Not so stable coins

The break of the Bank of England and the collapse of Terra(LUNA)

On the surface, a cryptocurrency collapse and a breach of England’s Central Bank don’t have much in common. However, when one starts to dig a little bit deeper, it turns out they do. Today, in Equi’s first blog post, we will delve into the concept of currency pegs, the break of the Bank of England, and the Terra(LUNA) collapse. Going from past, to present, to future, we’ll examine the factors that led up to these monumental events and use the learnings obtained to consider what may be looming over the horizon. Let’s get started.

Currency pegs are policies in which a target fixed exchange rate is set between a nation’s currency and a foreign currency, or a basket of currencies. Fundamentally, these systems have inherent pros and cons. The former lays the foundation for stable planning, allowing governments to forecast revenues and associated expenditures without having to consider the impact of volatile foreign exchange rates. Additionally, a “peg”, in the theoretical sense of its application, offers emerging economies stability in the face of often unfavorable circumstances. These nations effectively outsource monetary policy to more developed governments that have the freedom to make responsible decisions, free from the impacts of corruption.

On the opposite end of the spectrum, pegs are often accompanied by a series of flaws. As mentioned above, governments that seek to peg their currency to another country’s are effectively outsourcing their monetary policy, often restricting the freedoms they have to enact policies or monetary decisions that would be beneficial to their own national economy. Additionally, pegs are often subject to speculative attacks. These occurrences are plentiful across history and arise when the structural integrity of peg systems starts to deteriorate, often due to complications related to the “impossible trinity” described below. In these situations, financial institutions and well-funded traders are known to exploit these weaknesses for profit, many times going up against the central banks of large countries. These factors can be concisely described by the impossible trinity of fixed exchange rates, also commonly known as the trilemma:

The Trilemma

A country is only able to manipulate two of the three sides of the triangle.

1. If they want to maintain fixed exchange rates and free capital flow, they will need to follow the monetary policy (i.e. interest rate policy) of the peg currency in order to maintain the value of their currency and the integrity of the peg.
2. If they want to maintain free capital flow and monetary policy autonomy, they would need to abandon the fixed exchange rate in favor of a floating rate system.
3. If they want to maintain a fixed exchange rate and monetary policy autonomy, the country would need to control capital inflows and outflows in order to maintain the value of their currency at the desired rate.

In the early 1990s, the Bank of England encountered one side of this trilemma, an occurrence that resulted in the country abandoning the European Monetary System (EMS). Before delving into the underlying mechanisms that eventually led to this monumental happening, it is pertinent to understand the historical context of this event. In World War 2, the United States acted as the main supplier of weapons for the Allies. With most countries paying for these arms with gold, the US quickly became the largest holder of the commodity by the end of the war. With many countries unable to maintain the Gold Standard as a result of depleting their reserves, these circumstances paved the way for the Bretton Woods Agreement. This agreement was made in 1944 between 44 different Allied countries, where their currencies would abandon the Gold Standard in favor of being pegged to the United States Dollar. In essence, the dollar became the world’s global reserve currency, allowing for countries that took part in the agreement to utilize fixed exchange rates between their currency and USD. In addition, countries also had the option to redeem the US dollars they held in exchange for a fixed amount of gold. Despite years of smooth sailing, cracks in the system’s foundation started to emerge, eventually resulting in its failure. Throughout the 1960s, the dollar weakened amidst substantial deficit spending directed at a series of domestic programs, as well as financing for the Vietnam War. Over concerns about the strength of the US Dollar, countries started to redeem their holdings for gold, a happening that led to concerns as to whether or not the US’ gold reserves would be enough to meet the conversion demand. These worries turned out to be substantiated, and in August of 1971, President Nixon announced a temporary suspension of the system, a decision that led to the collapse of the agreement and paved the way for the currency crisis we are discussing today.

