high APY yield opportunities, just like the rest of the DeFi ecosystem. Investors have been able to earn nearly 20% UST yield on Terra's Anchor protocol thanks to various arbitrage opportunities, and it's starting to dry up. If VC-backed opportunities for high-yield APY yields dry up, UST demand could decline. If the demand for UST shrinks, it may lead to a negative feedback loop and liquidity problems for UST and LUNA, also known as a "death spiral", where a large amount of funds are withdrawn from the Terra ecosystem, causing the price of LUNA to plummet and eventually break its peg to UST. This situation is functionally very similar to emerging market currency crises.
Unlike Bitcoin, which has no centralized foundation, most smart contract blockchains have specific for-profit or non-profit organizations that serve as promotion and development centers. Terra has Terraform Labs, Solana has the Solana Foundation, Ethereum has the Ethereum Foundation, and Avalanche has Ava Labs. These are typically founder/VC-backed entities with dedicated leadership and staff to facilitate and grow the ecosystem, and often use pre-mined tokens as start-up capital.
Terraform Labs and other parties raised funds to build the Luna Foundation Guard, which will serve as a second layer of defense for the UST/USD algorithm peg, rather than relying solely on LUNA's peg.
One view is that it is similar to a country's sovereign reserve.In times of economic prosperity, emerging markets can use accumulated trade surpluses or currency sales to increase their reserves of foreign exchange assets, such as gold, dollars or euros.Then, if the country later experiences a recession and a currency crisis, it can defend the value of its currency by selling some of the reserves it had previously stored, and take the proceeds from the sale.
“On the one hand, Terra bought a large amount of Bitcoin initially because it was bullish on Bitcoin.LFG could have bought USDC or USDT as a reserve, ETH as a reserve, or a combination of these assets as a reserve. But instead, they bought BTC as a reserve, thinking it was the best reserve, a decentralized, raw collateral that could be held long-term with minimal transaction risk. This further validates the argument that Bitcoin is the best digital reserve asset. But now, the bigger the Terra ecosystem is, the more BTC reserves are expected to be needed. LFG intends to add a small amount of other tokens as reserves as the project expands to other platforms. For example, if they want to expand the use of UST to the Solana ecosystem, they may buy some SOL as a reserve.
On the other hand, this poses a future risk to the price of Bitcoin.If Terra had problems and was forced to sell a large amount of Bitcoin to defend its peg to UST, it would be detrimental to BTC price, just as their current purchases are detrimental to price. The unsustainable Anchor protocol on Terra (with a yield of 20%) led to a lot of UST demand, and with this new reserve practice on Terra, UST demand led to BTC demand. This can be considered an indirect, artificial or unsustainable source of BTC demand that will eventually dry up. Active bitcoin traders should keep a close eye on LUNA and BTC reserves relative to UST market cap, because if it starts to collapse and is forced to defend the UST peg, we could see rapid selling pressure on BTC worth tens of thousands of coins. "
I then continued to monitor Terra, increasing its risk assessment. In my May 1 report I wrote:
Luna notes
Looking back at the April 3 premium report, I discussed the design of the "UST" and expressed some concerns.
In an update a month later, UST's market cap has increased, while LUNA's has decreased, so collateral is getting worse:
This is different from how DAI is collateralized. LUNA is an algorithmic stablecoin, not a crypto-collateralized stablecoin. Regardless, LUNA's market capitalization is an important variable for UST's long-term integrity.
LFG's BTC and AVAX holdings add less than 10% to its total collateral, so even accounting for these reserve assets weakens the ratio.
Meanwhile, reserves at Anchor, which provides artificially high yields for UST, fell 40% in April. This decline represents high yields for many stakers. Ultimately, the founders either need to pump more money into it, or the yield must stabilize at market rates, which may reduce demand for UST.
We're at a stage where it's worth watching Terra peg to UST in the coming months.As the value of LUNA decreases, the amount of collateral LUNA provides to algorithmically back the UST peg has decreased. This could be salvaged a bit by a general crypto market price rally, but either way, I'll be watching it closely here. Meanwhile, LFG's reserve direction continues to dwindle.
The worst-case scenario is that UST begins to depeg and LFG is forced to sell some or all of its $1.6 billion in Bitcoin to an already weakened market in order to defend its peg to UST. I think the way it works is that UST holders will be able to redeem Bitcoin, at which point many of them will choose to close their positions and get their cash back. At that point, the Terra network would be severely compromised, and the price of Bitcoin could take a noticeable hit.
