Chapter 3
The Second Turn: Unstablecoin

When FTX melted down, the prevailing emotion was shock, but when the terra usd stablecoin (ticker symbol: UST) had fallen apart six months prior, it had been schadenfreude.

For those who didn't lose piles of money on it, the sound of terra usd crashing was the perfect music to dance to as they shook their hate of crypto and its culture right on out.

That story had a different villain, a man named Do Kwon, the Korean cofounder of Terraform Labs, the company behind terra usd and its twin coin luna (technically, "terra," but no one called luna that). But it's a story that's also crucial to FTX and Alameda Research.

What we don't know is this: Were Alameda's debts to FTX already so bad before Terra that both were already doomed? Or could FTX have saved itself by letting Alameda go under with other hedge funds like it in May or June?

So here's what happened: terra usd was an algorithmic stablecoin running on its own blockchain, also called Terra. A stablecoin is a token that is designed to maintain a consistent price in the market. In almost all cases, that price is one US dollar.

Stablecoins are useful, especially for traders. For example, if a trader looks for brief jumps in a certain minor cryptocurrency (known colloquially as "altcoins" or "shitcoins" or "alts"), he or she can keep their cash ready in a stablecoin on an exchange. Then, when opportunity arises, buy an alt quickly and watch its price go up.

Next, when they have made enough, they can sell back into a stablecoin just as fast, maybe turning $100 into $121. If they post a screenshot of the trade on Twitter or in a Telegram channel, fans will call the trader a genius.

Plus, stablecoins make it easy to move between trading venues without passing through a bank account (which is slow and janky). They can withdraw a stablecoin onto a blockchain and move it to another exchange without ever troubling the bank's anti-money laundering team. This way a trader can use six exchanges, but their bank only ever sees one. Plus, it's just faster.

So stablecoins make life easier, at least so long as people still think in dollar terms. And don't let anyone kid you: they all do.

Stablecoins are useful but boring.

Stablecoins

When it seems necessary to explain something that there's a very good chance some readers have read about before, I'm going to mark it off in a box like this.

For example, if you read any coverage of the terra stablecoin crash, then you read some version of the following explanation of stablecoins:

Most stablecoins work the same way. Some qualified institutional partner deposits actual bank account dollars with a stablecoin issuer. The issuer then creates a token on some blockchain that stands in for that dollar.

So it's like a coupon that can be exchanged for cash.

Then there are stablecoins created as debts. So someone puts up some collateral (a cryptocurrency), and a percentage of its value is borrowed as a stablecoin. This is good for traders because they can make bets without selling assets they believe will go up in value long term.

Those are the two big models. The first is very safe (but definitely not as safe as a US bank deposit). The second is usually safe (see Chapter 19).

Then there was terra usd.

Terra had an audacious design. It attempted to use software in order to control its supply (more on this in Chapter 34). That way, it could match up with demand in just the right way that it would tend to trade for $1 on the open market.

That might sound crazy, but it is basically how the US dollar works.

I'm just kidding. It was crazy.

But it wasn't crazy because its design was wrong. It's really that Terra's history was wrong.

The US dollar, today, works through supply-and-demand management. The Federal Reserve uses various levers to increase and decrease the amount of dollars on the market as needed. Or to increase or decrease demand. It mostly increases, because it believes a little inflation is good for the economy. But that's changed somewhat, very recently, as I will discuss in Part II.

But it's true when people say there's nothing backing the buck. Well, nothing . besides the whole US economy. People want access to the US market (including folks living in it), and dollars are the language commerce speaks here.

But the dollar is not explicitly redeemable for anything, not like it once was. There is gold in Fort Knox, but it's not for you. There is a level on which dollars are backed by US Treasuries, but the circularity of that is not something you want to contemplate if you want to sleep well tonight.

Here's what dollars are actually backed by: faith. And that's not stupid. Because the United States has earned it. The dollar has proved its reliability.

Dollar users have faith that the US economy is going to continue being this engine that people want to trade with. Because they want to trade with it, they will want dollars. So that demand for dollars insures the value of dollars.

That sounds like mysticism, but it's really the same reason anything has value deep down.

The dollar earned that faith through a process. When the US economy was smaller and the US government was newer, the dollar was backed. It was first backed by silver, and then it was backed by gold. In those years, precious metals stood in for the track record the state didn't have yet. That approach became untenable, and at a certain point President Richard Nixon broke the buck.

On August 15, 1971, President Nixon went on TV and said, "I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets." Well, Nixon never got around to unsuspending it, and now he's dead.

So the dollar floats freely still. Except it's not free, because the Fed manages it. It's not algorithmic, though. They do it with data gathered by hand, charts, meetings, and press releases. It's very analog.

But more important than how it works is how it got there. It's that history, its track record.

So Terraform Labs came along and tried to do the same thing as the Fed on the blockchain, only they skipped all that pesky stuff about building up an economy first, going through a whole messy period of competing currencies, settling on one, all while mucking about with gold and silver backing for a while (or something like them). You know, earning faith.

Terraform Labs just fired up a blockchain and started spitting out tokens and wishing everyone good luck.

It had a good story in the beginning. I first wrote about terra in 2018. One of its cofounders was Daniel Shin, who ran a big e-commerce company in Korea called TMON. At the time, he said he wanted to launch a stablecoin for people to use on his ecommerce sites and all the others as well, because the margins in e-commerce were tiny and credit card fees were killing them. So if people would pay in cryptocurrency, both companies and customers would come out ahead.

Practically, it sounded like a tough sell to me, but I could see the logic.

Terra actually ran on two tokens: terra usd, the stablecoin, and luna. Luna was what we call a governance token, but it was also essential to the stability of the system.

We'll get into this more later, but in short, terra and luna did this dance where the supply of terra usd would expand and contract based on the demand. That way, there was always just the right amount of terra usd in the world so that its price stayed fixed at a dollar. Unlike the dollar, this was all automated.

Sometimes terra usd would be created. Sometimes destroyed. Luna holders could get rich as demand for it went up, but if the stablecoin fell below its peg, luna holders would feel a pinch.

So the 2018 story was about e-commerce, but that changed. In 2020, decentralized finance (known as DeFi) had started to catch on with people who were into making money much too fast in the cryptocurrency game. It was the first time in a couple years that it felt like anything in crypto was clicking. Terra's creators moved in fast to grab a piece.

So now demand for terra usd would be driven by investors, not consumers.

In 2021, Terraform Labs launched Anchor, a savings account for terra usd. It offered a 20% yield to anyone who stuck their stablecoins inside.

No limits. No caps. Just a 20% easy annual return. For what?

Anchor did some lending, like a bank. It also got some returns on the stuff people put up as collateral to borrow. But it didn't get to a 20% profit. The truth is: the blockchain just covered the yield out of pocket. That sounds crazy, yes, but that's really how it actually worked.

Call it a growth hack. Early on, the terra blockchain had accumulated a giant pile of terra usd through its open market operations. So they were just using it to kickstart demand.

This rickety shotgun shack of a financial system was Kwon's doing. Kwon was Shin's cofounder. Like SBF, he has a huge risk appetite. But he is also completely different from SBF. Where SBF is frenetic, Kwon is cool and calm.

He famously got served by the US Securities and Exchange Commission at a conference in New York and hung...