The Dark Side of the Moon is the Invisible Hand
What Happened
Much ink has been spilled about the Luna/UST fiasco. Instead of recounting the sequence of events that will inevitably end up in a Netflix docuseries, I’ll just focus on the underlying business model. Believe it or not, even in DeFi, you need a viable business model, and more importantly, investor trust, to survive.
Business Model Explained
The business model of Luna/UST was essentially that of a financial institution: get some money, and make more money off of it. Money is the raw material and the finished goods of the business. In CeFi, money is fiat currencies; in DeFi and specifically in the case of Luna/UST, money is the stablecoin $UST, which is algorithmically pegged to the US Dollar (i.e. unsecured with any fiat currency collateral).
UST could have been profitable and sustainable had it run a business model where it acquired money at a lower rate than the rate at which it sold.
UST’s reality deviated from this model.
To recap, there were four main sources of revenue:
Interest income earned from lending out UST,
Rewards for staking the token held as collateral,
A small cut of transaction fees, and
Donation from the Luna Foundation Guard (LFG)
There was one main source of COGS:
The affiliated Anchor protocol famously marketed a 20% (!) “savings” yield, which served as the floor for COGS
A sustainable business model doesn’t rely on donations. For the time being, transaction fees can’t single handedly sustain the whole business. So let’s focus on the first two sources of revenue.
Now, here’s where the Invisible Hand comes into play. These two key revenue streams were heavily dependent on the supply/demand dynamics of UST. To maximize interest income, UST needed 1) sufficient demand from prospective borrowers to sustain a high lending APR%, and 2) sufficient lending APR% to cover its cost of capital.
As for 1), demand from prospective borrowers was largely driven by how wide the UST use cases were; so UST holders were incentivized to build out the UST ecosystem and make $UST a widely accepted and highly circulated vehicle. Yet there was a ceiling to $UST’s lending APR%-the fiat lending rate. Imagine, why would a prospective borrower sign up for an 10% UST loan when that person could easily take out a personal loan at a lower rate or a HELOC at an even lower rate (or another crypto loan at even-even-lower rate)? So the lending APR% was likely capped around 10- to 15% due to CeFi competition and the exuberance in the DeFi market.
With the constraint on interest revenue, one would expect a cost of capital somewhere below 10%. Not quite! The affiliated Anchor protocol famously marketed a 20% (!) “savings” yield to drive up demand for UST.
Taken the lending yield and cost of capital together, Luna/UST holders were essentially banking on a 10%+ rewards rate from staking tokens❕just to breakeven❕
The rewards rate here is driven by… again the Invisible Hand. The more demand for $UST, the higher the rewards rate.
And turns out, the demand for $UST didn’t spread like wildfire before its collapse.
Where We Go From Here
The business model of a financial institution isn’t inherently flawed. Many “old-school” CeFi’s use the same exact model to generate billions in profit per year. (and btw the selloff in Bitcoin has got to be driven by LFG’s technical pressure than a reflection of Bitcoin’s rising adoption)
The first flaw was profitability, as illustrated above.
The second, more fatal flaw, was trust.
As an unsecured stablecoin, $UST lived and died by its holders’ trust in the system. This is not the first time the market has seen a “run on the bank”. When the Reserve Fund broke the buck in the height of the Financial Crisis, the Fed had to restore trust with a $700bn+ cannon called the Commercial Paper Funding Facility. When COVID shook the market only two years ago, The Fed had to re-open the CPFF to restore investor confidence.
In the DeFi market, no single entity can (yet) rival the position of the Fed in the CeFi market.
Losing trust, especially in DeFi, comes at a high cost.
Looking ahead, whether and how algorithmic/unsecured stablecoins can restore investor trust should determine the fate of this market.