Behind the Ten Million Dollar Gamble: Is Luna a Ponzi Scheme?
Research institute: Mint Ventures
Researcher: Xu Xiaopeng
Luna, whose market cap has skyrocketed this year, once again becomes the focus of the industry again. Terra’s co-founder and CEO DO kwon and Crypto KOL Sensei Algod made a million dollar bet on whether the price of Luna can stand above US$88 a year later (later DO kwon asked to raise the bet to US$10 million).
As one of the public chains with the strongest rising potential in the past year, Terra has high research and discussion value.
Mint Ventures also released its first research report on Terra in early August 2021, titled as Terra: Rise of the Stablecoin Army. Since then, we have been paying attention to the development of Terra ecosystem.
This report is our thoughts on Terra so far, and it is only used as an initial guide.
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*The main text is 6,112 words, which is expected to take 10 minutes. It can be read in several times after collection.
Summary of Views
• Terra is not currently a Ponzi scheme in the traditional sense, despite its Ponzi shadow.
• The real disagreement point for Terra in the market lies in the rationality of its public chain development model. Supporters argue that Terra’s high-interest deposit approach is similar to subsidies for customer acquisition and retention in the Internet field. Although there were huge losses in the early stage, the current subsidy money will be earned back in a roundabout way from the long-term ecological prosperity in the future in terms of the overall life cycle of users. Opponents believe that Terra’s development model of subsidy + public chain tokens + anchored to stablecoins is difficult to form a steady state and will eventually die in a negative spiral caused by a Luna price crash.
• One of Terra’s challenges is the insufficient “economic bandwidth” of its token, Luna, which makes UST more vulnerable than DAI.
• The second challenge of Terra is that its business cycle of public chain + stablecoin growth may be interrupted by various internal and external factors, and its spiral turns from upward to downward. As an investor in Luna and UST, you need to pay close attention to these factors.
This report is only for discussion. There may be biases and errors in facts, data, and opinions. Please do not use it as an investment basis. We also expect more investors to provide differentiated views and participate in the discussion.
Before debating whether Terra is a Ponzi scheme, we need to reach a consensus: what is a Ponzi scheme?
1. What is Ponzi?
Ponzi is a financial model that pays the yields of old investors with the money of new investors. Its name comes from an investment scam set up by Charles Ponzi, an Italian American immigrant. He made up an investment project in which he could use the funds raised to buy European stamps (very cheap locally) and sell them in the United States for arbitrage (very expensive in the United States). Under the promise of high investment returns (40% return in three months), he developed more than 40,000 investors in about a year. Eventually the scam was exposed and Charles Ponzi was jailed.
1.1 Forms of Ponzi scheme
Not all behaviors that eventually fail after raising funds and cause losses to investors are Ponzi schemes. Even with the support of external funding, startup failure is still a high probability event in the business world.
Most Ponzi schemes can be classified into two types:
i. A Ponzi scheme originally aimed at fraud
This subjective purpose is often reflected in follow-up actions. The most important point is that the project party did not put the money into commercial projects or actual operations it claimed. For example, Charles Ponzi did not really use the money to buy European stamps, and the well-known domestic fraud project Plustoken did not use the raised BTC and ETH for so-called arbitrage. Because this type of Ponzi scams is not for the purpose of running a business, taking money to do these things will only increase the operating cost of the project for no reason. Even if it occasionally operates the actual business, it is more just pretending.
ii. It was a serious business plan at first, and then it went to Ponzi fraud
In such cases, the project party did not raise funds for the purpose of fraud at the beginning, but the problems and failures of the business model pushed it to gradually onto the road of Ponzi fraud. For example, for the once-popular P2P projects and long-term rental apartment projects with frequent thunderstorms in recent years, the founders of most these projects did not take fraud as their original intention, and the investment funds and rent received by the project were indeed invested in the operation, such as investment in normal supply chain financial projects, or for the acquisition of urban housing rental rights with moderate prices. However, due to a variety of internal and external reasons, such as fierce competition, flaws in its own business model and deviations in its operating model, the project party began to actively or passively move towards fraud, diverting the money of investors and users into models that could not be sustained in the long run, or simply building a capital pool to absorb more public funds through a classic Ponzi scheme of “returning the old with the new”. In the end, if the project party cannot reverse this situation and return the project to a healthy business model, Ponzi scheme cannot avoid the fate of collapse due to insufficient cash flow.
