This is the mirror.xyz version of the original Bookie post on Substack

🎧 To get this essay straight in your ears: listen on Spotify or Apple Podcasts.

I was in the middle of writing another piece but shelved it so I can start capturing my thoughts on some really crazy events that took place this past week.

Those of you who are tuned into crypto probably already know what I’m talking about. But I also know there’s a good chunk of you who aren’t and, in classic Bookie fashion, I figured I would try to understand what actually happened by writing about it.

Sprinkle in elements of me being catastrophically wrong along with some important lessons about critical thinking and this turned out to be a really worthwhile exercise.

Alright, enough preamble. Let's jump in and speed-run through what happened last week.

Do you all remember my Bookie article a few months back about stablecoins and the future of money? Remember how I was raving about Terra ($UST)? Remember how I even characterized it as this beacon of hope showcasing all the potential benefits digital currencies can bring to society?

Well, here's what happened last week.

In what's been dubbed "Meltdown Monday", a series of market events led to the $UST stablecoin losing its peg to the US dollar. At the time of this writing, $UST is valued at $0.18 after spending most of its history valued at $1. The subsequent, "de-pegging" of $UST triggered a chain reaction that ultimately caused $50B—that’s BILLION with a B—of market value to evaporate practically overnight.

Terra at its peak was one of the top 10 most valuable cryptocurrencies based on market cap and its implosion might turn out to be the largest single-asset class collapse the world has ever seen.

I'll pause here and acknowledge that while I’ll be describing the mechanics behind what happened, I don't want to gloss over the real pain this disaster has brought on.

I'm fortunate enough to characterize all this as just consequences from yet another dumb crypto investment. I get to wipe some egg off my face and participate in this intellectual exercise of self-reflection.

But real people and businesses had their entire livelihoods tied to this asset class and their financial situation has just taken a dark turn for the worse. Reports of attempted suicides have already surfaced and Terra Reddit threads are filled with links to the National Suicide Prevention Hotline.

It's important to explore the market conditions that led to this event but I also don't want to lose sight of the real human cost tied to this financial catastrophe.

So why did this happen? What does it mean for the future of crypto? And what can we all collectively learn from all this carnage?

Before we go any further, let’s talk about how the Terra ecosystem actually works.

Stablecoins have all the properties of digital currencies—faster settlement and easy access to Web3 services—but are stably pegged to a real-world asset like the US dollar.

Major stablecoins like Tether and USDC maintain their peg with collateral—each token is worth $1 and every token in circulation is supposed to be backed by a $1 worth of cash or cash equivalents centrally held somewhere. Much like how our paper dollars used to be redeemable for gold, stablecoins should always be redeemable for real dollars. That trust is ultimately what ensures these tokens hold their value.

Terra ($UST)—the subject of today's piece and the third-largest stablecoin in circulation—is an algorithmic stablecoin. There's no centralized entity that keeps collateral stowed away for you to redeem. Instead, $UST relies on smart contracts, incentives, and trading activity to hold its value. Its peg to the dollar is ultimately a function of people believing in the stability of all these moving pieces.

We'll touch on how that trust started breaking down shortly.

So how does it work?

The Terra protocol actually consists of 2 tokens: Terra ($UST), the stablecoin we referenced above, and Luna ($LUNA) the governance token that lets you vote on what the Terra protocol is allowed to do.

Built into the algorithm is the rule that you can always redeem $1-worth of $LUNA for 1 unit of $UST and vice versa. That means if $LUNA is priced at $90, you can redeem it for 90 $UST tokens and your $LUNA gets taken out of circulation to mint these 90 $UST tokens.

Conversely, if I had 90 $UST tokens, I can redeem them for 1 $LUNA worth $90—burning my 90 $UST tokens to mint the 1 new $LUNA token.

And you can always make this exchange even if $UST is worth less than a dollar.

So, to summarize:

1. $X worth of $LUNA can always be exchanged for X units of $UST. And X units of $UST can always be exchanged for $X worth of $LUNA

2. Every time you exchange $LUNA for $UST, $LUNA gets destroyed to create new $UST. And every time you exchange $UST for $LUNA, $UST gets destroyed to create new $LUNA.