In response to the vacuum that existed post-Bretton Woods era, the EMS and the Exchange Rate Mechanism (ERM) were introduced in 1979. At the center of this system was the European Currency Unit, an accounting unit that acted as a basket of currencies, in which each member’s national currency was assigned a weight based on its economic importance. Although this served as a proxy of sorts, the ERM was responsible for the day-to-day functionality of the system as a whole, ensuring that bilateral exchange rates between the currencies of the participating European nations remained stable, allowing for the fluctuation of margins up to approximately +/- 2.25%. On a theoretical basis, when currencies did not adhere to these strict bands, the central banks were expected to intervene, buying up the weak currencies and selling the strong ones in an act of restabilization. To understand how this works we can look at a theoretical example. Imagine there is a fixed exchange rate between the dollar and the pound, in which the supply of pounds equals the demand at the fixed exchange rate. If the demand for pounds rises one day, or in other words, there is an excess demand for pounds in exchange for dollars, the US central bank would satisfy this excess demand by selling pounds and buying dollars, maintaining the exchange rate at a fixed level. This sounds simple in theory but is oftentimes difficult to implement in practice.

The primary objective of the EMS was to ensure stable currency behavior between European Countries, mitigate inflationary pressures, and foster an environment of both political and economic unity. These actions would eventually pave the way for the Euro, but not without a host of difficulties first. Although there was no formal decision to have a reserve currency within the system, the Deutsche Mark and the German Central Bank grew increasingly important within the EMS due to Germany’s economic strength. Acting similarly to the United States within the Bretton Woods Agreement, European countries centered their monetary policies around the low inflation policies of the Bundesbank. As a result, the German Central Bank found itself in an obligatory role to help maintain the pegs of other currencies, if the need arose.

Over the course of the 1980s, the system appeared to work, and countries that participated in the EMS agreement exhibited steady declines in inflation:

CPI Inflations 1980 - 1990

Then, on a fateful day in November of 1989, the Berlin Wall fell, an event that would precede the reunification of East and West Germany, which would occur almost a year later in October of 1990. As one might expect, in order to successfully unify two land masses into a functional nation-state, some form of economic stress must be taken on. The Federal Republic of Germany decided to run extremely large budget deficits, supplement the wages of the workers that were previously part of East Germany, and undertake hosts of infrastructure projects in the region. The German Central Bank, concerned with the potential rise of inflationary pressures in the region (evidently spurred by past experiences with horrible inflationary occurrences during the era of the Weimar Republic), then took a very hawkish stance, raising policy rates. These actions proved to be extremely burdensome on countries situated within the EMS agreement, particularly for the United Kingdom. Starting in October of 1990, when the country officially joined the EMS, they found themselves in a predicament, one that can be summarized as follows:

– Their economy was in bad shape, with inflation almost three times higher than that of Germany.
– Because of the EMS system, they were forced to enact a monetary policy that aligned with Germany’s, rather than what their economic situation called for.
– Instead of engaging in an expansionary monetary policy to depreciate their currency and stimulate exports, they engaged in a contractionary monetary policy to align with the Deutschmark’s appreciation.
– Due to high German interest rates, capital flows started to occur from the UK toward Germany. The UK’s foreign FX reserves started to rapidly shrink while they were spending billions trying to maintain the peg.

Enter speculators. George Soros, the legendary trader, and his then protege, Stanley Druckenmiller, noticed the pattern that is alluded to above, particularly how the monetary policy of the UK did not match the trajectory of the underlying currency itself. In other words, the country was attempting to appreciate the pound in the midst of an economic environment that pointed towards depreciation. The trade was relatively simple, Soros would short the pound (a value that eventually reached 10 billion pounds), using the proceeds to buy stronger currencies, such as the Deutschmark, in the hopes of the pound breaking the peg and devaluing. With Soros selling short an amount of pounds that exceeded the value of the UK’s FX reserves, the UK was unable to buy the amount of its own currency required to keep the peg afloat. As a result, on September 16th, 1992, the day now known as Black Wednesday, the Bank of England engaged in one last hopeful effort. They raised interest rates from 10 to 12 percent, then from 12 to 15 percent, all in the hopes of stimulating enough currency inflows to protect the peg, an action that proved to be too little too late, forcing the country to abandon the EMS.