With regard to the full life cycle of Ponzi finance, interested readers can read an article (One article takes you to deduce the development and life cycle of Ponzi scheme) written by Alan, the official account of “Daiguan” .
The above two Ponzi development paths can also be summarized in the following figure：
2. Is Terra a Ponzi scheme?
The author’s current conclusion is: Terra ecology has the shadow of Ponzi, but the author believes that it is too early to characterize it as a “Ponzi scheme”.
It is said that Terra has the shadow of Ponzi because it has enabled the classic behavior of Ponzi: attracting public deposits at high interest rates.
2.1 How much is Terra’s deposit subsidy on UST?
In the Terra ecosystem, the lending protocol Anchor acts as a “state-owned bank” and promises ultra-high current yield of 19%-20% to absorb public deposits (in the form of UST). According to Coingecko data, the current total circulation of UST is US$15 billion, and the community pool of the official fund has 2.1 billion UST. Meanwhile, the UST deposit on Anchor is 10.4 billion, accounting for 80.6% of the total market cap of UST after deducting official funds. Most of the UST in circulation are for obtaining high interest of Anchor.
So how much does Anchor need to spend every year in order to maintain the 19%+ current deposit income? We can do a simple calculation:
Anchor’s main income includes: loan interest + PoS reward income for loan collateral (currently bLUNA and bETH) + liquidation penalty
Anchor’s main expense includes deposit interest.
Based on the current deposit and loan amount and interest rate of Anchor (03/17/2022), we calculate the net expenditure of Anchor:
Annual net expenditure of Anchor is: total income — total expenditure = (25.76*11.77%) + (42.73*7.15%) 1+ (10.47*4.8%) 2 -104.05*19.5%4=-13.7 (billion US dollars)
1 For Anchor loan interest, see APR at https://app.anchorprotocol.com/
2 For Staking income of bLUNA, see APR at Terrastaion
3 For Staking income of bETH, see APR at https://launchpad.ethereum.org/en/
4 For Anchor deposit interest, see APR at https://app.anchorprotocol.com/
It should be noted that, considering that Anchor itself provides high ANC token subsidies for borrowers and Anchor is in a state of loss as a whole, Anchor also faces additional ANC token price maintenance costs in order to maintain the ANC token price, that is, to solve the problem of selling pressure of ANC tokens.
That is to say, Anchor needs to bear annual expense of about US$1.37 billion without considering the liquidation income, the maintenance cost of ANC token price, and the salary of team members.
Obviously, Anchor alone cannot afford this expense.
Just in February of this year, just as Anchor’s reserve pool was about to bottom out, Terra’s ecological fund LFG (Luna Foundation Guard) announced that it would allocate 450 million UST to Anchor to replenish its reserve pool.
This confirms one point: unlike other lending protocols, Anchor is essentially an integral part of Terra’s planned economy. Its current business operation is not for profit, but a product officially funded by Terra to subsidize the scale expansion of UST.
2.2 The key point of the Terra dispute: can the two-wheel model of stablecoin + public chain succeed?
But it does not seem plausible to say that Terra is a Ponzi scam simply because “Terra is absorbing deposits with high subsidies”.
Although the subsidy scale of US$1.37 billion is huge, this expenditure is not unbearable in the short term. Because Terra’s current market cap is US$30 billion+, the ecological fund has a short-term reserve of more than US$3 billion, and it has the explicit or implicit institutional and consortium support behind it.
As mentioned in the previous “Forms of Ponzi Scheme”, there are two situations to form a Ponzi scheme. Or the initial subjective purpose is to defraud, and the funds raised are basically not invested in the claimed business projects. Or although the project party has no subjective intention of fraud in the initial stage, it still keeps investing and promoting when its business model has obvious fatal defects, and attracts the public to invest in its projects or pay for its services.
Let’s first assume that Terra Labs and the real-name team behind the Terra ecosystem have no malicious intention of subjective fraud, which is different from pure crypto Ponzi scheme projects such as Bitconnect. The reason why this assumption can be made is mainly from:
· The core team members use their real names
· The project ecology has visible growth and investment
· The project operates based on the public chain, and the financial information is relatively transparent and checkable (although the transparency of Terra’s on-chain data is still far from Ethereum, BnB chain, etc.)
· Since its establishment, the project has received continuous attention and capital investment from well-known funds around the world
Of course, the above conditions still do not fully prove that the Terra team has no intention to construct a Ponzi scheme subjectively, but greatly reduces the possibility.