3. You can make this exchange even if the $UST stablecoin isn’t worth $1

This mechanism is critical to understanding what happened on Meltdown Monday so let’s really drive this point home with an example.

Let’s say I currently hold 5 $LUNA priced at $90 each—so $450 worth of $LUNA total. Now let’s pretend $UST suddenly goes below its peg of $1 to $0.90.

When $UST was worth a dollar, my $450 wroth of $LUNA would allow me to get 450 units of $UST. But now that UST is $0.90, I can now get 500 $UST tokens. So I buy the 500 $UST tokens and—because a token of $UST gets me the equivalent dollar amount of $LUNA—I can immediately exchange it for $500 worth of $LUNA.

So I just turned my $450 into $500 with just this simple $LUNA-$UST exchange mechanism—which finance bros call arbitrage.

And by making this exchange, I just removed 500 $UST tokens out of circulation. When enough people do this, the supply of $UST decreases to ultimately raise the price of $UST back to its $1 peg.

Econ 101: Supply-and-demand.

Of course, this only works when enough people are holding and exchanging $UST and $LUNA. Stablecoins function a lot like currency, people need to believe in their intrinsic utility for them to maintain their value.

I cited a few real-world examples for why people would want to hold onto $UST in my Future of Money piece:

• $UST is facilitating a significant number of e-commerce and brick-and-mortar transactions in Korea

• It announced a partnership with the Washington Nationals MLB team and will be accepted as a form of payment in their stadium

• It gives you access to a ton of financial services like crypto ETFs, loans, and high-yield savings accounts built on top of the Terra protocol

It turns out that the OVERWHELMING majority of people held $UST just to use a service called Anchor—Terra’s version of a high-interest savings account that provides 20% returns on all deposits. For comparison, my high-yield savings account only offers 0.6%.

20% is an absurd APY! I could be making 40x more money taking every dollar I would’ve put into a traditional savings account, buying $UST, and then depositing it into Anchor.

At its peak, 70% of all $UST in circulation was held in Anchor. And with $UST widely considered a dollar equivalent, all of this sounded like a great risk-free bet.

Seems too good to be true? Certainly not to me 7 days ago but I'll admit the answer would've depended on who you asked.

The Luna Foundation Guard (LFG), led by Terra founder Do Kwon, oversees the entire Terra ecosystem and were the ones responsible for Anchor's bootstrapping strategy.

The LFG uses its initial capital to buy $LUNA and sells the $LUNA for $UST to fill up the Anchor protocol reserve—the big slush fund that pays Anchor depositors the absurdly high 20% interest rate.

One could characterize this arrangement as the LFG essentially paying people to use Anchor, which encourages people to hold $UST, which drives down the supply of $LUNA and increases its price.

As long as the value of $LUNA keeps increasing, the LFG can continue exchanging $LUNA for $UST, filling up the Anchor protocol reserve and continuing to pay these juicy interest rates. What a beautiful positive feedback loop 😊.

But minting money out of thin air in order to juice up demand also sounds A LOT like a Ponzi scheme! In hindsight, a decentralized stablecoin that was effectively holding onto its own stablecoin as collateral should've been a red flag...

In my defense, this method of artificially generating demand isn't illegal nor novel—developing countries do this with their new currencies in order to jumpstart initial supply and demand.

We just needed to go on long enough for $UST to become a widely-used stablecoin before the LFG reserves run out of money.

Funny enough, a crypto entrepreneur I met the Saturday before Meltdown Monday warned me about this scenario.

This wasn’t a crypto meetup. I was at a friend’s birthday party and the guy was standing between me and the slice of cake I really wanted.

He’s a cool guy though and here’s roughly how the conversation went down:

• Me: [Saying a bunch of crypto nonsense trying to sound smart] "I'm really excited about Luna, here's how it works [blah blah blah]"

• Him: “Phil...this sounds a lot like a Ponzi scheme.”

• Me: "I wouldn't call it a Ponzi scheme...it's more like a perpetual motion machine."

• Him: "Perpetual motion machines also don't exist. The laws of physics don’t allow it."

• Me: "No but it just needs to work for a little while longer."

• Him: "That's also what Ponzi schemes claim before they unravel!"

