Why Stablecoin Staking Doesn’t Make Sense (And Terra / LUNA Proves It)
I’ve long wondered about the rationale behind stablecoin staking. It didn’t really make sense to me from a risk/reward perspective. I have previously highlighted that the risks behind such staking may not exceed the reward, because of the carry trade risk and uncertainty risk, which played out in Terra’s / LUNA’s case:
Before you think I am just jumping on the bandwagon to bash Terra, I have written about the carry trade risk in a previous article (in 2020), reproduced below for ease of reference:
3. Beware the carry trade
For those who are unaware of the actual carry trade, this involves shorting (or borrowing) a lower-yielding asset to buy a higher-yielding asset.
Based on my brief understanding of many DeFi projects (please correct me if I am mistaken), the basis of their project is a carry trade. After all, I have heard people saying why DeFi will outlast the previous ICO boom precisely because of all the ETH-equivalents (or ETH) locked into their protocols. This is because you would have to buy their token first, and/or be paid interest in their token.
However, the carry trade comes with one big risk — the decimation of your initial capital. Yes, the yields you earn would be eye-popping in this environment, but the risk is that the underlying token’s loss in value far outweighs the yield earned by holding that token, instead of ETH or BTC.
Many people have described the carry trade as picking up dollar coins on train tracks. You have to be able to get out of the way when the train comes, or risk getting flattened.
Thus, if you think you see some light at the end of the tunnel… Better hope that it isn’t a train (à la the recent SushiSwap dump, where the founder dumped his/her tokens on the market and caused a 99% loss in value in the $SUSHI token. No amount of yield is going to be able to compensate you for that.).
I actually referenced the SushiSwap debacle at that time, which carried eerily similar echoes of what happened to Terra (high yields but total loss of initial capital).
I also talked about the uncertainty risk in another article, also reproduced below for ease of reference:
4. Anything crypto related
Some of the listicles give examples of staking or contributing a stablecoin to a DeFi pool to get yield. The yield is attractive, ranging upwards of 5% per year, and you don’t participate in the price volatility of crypto if you stake a stablecoin.
Well, the obvious drawback to this is that it is crypto, notwithstanding that you are staking a stablecoin. The key thing to remember is:
If you put money into crypto, be prepared to lose it.
The benefits of staking or DeFi yield, to me, is a bit odd. You must realise that there is no “low risk” alternative in crypto. You may think that staking a stablecoin is “low risk”, but please, anyone with any knowledge of how markets work will tell you that you are still earning a risk premium.
In this instance, let’s call it an “uncertainty risk premium”. You are faced with numerous risks, such as contract and liquidity pool risk, for that 5%++ or so per annum. You also don’t even know how stable the DeFi pool is (pun very intended) and if you really want to see actual dollar returns and not just fancy percentages, you have to be prepared to allocate a substantial amount of money to this (as a reminder, each $10k will earn you $500 a year).
Additionally, if you stake a stablecoin, it kinda defeats the purpose of going into crypto anyway. After all, I don’t go into crypto to earn 5% p.a., I go into crypto for that moonshot chance to retire.
Let’s just use BTC as a proxy. Even if you bought at the peak of 2017/2018 of approx. US$19k, the recent peak of US$60k means that you would have made 300% in a span of 3 to 4 years. That’s a simple return of 75% a year, if I use 4 years.
If you compare trough to trough, after the crash in 2017/2018, BTC bottomed at around $3k. The recent pullback was about $30k. That is a 1,000% return (10x, as they say) over 3 to 4 years, or approximately 250% a year if I use 4 years.
Even if I use peak to trough, $19k to $30k in 3 to 4 years, that is still a 50% gain, or approx. 12.5% a year using 4 years.
Do I even need to talk about the 2018 trough ($3k) to the late 2021 peak ($60k) — 2,000% over 3 to 4 years?
What is 5% per annum compared to that, particularly if you only intend to allocate a small portion of your portfolio to crypto?
If you intend to allocate any amount of capital into crypto, you might as well take the moonshot. You can find your 5% p.a. returns in other traditional investments.
I also picked on the pun about the “stability” of the stablecoin / DeFi pool precisely because of this risk.