If Terra is not a subjective Ponzi scheme, then does it meet the second Ponzi scheme: keep investing and promoting when its business model has obvious fatal defects, and attracts the public to invest in its projects or pay for its services?
We believe that this is the key point of the current dispute. We have disagreements on Terra’s public chain development model.
Supporters argue that Terra’s high-interest deposit approach is similar to subsidies for customer acquisition and retention in the Internet field. Although there were huge losses in the early stage, the current subsidy money will be earned back in a roundabout way from the long-term ecological prosperity in the future in terms of the overall life cycle of users. Opponents believe that Terra’s development model of subsidy + public chain tokens + anchored to stablecoins is difficult to form a steady state and will eventually die in a negative spiral caused by a Luna price crash.
This is actually the core point why Terra founder DO kwon and crypto KOL Sensei Algod made a million-dollar bet on whether the price of Luna can stand above US$88 a year later.
So, what is Terra’s business logic?
In short, Terra is a public chain ecosystem built around stablecoins. Its business goals can be summarized into two points:
· Promote the large-scale adoption of its stablecoins represented by UST to replace centralized stablecoins such as USDT and USDC
· Promote the prosperity of the Terra public chain and provide a platform for open finance and other applications to develop the Web3 economy
Whether it is a stablecoin or a public chain, the project party can benefit from its development and indirectly tax (rent-seeking). This is why stablecoins and public chains have always been the most popular track for entrepreneurship in the crypto business field.
However, unlike most separate stablecoin projects and separate public chain projects, Terra deeply binds its own stablecoins to its public chain business. Specifically, it is reflected in:
· Terra’s public chain ecology provides initial application scenarios for stablecoins and solves the biggest problem of stablecoins — cold start
· Stablecoins such as UST need to burn Terra’s token Luna to be minted. The larger the issuance scale of stablecoins, the larger the deflation scale of Luna, and the smaller the total supply. On the contrary, when UST is reversely redeemed for Luna, the supply of Luna will increase
· Luna is essentially an invisible collateral for stablecoins such as UST. The higher the market cap of Luna relative to stablecoins and the better the transaction depth, the more sufficient the collateral, the less the risk of stablecoin de-anchoring, and the lower the cost of maintaining consensus, and vice versa
Based on the above three points, we can conclude that UST is the engine of Luna, and Luna is the stabilizer of UST. When the two interact, it is easy to form a positive spiral when the trend is good; otherwise, it is easy to fall into a death spiral.
2.2.1 Luna’s vulnerability: insufficient economic bandwidth
The robustness of Luna as the stabilizer of the Terra stablecoin system is determined by its “economic bandwidth”.
Economic bandwidth is a concept proposed by Ryan Sean Adams, founder of Bankless. This concept emphasizes that the key to the competition of public chains is not “TPS” (transactions per second), but economic bandwidth. The economic bandwidth is determined by the circulating market cap, transaction depth and degree of decentralization of the public chain tokens. The higher the circulating market cap, the better the transaction depth and the higher the degree of decentralization, the higher the economic bandwidth of the public chain tokens, so it has the ability to carry a larger economic ecology on it.
We can compare the economic bandwidth of the public chains with the largest market cap:
From the above table, Luna has ranked in the forefront of crypto assets in terms of total token market cap and transaction depth. Its recent transaction depth has even surpassed that of BNB, which has twice the market cap.
So, how about the above economic bandwidth relative to Terra’s UST issuance scale of US$15 billion?
We can compare DAI, which is currently second only to UST in issuance scale, with UST:
We found that in terms of stablecoin/collateral ratio, UST is 0.463 which is 16.4% lower than DAI’s 0.627, so it seems that UST’s LTV (loan-to-value ratio) is lower and safer. However, combined with the economic bandwidth concept we mentioned above, the economic bandwidth of DAI’s main collateral assets is much better than that of UST’s collateral assets.
Among DAI’s collateral, ETH accounts for more than 40%, followed by USDC, accounting for more than 34.4%, and then WBTC.
The economic bandwidth (total asset market cap and transaction depth) of DAI’s collateral comprehensive assets composed of stablecoins such as ETH+WBTC+USDC is much higher than that of Luna. From this point of view, the security of UST is indeed lower than that of DAI.
However, the problem with DAI is that the assets controlled by centralized institutions account for a relatively high proportion of its collateral. WBTC, the wrapped asset of both USDC and BTC, is guaranteed and controlled by centralized institutions, so it has more obvious vulnerability in the face of supervision.