• Me: [Awkard pause] "We'll be fine."

Call it whatever you want, this whole system of incentives led to $LUNA’s meteoric as one of the largest cryptocurrencies in the world. Starting at $1 per token at the beginning of 2021, it rapidly ascended to a high of $119 this past April.

Investing in $LUNA—which is what I did at $90 per token—was betting on more people wanting to hold $UST. It turns out that was also a bet on Anchor’s interest rate continuing to make it an attractive reason to do so.

The more people who want to use Anchor, the higher the demand for $UST. The higher the demand for $UST, the more people are willing to burn $LUNA to hold $UST. And then less $LUNA supply would keep increasing the price of the remaining $LUNA tokens.

As long as people continued to believe in the directional appreciation of $LUNA, $UST remains stable and the party keeps going.

Everything that makes Terra such a juggernaut can also lead to its swift, unforgiving demise.

Let’s use an extreme example to explain:

• Let’s say $LUNA is priced at $1B per token

• You exchange your $LUNA for 1 billion $UST which mints 1 billion new $UST tokens (yay, more stablecoin liquidity)

• Then let's say that the price of $LUNA falls to $1 for no good reason

• You can now exchange 1 billion $LUNA tokens with the 1 billion $UST you hold

• So suddenly a ton of $UST is gone and there's a LOT more $LUNA floating around

• $LUNA supply goes up so much that it puts downward pressure on its token price

• All that $UST that just left circulation means there's fewer $UST to facilitate transactions, making people start to question its underlying utility as a stablecoin

• Oh and one other thing: Now there’s also less $UST in Anchor to pay those interest-bearing savings accounts which gives people even less desire to hold $UST.

• Now there’s widespread lack of confidence in both $LUNA and $UST and the cycle repeats

This is what crypto folks call the “Algorithmic Stablecoin Death Spiral” and it's exactly what happened on Meltdown Monday.

In what the LFG characterized as a “coordinated attack”, some very very well capitalized traders began accumulating over $1B worth of $UST during the run-up. Then on Monday, May 9, they sold approximately $285 million $UST simultaneously across platforms like Anchor, Curve, and Binance. That’s a ton of $UST getting destroyed and a ton of $LUNA suddenly entering the ecosystem.

This wasn't actually the first time something like this happened. Terra's actually weathered a few massive $UST liquidation events in its history and emerged unscathed.

In January, Terra’s stability faced its biggest challenge after a Web3 Defi service called Degenbox collapsed.

Remember that 20% APY on Anchor? If someone is paying you 20% risk-free, why not just borrow a ton of money at lower interest rates, and put that into Anchor? You can take out a $1M loan charging 2% interest and put that $1M into Anchor. Anchor gives you $200K, you pay back $20K to the person who loaned it to you and you just netted $180K in profit. You take your profits to secure an even bigger loan and repeat the same process.

This is a recursive borrowing strategy—effectively minting money from thin air—and it’s exactly what Degenbox and a ton of other retail and institutional investors did during the $LUNA run-up.

Once Degenbox collapsed, so much $UST got liquidated that $UST briefly de-pegged and $LUNA slid from $100 down to $46.

That's when Jump, 3AC, and other institutional Terra-Luna investors loaned the LFG $1.5B worth of Bitcoin ($BTC). All that Bitcoin was then used to buy back the excess supply of $LUNA, stabilize its price, and also gave $UST holders a way to redeem $UST to $BTC.

Crisis averted and many even praised this new influx of Bitcoin collateral as a smart insurance policy.

Should we have been more skeptical of an algorithmic stablecoin suddenly relying on collateral?

Maybe. But no one else seemed to care and the price of $LUNA shot back up to all-time highs.

Now, back to Meltdown Monday. This was a much larger liquidation event than what happened with Degenbox in January.

So much $UST left the system that the stablecoin de-pegged and the LFG was forced to start deploying its massive Bitcoin emergency fund.

The plan was to use their $BTC to buy $LUNA to create enough $UST to stabilize the peg. They hoped that by selling this much $BTC, the price of $BTC would get pushed down. They can then buy back the $BTC collateral on a lower basis. And buying back the $BTC would increase the price and demand for $BTC—increasing the amount of collateral they hold in their emergency fund.