However, this Terra incident reiterates the whole point that there is no low risk alternative to crypto, and raises many more interesting points to analyse and break down. I will delve into the concept behind such DeFi protocols, and you will see that Terra is just the most recent example — there have been blowups in the past, and there will be blowups in the future. I just hope that with the understanding of Terra now, people are more cognizant of the risks and make a proper risk/reward assessment.
Since I work as a compliance officer, let’s start of with the regulations… Or lack thereof.
1. Are there Regulations?
Since regulations and regulators differ from country to country, I am going to use my local regulations and regulators (Singapore and the MAS) as examples, but I’m sure you can draw the parallels wherever you are.
In Singapore, cryptocurrency is generally regulated under the Payment Services Act (PSA), and defined as a Digital Payment Token (DPT). This is an important distinction because MAS looks at the substance over the form of the token. So, if the token resembles a security, it would be regulated under the Securities and Futures Act (SFA) instead of the PSA.
Why is this important?
Well, because several key prohibitions are located in the SFA, and many people mistakenly believe that the MAS can enforce those provisions in the crypto world. The key prohibitions I am referring to are located in Part 12 of the SFA:
- The prohibition against market manipulation (Section 198); and
- The prohibition of insider trading (the whole Division 3 of Part 12)
What are the things in common in the above prohibitions? They only apply to the capital markets products defined in the SFA.
So, since Bitcoin, Ethereum, etc. are not caught under the SFA but instead are defined as DPTs under the PSA, you have this conundrum where the prohibitions in the SFA do not technically apply when you start looking at DPTs.
And, interestingly enough, the PSA does not contain similar prohibitions.
MAS has also recently clarified in their FAQ (question 23) that certain types of ‘stablecoins’ are considered DPTs and not E-Money by definition because they are not actually stable (great foresight there actually — see 23.5, where they call out “stablecoins that aim to maintain stable values through algorithms that adjust the supply of the stablecoins in response to changes in the demand”).
This means that all the stablecoins, including UST, are actually DPTs (since UST clearly falls within the above FAQ), and MAS has repeatedly said that DPTs are not suitable for retail investors.
The warning signs are abundantly clear — caveat emptor. MAS is not going to bail you out if you lose money on these things that they repeatedly told you not to buy.
So, what does the PSA do then?
Well, it lays out the licensing requirements and regulates other areas. However, in the area of DPTs, MAS is clear that the main risks that they are focusing on were technology and money laundering risks (they recently added consumer protection and financial stability in a recent speech).
So, this is the wild, wild, west for now — the traditional securities laws do not apply to you.
Terra specific application
So if we then apply this to what happened to Terra, all the calls for the founder or the alleged players who ‘crashed’ the market to be arrested on market manipulation / insider trading etc. are all a bit misguided, because those laws don’t apply here. While I am not suggesting that you go and insider trade (if you somehow get that idea, you better consult your own lawyers), the angle at which they are coming to ‘attack’ is wrong.
At best, they have to try to nail them on the broader areas of law, such as the Penal Code, where there are items like cheating, criminal breach of trust, etc. that would apply across all industries. However, since it is a criminal offence, the bar to prove such offences is higher compared to a civil case (beyond reasonable doubt vs. the balance of probabilities).
So, good luck to the “concerned citizen” who filed a police report… Prima facie, it is unlikely that the police will be able to prove ‘beyond reasonable doubt’ that Do Kwon breached something in the Penal Code (no, being aggressive and insulting people on Twitter do not count).
Of course, this may change if there was evidence of him actually pulling off fraud like faking documents and the like. I’ve seen some folks comparing him to Elizabeth Holmes, but you have to remember that she literally faked things. If Do Kwon just wrote bad code, that is not ‘faking’ it, that is just bad code.
This brings me to my next point…
2. The Laws of Code and the Free Market
So if there are no laws nor regulations, then, what rules?
Well, the code and the free market rule.
In this case, talking about Terra from the outset will show the clearest example of this. After all, UST is built on those 2 principles i.e. that the code and the free market will work together to ensure that 1 UST = 1 USD.
A high level overview of UST
Since I am not a coder, I will explain the conceptual understanding of how UST should work with its sister token, LUNA.
In an ideal world, UST = US$1. This is supported because the code allows two things to happen:
a. You can convert 1 UST into US$1 worth of LUNA.
b. You can convert US$1 worth of LUNA to 1 UST.