However, if we exclude the regulatory factors and only consider the ability of stablecoins against de-anchoring under huge market fluctuations, UST is obviously inferior to DAI now. The fundamental reason is that Luna’s economic bandwidth is insufficient.
2.2.2 Improve economic bandwidth: Business cycle of stablecoin + public chain
So, how can Luna improve its economic bandwidth?
In the author’s opinion, like most public chains, for Terra and its token Luna, it is the breadth and depth of its consensus that determines its total market cap and transaction depth, and the breadth and depth of the consensus are driven by the narrative, which is constructed based on the following layers:
· Quantitative narrative — core business data: TVL, the number of active and non-zero asset addresses on the chain, the number and value of transfers, the number of web3 projects and the number of developers. These objective data construct the narrative basis and are easy to compare horizontally.
· Qualitative narrative — various stories and logical reasoning: For example, with the development of the Comos ecosystem, Terra’s stablecoin is easier to be applied in the big ecosystem; for example, UST enters the Aave lending market, resulting in more financial scenarios, etc.
In order to promote the narrative and build stronger economic bandwidth, Terra has built a set of self-reinforcing business models based on its stablecoin + public chain two-wheel model, in the following order:
i. First, it creates DeFi scenarios in the public chain and provide subsidies (represented by Anchor), which shapes the demand for stablecoins
ii. Demand has driven the minting scale of UST, and users began to be introduced
iii. It has improved the data performance of the ecology, such as TVL, number of addresses, transfer activity and the number of projects participating in the ecology
iv. The boost of indicators can strengthen the attraction of Luna’s narrative
v. Based on the improvement of the consensus and fundamentals, it is possible to promote cooperation with more leading projects
vi. The enhancement of narrative and consensus can improve the transaction breadth (number and region of investors) and depth, gradually pushing up its price
vii. The actual controller party obtains funds by cashing out or burning Luna
viii. Continue to subsidize the first step with cashed-out funds to promote the above cycle
In this cycle, the main expenditure link of this business model is the first link, and the main income link is the seventh link. As long as the revenue of the seventh link is enough to support the first link, the cycle can continue and help Terra move towards its two major business goals:
· Promote the large-scale adoption of its stablecoins represented by UST to replace centralized stablecoins such as USDT and USDC
· Promote the prosperity of the Terra public chain and provide a platform for open finance and other applications to develop the Web3 economy
The better these two goals are accomplished, the lower the cost of maintaining the above cycle, which is reflected in the increase of external third-party scenarios for stablecoins and the expansion of its acceptance range. More native Web3 projects and developers will pour into the Terra ecosystem, building more applications spontaneously and attracting more users.
2.2.3 Potential risks: Where might Terra’s business cycle get stuck?
The main challenge in maintaining Terra’s business cycle is that there are problems in the narrative construction process from the third to sixth link, that is, the maintenance cost of the Luna token price is getting higher and higher, resulting in insufficient income and funds in the seventh link to support the subsidies in the first link.
Possible factors causing this problem include:
· Crypto asset prices collapse. The narrative value and valuation of the entire track projects will be hit hard, and Terra’s stablecoin and public chain will not be spared.
· Unexpected events within the project (eg Abracadabra affected by a scandal). The event will lead to a sharp drop in the price of Luna tokens and loss of liquidity, which in turn will trigger a potential under-collateralization of UST, resulting in a death spiral. And the team could do nothing about it.
· Regulatory shock. Regulation will limit Terra’s access to more financial means to maintain the operation of the project and deal with emergencies, or regulation itself is an emergency.
· The above business cycle will not be able to actually attract enough developers and users to enter the Terra ecosystem, the market’s narrative view of Terra will turn negative, or the current public chain value evaluation framework will change significantly.
If you are an investor in Luna or a holder of UST, you need to be very vigilant about the above situation.
2.2.4 Terra’s Response: Launch the Luna Foundation Guard and increase non-Luna reserve assets
If we summarize the current core issues of Terra, there are two main ones:
· As the collateral for the ecological stablecoin UST, Luna is relatively fragile due to its insufficient economic bandwidth compared with the current total market cap of US$15 billion and growing UST.
