May 17, 2022

What the hell just happened?

Welcome to the Block & Mortar newsletter! Every week, we bring you the top stories and our analysis on where business meets web3: blockchain, cryptocurrencies, NFTs, and metaverse. Brought to you by Scott Robbin and Q McCallum.

But first, some background…

One complaint about crypto is that a token's price can experience wild swings.  That's where stablecoins – tokens that maintain a fixed ratio of exchange, or peg, with some fiat currency – come into play. Many stablecoins are pegged to the US dollar, and usually in a one-to-one ratio.

Issuers of fiat-backed stablecoins collateralize their tokens with actual deposits of dollars, or some near-equivalent, like government bonds.  For each dollar's worth of T-bills the issuers buy, for example, they mint one token of the stablecoin. Try to think of it like gift cards: you pay ten bucks and get a piece of plastic. You later hand in that card for ten dollars' worth of merchandise. The gift card is kind of a cash equivalent. 

Someone who issues an algorithmic stablecoin, since they like excitement, backs their token with … pools of some other crypto tokens.  What happens when the underlying tokens' price moves around, though? The issuer blends math and code to buy or sell those tokens (adding to or removing from the underlying pool) so that the stablecoin maintains its peg.  The stablecoin's price may diverge from its peg just a little here or there, just quick jitter, but overall it's pretty much in lock-step with the fiat currency.

At least, that's how it's supposed to work.  And the whole reason we're explaining how it works … is so that we can talk about a case where it didn't work.

Things Go Wrong™: “What happened with TerraUSD and Luna?” edition

TerraUSD (ticker symbol: $UST) is an algorithmic stablecoin pegged to the US dollar, through a backing token called Luna ($LUNA).  We'll spare you the deep details – explaining this to our friends gave us flashbacks of explaining 2008's collateralized debt obligations – but you'll want to keep three points in mind:

  • TerraUSD and Luna are connected.  Traders swapping $UST and $LUNA, in an attempt to profit, drives the mechanism that keeps TerraUSD's price to $1.
  • Unlike old-school stock exchanges, crypto's DeFi operations don't have a long history of rules and norms to lean on when things go awry.
  • Crypto markets run 24/7.  There's no "we can sort things out while markets are closed." When something goes wrong, you have to sort it out in real-time.

The weekend of 07 May, something happened.  It's still not clear what happened, precisely, but the stablecoin slipped its peg.  No big deal, right?  This is when all that software kicks in, the traders swap $UST and $LUNA, and we're back to parity with the US dollar.  

Instead, both TerraUSD and Luna kept moving.  Downward.  Because of how the two tokens are connected, $UST slipping its peg led to the creation of more $LUNA tokens, and the increased number of $LUNA tokens led to a decrease in the per-token price.  This was compounded by certain tokens being locked away for staking purposes, so some holders were simply stuck watching the free-fall.  And as traders crowded the proverbial door, activity halted on $LUNA's underlying blockchain.  Twice. 

By Friday, 13 May, TerraUSD had tumbled from a dollar to almost a quarter.  $LUNA had fallen from its high of almost $120 down to … well, technically not zero, but so close to zero that it should have been expressed in scientific notation.   Along the way, the panic reverberated throughout the wider cryptocurrency space, briefly taking Bitcoin and Tether on a downward slide

As of this writing, $UST is back on its feet but it's limping.  The parent organization Luna Foundation Group (LFG) injected some capital into the system, bringing $UST back to about $0.25 … but it's since drifted back down to $0.12. 

And as for what comes next, there are still more questions than answers.

And then …?

For one, it's not clear what will bring $UST all the way back to its one-dollar value while also bringing $LUNA's price out of the gutter.  Part of the problem is that, because of how the two tokens are connected, some proposals to save TerraUSD won't help Luna all that much.  Then there's the trust issue, in that even a well-designed plan may not attract investors.  

Taking a wider view, there's also the uncertainty on how to handle future such crashes.  Wall Street has experienced its share of adverse events over the years – from flash crashes, to market manipulation, to full-on market meltdowns – and developed rules and norms to maintain stability going forward.  Stress tests, circuit breakers, and regulations all provide padding that keeps that world (mostly) on-track.  Crypto is a young space and is still sorting itself out. 

Given that, how could stablecoins avoid this kind of crash in the future? 

On the one hand, a key lesson from risk management is that incidents often occur when several smaller problems all happen to collide.  There's rarely a single, isolated cause.  So while it may mollify some investors to ban algorithmic stablecoins or take some other hasty, sweeping motion, that would be a blunt instrument when precision is in order.  It would serve us well to sort out precisely what factors led to the TerraUSD/Luna fallout so that we can prevent that combination from coming together in the future.

On the other hand, algorithmic stablecoins do not have the best track record.  How many more will we see before someone gets it right?  We can see why some investors would steer clear.

At least something went up in price this week

While plenty of people have had a rough few days, at least someone has experienced a win:

About two weeks ago, the Otherside metaverse land rush saw about $320 million in transactions. (Plus another $175 million in Ethereum gas fees, but let's not mention that.)  One Otherdeed has already sold for a very large multiple of its original price. Going from about $6,000 to $1.5 million.  Not bad for two weeks of … holding onto an asset.

That said, this wasn't just any Otherdeed.  It held a special potion.  And when it comes to NFT valuations, such special attributes lend themselves to higher prices.

But what does that potion do? And how will holding that potion improve the in-game experience?  We're not sure, since Otherside parent company Yuga Labs has revealed very little of what their metaverse implementation will entail.  We'll have to wait and see.

One thing we do know: if the seller is based in Germany, they can properly report those crypto winnings to the government. The German finance ministry recently released tax guidance on income made from crypto.   

(If you're so inclined, you can read more on the website for the Bundesministerium der Finanzen.  Auf Deutsch, natürlich …)

In more upbeat news…

Kraft Heinz, the parent company behind Lunchables, Velveeta, and the eponymous ketchup, has its eye on the metaverse.  This isn't about plots of digital land, though.  The company plans to explore "digital twins" of its facilities and supply chains in an attempt to streamline its operations.   This partnership with Microsoft will allow Kraft Heintz to model and test optimizations in a virtual setting prior to implementing them in the real world.

TheVatican.eth

The Vatican is the religious center of the Catholic world.  The Vatican Museums are home to an immense art collection of over 70,000 pieces.  The museum recently unveiled plans to digitize some of the artwork and make it available as NFTs. The primary mission of the project does not appear motivated by profit; rather, its purpose is “to democratise art, making it more widely available to people worldwide regardless of their socio-economic and geographical limitations.”

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Note: We’d like to thank Shane Glynn for reviewing early newsletter drafts. Any mistakes that remain are ours.