Conceptually, this will then ‘stabilise’ UST at US$1 because if UST slips below US$1, I will buy 1 UST, convert it to US$1 worth of LUNA, sell the LUNA, and keep the profit. Similarly, if 1 UST is worth more than US$1, I will buy US$1 worth of LUNA, convert it to 1 UST, and sell that 1 UST for more than US$1.
Basically, what is happening in the above scenario?
Arbitrage is happening.
Arbitrage is the epitome of the free market.
Thus, the way UST and LUNA work is actually a combination of the code and the free market. The way it is set up almost assumes that the free market will take advantage of any mispricing and earn arbitrage profit. It is like inviting people to exploit the loopholes and inefficiencies in your tokens.
But, as with anything that involves the free market, this timeless quote always rings true (it is attributed to Keynes, but it may not actually be him):
The market can remain irrational longer than you can remain solvent.
The above ideal scenario assumes a rational market and arbitrageurs that are willing to base their trades around the assumption that UST will always come back to US$1.
However, that is still an assumption. There has to be trust for it to work. For instance, back in the days of USDT, critics were calling out that the company behind USDT didn’t actually hold 100% of the value in USD, but only approximately 70%. Thus, USDT should then logically trade at $0.70.
But, that didn’t happen. Somehow, the logic failed and the trust in USDT to maintain its peg to US$1 continued to hold, so no matter what was thrown at the market (e.g. audit reports), it didn’t break the peg.
Unfortunately, that didn’t happen for UST. As an algorithmic stablecoin, the code was open for all to see (if you knew how to read code), and some prominent people were warning that if UST were ever to break the peg, there would be a ‘death spiral’ as the free market takes over. Unfortunately for Do Kwon, instead of listening to the warnings, he posted his now infamous “this didn’t age well” tweet:
But what about the LFG and the 20% Anchor protocol?
Well, glad you mentioned that. Do Kwan’s reply could have been because he believed that his LFG (Luna Foundation Guard) and the Anchor protocol would provide enough ammunition for him to fend off any would-be attackers in this space, but there are some detractors that just call it a massive ponzi scheme.
Well, there is some merit to the ponzi accusation, but the concept of having a war chest to defend your product and / or incentivise customers to use your product by undercutting all competitors has already been popularised by the SoftBank VC-type of companies. So, it is only a ponzi if the VC tap stops running…
Well, as at the time of writing, UST and LUNA did indeed collapse, the LFG and all the other reserves were unable to restore the peg, and Do Kwon is in the midst of trying to do a fork to LUNA Classic and revive the ecosystem. Vitalik has also written about this and some feel that he leans towards the side of “regulation”.
But, if you studied crypto history, you will find very similar patterns to the first Ethereum DAO hack, and you shouldn’t be surprised at Vitalik’s response. The main difference here is that Do Kwon didn’t listen. You can see the parallels:
In the first DAO, someone did warn the DAO coders that there was a potential exploit. I believe that the coders were trying to fix it, but someone exploited it first. This led to Ethereum itself forking based on comments from Vitalik, and the ‘crypto purists’ that insisted that the smart contract remain immutable went on to mine Ethereum Classic (ETC), whereas the fork took on the ticker ETH, and the free market has obviously priced ETH wayyyyy higher than ETC.
The parallels are eerie.
This helps illustrate my point. Since there are no laws or regulations around this, then the smart contract IS the law. If there are loopholes or logical fallacies in the smart contract, that is fair game (just like there are still loopholes in the actual law today). After all, UST’s code is built to invite arbitrageurs to come and take advantage of any mispricing to make money.
So, if anyone is smart enough to exploit the loopholes, he/she is well within his/her rights to do so in the crypto ecosystem because the smart contract IS the law. The free market will take over after that.
“Lagi worse”, as they say in Singlish (i.e. even worse), is when the coin or protocol depends on the free market as part of the mechanism (like UST did). This is because a “smart contract” is not technically “smart”, but rather, blindly self-executing. At least a human can pause and think instead of blindly executing orders, but a smart contract cannot. This is not a new problem in the coding world, which is why there are bugs and day 0 exploits even at the most reputable tech companies (e.g. MAMAN — an interesting acronym given the rebranding. Basically, the ex-FANG+M).
