The Moral Obligation to Test Markets
Collapses in the free market can be brutal, but it's better in the long run
In light of the recent LUNA fiasco, which saw one of the largest projects in the blockchain and cryptocurrency space get absolutely nuked from $40 billion to zero within a matter of days, there have been heightened calls for regulatory oversight. The spotlight being shone on the project has most certainly left a blot on the reputation of the space, and the involved parties (particularly those who may have intentionally caused the crash) are facing enhanced scrutiny — even Do Kwon, who was notoriously braggadacious for telling people to “have fun staying poor” appears to have been humbled. After all, LUNA and UST both had millions of holders across the world, and any of them who were irresponsibly concentrating their portfolio in the Terra project would have been completely destroyed. During the crash in 2008, many retail traders and investors were of a similar mindset: that the bankers and speculators who had predicted that this collapse would happen would be forced to face charges. With regard to Terra, there have even been calls for Do Kwon to face criminal charges for negligence, lack of experience, and incompetence. But should there be?
“Schumpeter’s gale”, more commonly known as “creative destruction”, is the phenomenon in a free market in which businesses and organisations are put out of business by their more competent adversaries. This can occur in many forms: a new business may be more competent than their competitors, may have more capital than their competitors and establish economies of scale (Amazon versus high street retail), or may be so innovative that they render their competition technologically and pragmatically obsolete (Netflix versus Blockbuster). In all these cases, “creative destruction” refers to the process in which one business model either loses significant market share or is completely destroyed, and the result of this process is that life improves for the consumer as costs are driven down, inefficiencies are culled, and technology improves. This is the nice side of destruction in the free market that is only really noticed by the companies whose businesses are obsoleted, and the process is largely cheered on by society at large as the improvements are reflected in their quality of life.
The dark side of creative destruction is felt by those who have a stake in these failed business models, since their assets will be completely destroyed. In the case of Terra, one could argue that the reason for the lost peg was due to an underhand interference from fund managers and speculators who had the capital to move markets, and that these people are responsible for the collapse. This may have been true over the short term: it is very likely that a coordinated attack on the Terra’s infrastructure was the reason for its collapse, and that this destructive speculation was done so with the goal of profiteering at the expense of the millions who held LUNA or UST.
However, it would be an oversimplification to depict such profiteering as a callous disregard for others. Quite the opposite. Before the attack there had been a wide array of theories as to ways in which the algorithmic stablecoin could fail, and many people predicted that the duality of LUNA and UST in the Terra ecosystem would cause an inevitable death spiral. These warnings were heeded to an extent, and for this reason Terra tried to back themselves somewhat with Bitcoin as collateral, but it didn’t work. Bitcoin has only existed since 2009, and Ethereum has only existed since 2015, meaning that the industry is still in its initial stages of growth — it may be the fastest growth of any industry in history, but it is nevertheless still in its formative years.
This wasn’t the first time that algorithmic stablecoins have been attempted, and it was for this reason that quite a few people had been explaining the potential shortfalls months (and in some cases, years) before Terra’s downfall. One of the first algorithmic stablecoins, NuBits, was introduced in 2014 and had relatively similar operational mechanics when compared with Luna. NuBits functioned well for several years, and many holders were very happy with the project until June 2016 when the peg finally broke thanks to bullish action in the price of Bitcoin.
Operationally, there were many similarities between Terra and NuBits (the largest differentiator being the relative market caps), but the one constant across both projects is that the lack of over-collateralisation meant that the ability for each stablecoin to maintain its peg was largely due to trust persisting. Algorithmic stablecoins can provide incentives to holders and arbitrageurs in order to maintain their pegs, but ultimately entire projects can collapse rather quickly when trust is lost.
Bitcoin is not volatile
Bitcoin often receives criticism for its price volatility, and to an extent this criticism is a plausible one, especially for those who are thinking short term. Short term thinking, however, is the worst way to think about any investment; at the extremes of short-term thinking you cease to become an investor in favour of becoming a trader, and in so doing open yourself up to a litany of unnecessary stress and fixation on events that are ultimately irrelevant.
One thing that this entire fiasco will undoubtedly achieve is to teach speculators, in the most brutal way possible, the difference between digital property and digital securities: if a small group of (largely unaccountable) people have the ability to alter and change the code, or if there are marketing teams directly attached to the ecosystem, then it cannot be said to be a truly decentralised digital property — I’ve no doubt that many projects will be forced to reckon with the enhanced regulatory pressure over the comings months and years, and many will be penalised for issuing unregistered securities.
When one looks at Bitcoin, and particularly the price on a linear chart, it can seem extremely volatile - and indeed it is, as far as price is concerned. However, the fundamentals of Bitcoin paint a very different picture. The fact that there is a new block mined every ten minutes, and has been since inception (with the little exception of a few difficulty readjustments), and that Bitcoin continues to function perfectly as described in the white paper is a testament to its success and the importance of Bitcoin as a property. When one factors in that the fundamentals are the most consistent of any asset in any asset class the case becomes even more compelling. The same cannot be said for any other cryptocurrency.
The moral obligation to test markets
In order for the financial system to be stable over the long term, where more time, money and lives are involved, it must be volatile over the short term; experimentation with new asset classes and new types of technologies necessitates that many projects will fail. A lot of people suffered from the Terra disaster, but if the project were allowed to grow to become orders of magnitude larger, then the fallout could have been catastrophic. It is symptomatic of the zeitgeist that projects yet to be effectively tested can reach such large valuations. Appropriately, this naivety and exuberance has been tempered somewhat thanks to the crash, but it ought not be surprising to see more of such aforementioned excess in the years to come.
Just as George Soros was accused of “breaking the pound”, and was consequently touted as a figure of financial villainy, those who shorted the shit out of Luna were able to make some extremely impressive profits for their (correct) speculation. The ramifications for allowing a faulty stablecoin to continue to exist, when one knows that it isn’t strong enough to withstand attacks, are extreme.
The classic trolley problem posits the question of whether it is morally acceptable to take one life to save five. In the case of structural market inefficiencies compounding the potential risk of themselves with all the enthusiasm and parabolic growth of Metcalfe’s Law, a decision to destroy a market in the short term is a decision to save exponentially more people in the long term, and will eventually result in healthier and more stable free markets — “lemons” will be exposed and truly useful assets that can stand the test of time will remain.
The silver lining to this fiasco are the lessons learned by the industry as a whole (or at least, one would hope that many in the industry will have learned): principally that scepticism of yield is healthy, algorithmic stablecoins are riskier than their alternatives, and most importantly that cryptocurrencies other than Bitcoin have inferior property rights, even when one takes self custody. Bitcoiners should be cautious not to exercise too much schadenfreude at watching this failure, after all Terra dumped 80,000 Bitcoin on the market in a matter of hours. Collapses such as Terra are brutal for many people, and ought to be a cautionary tale for exuberance and lack of appropriate due diligence; the silver linings will shine most brightly when people learn from their mistakes, and that it is crucial to manage funds responsibly.
Enter Celsius…