“History doesn’t repeat itself, but it often rhymes.”

Mark Twain

Although cryptocurrency is touted as a revitalized take on traditional centralized financial institutions and systems, the ecosystem has been plagued with issues that have striking similarities to instances seen throughout financial history. A notable example of this is the recent Terra(LUNA) debacle. Before delving into the root causes of the system’s collapse, it is worth understanding the dynamics of stablecoins as a whole, and their role within the Crypto space. Stablecoins are cryptocurrencies that are pegged to different fiat currencies, existing as mechanisms that counter crypto’s inherent volatility, allowing traders and investors to “preserve” the fiat value of their investment without having to cash out from the ecosystem entirely. There are four main types of stablecoins: fiat-backed, cryptocurrency-backed, commodity-backed, and algorithmic-backed. Fiat-backed stablecoins, in principle, should be backed at a 1:1 ratio to their fiat-currency pairing, with stablecoins like USDC or USDT theoretically having one dollar of cash
or cash equivalent for each stablecoin. Commodity and cryptocurrency-backed stablecoins operate similarly, often pegged to different precious metals or tokens. Algorithmic stablecoins, on the other hand, operate differently. Not backed by any real-world asset, these coins essentially rely on code in order to modulate their supply based upon underlying demand, processes performed to stabilize their value relative to another asset, most commonly a fiat. In practice, algorithmic stablecoins will remove coins from circulation (burn), or create new coins (mint) based upon the demand for the coin at a specific point in time. When there’s too much demand for the coin, and the price of the coin goes above the peg, the algorithm will increase the supply in order to combat this price increase from happening and vice versa.

Delving deeper into the crypto ecosystem of discussion today, Terra was a public, proof-of-stake, smart-contract-based, blockchain system. Primarily, the technology was focused on creating a mass-payment processing ecosystem, as well as providing access to a host of different stablecoins. Although there were many moving pieces, the three most important underlying components of Terra, for our sake, are the system’s most prominent stablecoin (UST), the native token (LUNA), and the anchor protocol:

The Terra(LUNA) Ecosystem

The Terra ecosystem held two main assets at its core, the stablecoin, UST, and the native token, LUNA, where 1 UST was exchangeable for $1 of LUNA and vice-versa. LUNA had roles in the ecosystem ranging from a way to participate in the platform’s governance system, to facilitating a mechanism in which transaction fees could be paid. However, its primary role was to ensure the pegs of the stablecoins in the system were maintained. In order to understand how Terra’s algorithmic stablecoin system maintained the peg between UST and LUNA, we can look at two hypothetical examples, one where the price of UST goes above 1 dollar, and one where it falls below. Starting with the former, if the price of UST were to rise to $1.01, an arbitrageur would recognize this as an opportunity to profit from the inevitable algorithmic stabilization of the peg. Arbitrageurs could then purchase a certain amount of LUNA, exchange it for UST, a process that would “mint” the UST and “burn” the LUNA (i.e. remove it from circulation), and then sell the UST on the market in order to profit on the spread (i.e. the 1 cent difference between the UST and LUNA price). In the opposite scenario, if UST were to fall to $0.99, arbitrageurs would buy UST at a discount to where the peg should be, exchange this for LUNA, a process that would mint LUNA and burn UST, and sell it on the open market to again profit from the 1 cent spread.