There are two takeaways from this:
i. There may be smart contracts, but there are dumb people. Smart contracts don’t write themselves, they are written by people, who can be careless, code in logical flaws, etc.
ii. There may be smart contracts, but there are smarter people. If the legal equivalent is a lawyer finding all the loopholes in a given piece of legislation, then there are smarter coders who can spot the logical fallacies in the smart contract and /or the finance folks / arbitrageurs who understand how the market will react in certain black swan events, and then react accordingly.
The Terra debacle and Vitalik’s response shouldn’t be surprising to someone who saw how the first Ethereum DAO exploit panned out.
The timeline is almost the same, Vitalik proposed a radical measure to fork the blockchain (and exercise the kind of power that shouldn’t have been vested in anyone in the ideal decentralised crypto world), and the free market predictably took over to price the tokens based on demand and supply.
You can see that Do Kwon is also trying to fork his blockchain… Time will tell if he can revive Terra.
This brings me to my next point:
3. Humans are always involved, and all humans have fallacies.
No matter the era, no matter the technology, you have to remember that there will always be humans behind the screen, particularly when you involve the financial markets. And humans can be both predictable and unpredictable.
In the case of DeFi, you can assume that there will be both fear and greed on full display. Despite knowing that betting the house on any single transaction or product is inherently risky, some people will do it anyway.
People also tend to underestimate big risks like the black swan events and therefore do not take adequate protective measures. For instance, you could have bought insurance against the scenario of a UST depeg, but how many people actually bothered to do so? Vitalik can suggest a ‘deposit insurance’ all he wants, but until and unless an incident like this occurs, most people wouldn’t bother.
So, how then should a retail investor approach this space?
Well, there are two facets to this:
1. DYOR (Do Your Own Research)
There is no escaping this. Unfortunately, there are many regulations in the traditional financial industry to protect retail investors because many people actually fail to DYOR, and wholly trust someone (typically a salesperson) when making a product purchase.
If you try that in crypto, be prepared to lose your shirt.
There is only one person you can trust, and that is yourself. There is no one else to blame. You must be the one to understand enough of what you are buying to make an informed decision, and only you are accountable for the consequences.
Finfluencers? Bloggers? FinTok? FinTube etc.?
Nah, you can’t blame them. They don’t care about you, they are only posting to make money.
You are the one still ultimately responsible for your money. Do your research.
2. Take risk-based positions
Even after you DYOR (or even if you didn’t), you still need to assess the risk and take a risk-based position.
This is because, as a retail investor, it is unlikely that you will appreciate all of the risk scenarios or be able to compute the probability of losing money with any precision. Thus, the only way to ensure you don’t wind up on the street is to take a risk-based position.
Generally speaking, this means only putting what you can afford to lose into crypto.
An easy way to assess this is whether you would need to make any changes to your lifestyle or default on any obligations should you lose the entire amount. Yes, your stomach my churn, you may have a few sleepless nights, but if the amount doesn’t impact you materially, then that is something you can afford to lose.
(Granted, a good barometer is whether you can still sleep soundly at night, but technically not a prerequisite.)
You should never bet the farm, unless you are willing to lose the farm. I know people are envious of the initial YOLO crowd that sunk their life savings into crypto at the early stage and made out like bandits, but hindsight is 20/20. You did not see the ups and downs of the market (BTC has crashed 90%++ many times) and there is still the risk that all this amounts to nothing.
This axiom doesn’t just apply to crypto, though — it applies to all financial products. As a general rule of thumb, you should never have 100% (or close to 100%) of your networth in a single instrument (and that includes deposits! There is a cap to deposit insurance.).
Unless you are a professional or willing to sleep on the street, diversification is your friend.
4. What now?
Having said all the above, I will conclude with how I started.
Based on my own research and risk / reward calculations, I do not think that staking makes sense, much less stablecoin staking. This is because you are exposed to the carry trade risk and uncertainty risk, so earning a fixed yield on a small portion of your networth (what you can afford to lose) doesn’t sound very attractive, vis-à-vis the moonshot bet by just buying BTC or ETH directly.
Of course, there are some protocols that can still reward you if you got in early enough (e.g. some 800% APY type), because the fact that you got in early negates the carry trade risk, and the 800% APY negates the opportunity cost of buying BTC or ETH instead. However, the fact that you went in so early poses risks in and of itself (the protocol may not last also), but at least the crazy yields change the risk / reward payoff.
So, keep your eyes peeled, your powder dry, and let’s enjoy this crypto roller coaster — in a risk appropriate manner!