Sell $BTC, create more $UST, buy back $BTC, and increase collateral. Repeat and profit!

The Anchor protocol reserve gets replenished, $UST stabilizes, confidence gets restored, and $LUNA emerges even stronger.

There was a very tight window all of this needed to happen and (you guessed it) it didn't.

The panic happened so quickly that the LFG simply didn't have enough $BTC to weather the storm. And because crypto transactions are public, people knew when exactly the LFG had run out of $BTC.

Once word got out, even more people started cashing out their $UST to avoid the death spiral carnage.

Do Kwon—whose Twitter handle is ironically stablekwon@—employed every trick in the book to restore confidence

• Terra started rate-limiting the number of $UST>$LUNA redemptions

• Do Kwon played up rumors that there was going to be another capital injection worth billions of dollars (which became apparently quickly that it wasn't happening)

• He promised that if $UST survives, it'll get rebuilt into a collateralized stablecoin

• He proclaimed Terra's return to form "will be a sight to behold"

Within a matter of days, $LUNA went from being priced at $64 to essentially 0 (or $0.000488 to be precise). The price of $LUNA is so low that exchanges have completely delisted it. As for $UST, it's completely de-pegged to the dollar and only worth 18 cents.

Before the weekend, Do Kwon announced that they're halting the blockchain—essentially saying that they've given up and will no longer be processing transactions.

This was one of the fastest, most dramatic episodes of wealth destruction we have ever seen.

$LUNA’s crash generated even more widespread skittishness and the crypto market contracted 16% this past week.

Tether, the largest stablecoin in circulation, briefly lost its peg after people started panicking and selling en masse. Tether would've been a MUCH bigger domino to fall but has fortunately recovered.

The event even caught the eye of the US government. Much to the chagrin of crypto purists, Janet Yellen, the US Secretary of the Treasury pointed to this episode as yet another example of why crypto and stablecoins need to be regulated.

There's something uniquely American about proclaiming "Let me lose my money the way I want!" but it seems inevitable that regulation is coming. It's time for the community to react maturely, pragmatically, and collaboratively to the public sector entering this space.

I'm optimistic there's a path to a safer and more vibrant ecosystem at the end of it.

With the benefit of hindsight, there are 2 critical lessons that are top of mind for me:

1. Nothing is too big to fail. There were 114 projects built on top of the Terra ecosystem. It was one of the largest cryptocurrencies in the world and had support from some of the top venture capitalists in the space. This was supposed to be where all the smart money was. Turns out none of that matters if the underlying fundamentals of the project can't deliver.

2. FOMO and herd mentality is really powerful. Lots of very very credible people supported $LUNA. But lots of credible people also sounded the alarm about the risks. Algorithmic stablecoins have collapsed like this before and some even argue that their inherent design makes this kind of death spiral inevitable. Despite considering myself to be a fairly principled, open-minded decision-maker, I ignored the naysayers and discounted their points as just ill-informed skepticism. It's such a valuable lesson in how our beliefs influence the information we consume and not the other way around.

But I'll also conclude with this: I’m not ready to be a pessimist. This was a disastrous, failed experiment with awful consequences but I do think we need these sorts of mistakes to move us forward.

In the present moment—especially during moments of crisis—skeptics will always seem smarter than optimists. But don't be that guy who thought everything useful was already invented in 1920. Or that guy who predicted the demise of the internet after the Dotcom Bubble popped.

This isn't the end. Crypto’s clearly in a slump but it’ll bounce back—there’s too much momentum and talent for this entire sector to be held down forever. I'm optimistic that the learnings and response to this episode will bring more value than the destruction it caused.

So maybe the right strategy is to be skeptical short-term and optimistic long-term?

Honestly, who knows.

But I’m still an enthusiastic supporter of this sector…just one that has a lot less capital 😅.

• 📰 Terra: To the Moon and Back by Packy McCormick

• 📰 A great Twitter thread by @jonwu__

• 📰 Multiple articles from the MilkRoad newsletter

• 📰 UST Luna Meltdown: What Happened? by Ben Glove

If you’d like to notified of future posts every other week, subscribe to Bookie on Substack!