With this functionality in mind, what exactly kept people in the ecosystem? Other than holding the native token as a demonstration of bullishness directed at Terra as a whole, the Anchor protocol is arguably what spurred the majority of investor interest. Anchor essentially created savings accounts for investors, incentivizing depositors to lend out their stablecoins to Anchor’s money market, and the borrowers therein, in exchange for a 20% APY return. In the low-interest-rate environment observed across 2020 and 2021, this obviously offered more attractive returns than a traditional savings account, which likely contributed to the peak $40B+ market capitalization that the Terra ecosystem reached:

Terra Price Chart

Despite reaching a euphoric high, cracks started to appear in the foundation when broad financial conditions started to worsen, eventually leading to the ecosystem’s downfall. With many critics voicing their concerns about Terra prior to this incident, it was not a black swan by any means. However, the velocity was still surprising nonetheless. How exactly did it happen?

– Despite offering 20% APY to investors for an extended period of time, the protocol started to reduce rates offered to depositors of UST. More specifically, Anchor proposed to reduce rates by 150 bps each month that the number of lenders exceeded the number of borrowers within the protocol.
– With the protocol’s attractiveness diminishing, holders of UST started to leave. With 70% of UST in circulation held within the anchor protocol, redemptions started to spur what is known as a death spiral.
– With each redemption and subsequent exchange of UST for LUNA, UST was burned and LUNA was minted, causing the supply dynamics outlined below.

Change in Supply Dynamics

As the supply of LUNA became increasingly large, the price of the token started to fall. Out of fear that decreasing demand for LUNA would break the UST peg, more and more UST holders started to redeem their holdings, analogous to a traditional “run on the bank”, exacerbating the aforementioned supply dynamics, further reducing the price of LUNA, and spurring the death spiral alluded to below:

The Death Spiral

The end result? The price of both LUNA and UST sank towards zero as investor faith in the ecosystem collapsed. Algorithmic stablecoins at their core have, time and time again, proved to be problematic, since their fundamental value proposition is void of any underlying peg to a real asset with intrinsic value. Oftentimes, financial systems that try to create something out of nothing, so to speak, are not sustainable in the long run, and Terra proved to be another one of those instances.

At the core of each of these collapses is the trilemma. In the case of Black Wednesday, The Bank of England chose to maintain a fixed exchange rate and free capital flow, losing monetary independence. Despite this, each increase in German interest rates caused capital to flow away from the UK, towards Germany, eventually resulting in the peg being abandoned, as described earlier. In the case of Terra, the ecosystem was arguably attempting to maintain a similar system, with a fixed exchange rate set between the stablecoin and the US dollar, and free capital flow allowed to occur in and out of the ecosystem. Whereas the Bank of England could no longer maintain the peg once they ran out of FX reserves, the UST/USD peg broke once demand for LUNA evaporated due to its falling price. In this situation, the ecosystem was increasingly vulnerable to the “monetary policy decisions” enacted by the Anchor protocol, and as Anchor decreased the interest rates it paid, demand for LUNA fell. This eventually resulted in capital outflows, spurring the death spiral. In short, history tends to repeat itself, even as we move from systems that are long in the tooth to the newest technological innovations of today

Warren Buffet once said:

“You don’t find out who’s been swimming naked until the tide goes out.”

This quote conveys the fact that during bear market cycles we find out what is real, and what is not. In times of prosperity, economic stability, and abundant liquidity, individuals get away with building unstable companies, making irresponsible policy decisions, creating new technologies that exhibit clear Ponzi-like dynamics, etc. When the lights go off and liquidity dries up, these fragile systems break. It is no coincidence that during periods of financial turmoil we also saw famous uncoverings and blowups, including the likes of Enron, WorldCom, Lehman Brothers, Bernie Madoff, and now more recently, Terra. With liquidity reductions occurring as a result of QT, as well as poor consumer, market, and corporate sentiment omnipresent, investors have and will continue to be very selective about their investments, only allocating capital to the best and most sound opportunities. In this environment, the systems that have been misleading investors will likely break, cementing the fact that Terra may not be the last big-name blowup we see in this bear-market cycle.



All investing involves risk, including the possible loss of money you invest. Graphs, charts, tools, and graphics are used for illustrative purposes only, and may not reflect actual future performance. The contents of this website are for informational purposes only.

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