· Both its stablecoins and the Terra public chain ecology rely on its business cycle of “stablecoin subsidy — narrative and consensus strengthening — price boost — cash out \ mint for profit — continue subsidy”, but this cycle may be interrupted by various unexpected situations
Terra apparently also has a deep understanding of the above issues and has already started a series of actions, such as:
i. It established Luna Foundation Guard (LFG)
In January of this year, Terra established the Luna Foundation Guard (LFG). On the one hand, the funds of this Fund come from Terra’s official Luna grant, it also obtains financing from external institutions such as Jump Crypto, Three Arrows Capital, Republic Capital, GSR, Tribe Capital, DeFiance Capital, with a financing amount of US$1 billion. According to the news released by LFG on March 15 this year, its existing total reserve assets include US$2.2 billion of non-Luna assets and 8 million Luna tokens, with an estimated total value of about US$3 billion. The main goal of LFG is to expand the Luna ecosystem and maintain the anchoring of stablecoins such as UST. We can understand this ecological fund as a flexible special fund account, and Terra can use it more flexibly to deal with various business link issues.
ii. Start to incorporate more diverse asset classes into stablecoins to alleviate the problem of Luna’s insufficient economic bandwidth
Through the LFG mentioned above, Terra began to add non-Luna assets to the reserve pool. For example, the US$1 billion financing received by LFG in February this year will be allocated to BTC-dominated reserves. Later, on March 5, LFG announced that it would burn 5 million Luna in the reserve and mint them into UST worth US$4.50, which will be used to buy BTC as a reserve. Just 10 days later, LFG stated that its fund committee voted to burn another 4 million Luna and mint them into UST to purchase exogenous reserve assets. In addition to LFG, Terra’s founder and CEO Do Kwon has been stating that he will continue to increase his BTC holdings, making Terra one of the largest holders of BTC. On March 14, he said that he would provide UST with more than US$10 billion worth of BTC reserves. On March 17, crypto media Cointelegraph further confirmed the matter to Do Kwon and asked about the purpose of this part of BTC reserve. Do Kwon stated that it will be used for “short-term redemption of UST and as a more dispersed asset reserve”. Obviously, incorporating BTC into UST’s reserves and redemptions will alleviate the problem of Luna’s insufficient economic bandwidth.
Of course, as a participant and investor in the Terra ecosystem, as well as a holder of UST, you may also need to pay attention to:
In addition to the simple work of making reserve funds for Anchor, can LFG effectively deal with more and unexpected complex situations?
How does it work to include BTC into UST’s reserves and redemptions? Will it disclose the asset address for community oversight?
All this still needs to be observed.
3. Summary
In the opinion of the author, Terra is not a subjective Ponzi scheme, but an ecological adventure by a group of radical and bold experimenters. The sustainability of Terra’s development model is the focus that we should pay attention to and discuss.
Terra opens the business cycle of “stablecoin subsidy — narrative and consensus strengthening — price boost — cash out \ mint for profit — continue subsidy” with the new model of stablecoin + public chain. In the bull market, this cycle worked well, making it the 7th largest crypto asset in the world in just one year. Its stablecoin UST also surpassed DAI to become the largest decentralized stablecoin in market cap.
Despite this, compared to DAI’s collateral, the economic bandwidth corresponding to Luna’s total market cap, transaction depth, and degree of decentralization is still insufficient. This is particularly dangerous and fragile in a bear market with a shortage of liquidity and low market sentiment.
Therefore, in addition to the overall price situation of the crypto market, Luna and UST investors should pay attention to the changes in UST reserve assets and redeemed assets. At present, the Terra team has begun to incorporate BTC and other crypto assets with higher economic bandwidth into its stablecoin reserves, but the implementation details have not been disclosed.
In addition, we also need to pay close attention to regulatory actions on Terra ecosystem as well as the introduction of real users and developers to Terra’s business cycle. If the above problems are not properly handled, Terra may still face the possibility of interrupting the current business cycle, entering a negative spiral in the face of huge market fluctuations or other unexpected situations, and eventually being stamped with a “new crypto Ponzi scheme”.
Whether Terra finally goes further and successfully establishes an exemplary ecology of “stablecoin + public chain” two-wheel drive, or fails in the adventure, it provides a very good observation sample for crypto entrepreneurs and investors.
As discussing Luna in a group, I saw a group member said: “Fake it, until you make it”.
4. References
Ryan Sean Adams：ETH and BTC are Economic Bandwidth
Daiguan: A Ponzi Study Series by Alan
Principle analysis and prevention guide of “model coin” | Ponzi research
One article takes you to deduce the development and life cycle of Ponzi scheme | Ponzi Research
Ponzi financing, negative interest rates and Bitcoin | Token Watch