In this case, I would be a buyer of Bitcoin, but it could be messy if it happens. It could even mark the bottom of this cycle with a lot of forced liquidations, similar to Q4 2018 or Q1 2020. I'm not saying that this cycle will definitely happen, but I have observed that the risks of it have reflected this pattern.
Overall, the only investable asset I see across the digital asset ecosystem is Bitcoin, but even Bitcoin is best paired with some cash for rebalancing and lower volatility in this challenging macro environment sex. Whenever I analyze crypto as a Ponzi scheme, I classify everything else in the industry as speculation, depending on the specific asset in question. "
As much as I was growing concerned that it was happening, I didn't expect Terra to crash within a week of the second report. This sort of thing can go on for a long time when backed by big money like Terra, so I don't know exactly when or how it failed.
LFG didn't even have time to build an automatic bitcoin redemption mechanism, so LFG manually and centrally lent its bitcoin reserves to market makers in an attempt to defend the failed UST peg.
LFG's Bitcoin multi-signature address was exhausted, and a large amount of it flowed into the exchange. It’s unclear what the full chain of custody for its bitcoin is, but blockchain analytics firm Elliptic has tracked Binance and Gemini:
There is evidence that it was a well-funded attack that influenced the timing of Luna's collapse. A large entity short-sold Bitcoin and caused the decoupling of UST, as people described the protocol as a possible attack in 2021. For macro investors, it's like Soros shorting the Bank of England.
Blaming the attackers is beside the point, if something in the market can be successfully hacked, it will eventually be successfully hacked. This is by far the biggest failure of an algorithmic stablecoin. Since most of their tweaking mechanisms are public, it's easy for an attacker to figure out how to attack it.
The impact of Terra's collapse began to spread to the entire digital asset ecosystem.Many VCs have had exposure to the Luna token. Thousands of altcoins start to drain, various pools are scared away, and this is a period of reassessment for the entire ecosystem. People separated the wheat from the chaff and found that most of it was chaff.
first level title
concluding thoughts
I remain structurally bullish on Bitcoin as part of a portfolio, especially taking advantage of volatility to keep buying over time.
While there are risks to this view, I think the year 2022 will be seen as a good time for investors to add to their holdings on a 3-5 year time horizon, similar to 2020, 2018 and 2015.
While there are other neat blockchains out there, I personally don't think there are any that offer a decent risk/reward ratio and investors should exercise caution when speculating on any crypto token other than Bitcoin. Even for Bitcoin, investors must assess volatility and network risk to maintain appropriate positions.
I think of the constant monetization of Bitcoin as analogous to a bodybuilder's cycle of gaining muscle and losing fat.Bodybuilders focus on cycles of gaining muscle and losing fat so that after many cycles, they build up a lot of muscle while avoiding fat buildup.
During a bull market, bitcoin prices rise but face dilution from thousands of new projects. When liquidity is plentiful, funding is available to anyone with an idea and can lure investors with a promising narrative. Outside capital flows into Bitcoin, but then it starts getting distracted by these shiny new things and starts diluting into these other things.
Then during bear markets, liquidity flows out. Bitcoin prices took a hit, and thousands of altcoins took an even bigger hit. Over-indebted, pegs failed, Ponzi schemes were exposed, and fragile networks fell apart. Muscles stop growing and even shrink, but importantly, a large amount of unproductive hidden fat is burned so that the next growth cycle can start all over again.
With each new cycle, Bitcoin’s network effects and investment thesis have historically remained the same, while most other projects have stagnated and been abandoned by developers and investors.Bitcoin has continued to make higher highs in four major separate cycles, each with higher adoption and development, while most altcoins only survive one or two cycles.
Many famous coins ended up stagnating. Take the top 10 coins at the end of the bull run in 2017, each of which continued to underperform Bitcoin at the highs in the subsequent bear and bull markets. ETH, BCH, XRP, LTC, ADA, MIOTA, DASH, NEM, and XMR all reached lower highs in BTC terms during the 2021 bull market compared to the 2017 bull market.
Looking back at the bull market in 2013, it was basically the same. People today haven't even heard of most of these top ten coins. In this list, XRP denominated in BTC continued to make higher highs in 2017 compared to 2013, but not in the 2021 cycle, no one experienced a larger return cycle denominated in BTC .
I think this pattern will likely continue, with most of the crypto darlings in the 2021 bull market already seeing new all-time highs in BTC terms. Maybe one or two will go on to gain more heights at some point, but most won't.
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