Crypto Watch column | The Big De-peg: If it looks like a Perpetual Motion Machine, Run!

Genping Liu posted on 13 Jun 2022


(This article is first published on the Business Times)

Last month, the single event that rattled the crypto space was undoubtedly the collapse of the Terra stablecoin (UST), where over US$50 billion was wiped out from its ecosystem, and over US$400 billion from the overall cryptocurrency market. Not only did numerous retail investors see their savings evaporate overnight, but many institutional investors were hit hard too.

The series of unfortunate events brought to mind how I was once approached by an entrepreneur who was developing a perpetual motion machine.

He built a prototype, and explained with conviction and zeal how it worked: the machine simply requires an initial injection of force to jump start, before the various mechanisms could work in harmony to run the machine forever. He then went on to explain how the different parts interact and pull each other along. In spite of my engineering background, I quickly felt lost as I attempted to keep up with the details and make sense of everything logically.

There was one problem – the prototype was not functional. It showed a brief spurt of life before crashing to the ground. He claimed that the design still required a great deal of optimisation – which would be enabled by further funding. But in his eyes, there was no doubt that it would work and underlying principles would hold.

Any student of physics would know that such a device contravenes the first and second laws of thermodynamics (First: the law of conservation of energy and second: the entropy in an isolated system always increases).

Hence, to evaluate this investment, I think the key would be to adopt a system-level view and not be bogged down by the minute intricacies of how the different parts of the machine were supposed to work. Immersing in the details could befuddle even the best and the brightest.

Most Algorithmic Stablecoin Projects are much like the Perpetual Motion Machine

This was the feeling I got when I first studied algorithmic stablecoin projects back in 2017. A pure algorithmic stablecoin system typically has two tokens: one is pegged to a fiat currency like the US dollar and relies on the second token to “propel or pull on it” such that the former maintains its dollar peg.

When I tried to understand the mechanism’s design, I would quickly feel lost, before conceding that somehow, the design would be able to work. Even when I suspected potential problems, these concerns would be overridden by a faith that appropriate solutions will emerge, given the inherent complexities of the mechanism. My mind was simply tricked by the details.

However, when I took a step back to avoid confusing myself with the complexities of its moving parts, and adopted a system-level view by treating the overall design as a blackbox, I realised that what I was looking at might actually be a “digital perpetual motion machine”.

The analogy may not be perfect; it requires a vacuum for the perpetual motion machine to work and algorithmic stablecoins do not exist in a vacuum – they are always situated within an ecosystem, accompanied by a community. Theoretically, if there is sufficient value creation within the community to sustain a strong and growing economic ecosystem, this might present ample fuel to sustain the algorithmic stablecoin’s system.

In theory, algorithmic stablecoins may seem like highly efficient systems underpinned by their economic ecosystems. In reality, many of these projects are akin to perpetual motion machines, with underlying ecosystems that either have limited potential or are yet to mature. Despite having a crypto ecosystem as credit collateral, algorithmic stablecoins easily become overleveraged, and their weak foundations inevitably crumble.

In the case of UST, there seemed to be sufficient effort in the beginning to grow Terra’s economic ecosystem, but this rapidly spiraled into growing the adoption of UST at all costs. Over time, this system resembled a “digital perpetual motion machine” churning out UST magically.

Blockchain and Transparency in the Financial System

I firmly believe that blockchain technology brings newfound transparency to the financial world. The Big Short, a film distilling valuable insights from the 2008 Great Financial Crisis (GFC), shows how challenging it is even for experienced, professional investors to unearth inefficiencies in the market.

In the movie, Michael Burry is the numbers guy who collected and made sense of large amounts of data on the subprime mortgage bond market over the years to implement his short thesis. Mark Baum meanwhile, focused on assessing the people they were betting against, conducting extensive on-site due diligence on CDO managers and personnel at rating agencies.

These investigations required not only a sophisticated understanding of the financial industry, but also expensive resources and private access to Wall Street and high finance personnel – all of which are out of the reach of the common man, who are excluded from such crucial insights.

In contrast, blockchain projects exhibit an open culture within their communities. As a technology, blockchain democratises access to things such as real-time data, design principles, and analytical insights. Putting aside cryptocurrency scams, the motivation behind blockchain projects has always been about openness and transparency.

Data tracking, analytics, community debate, and voting are common characteristics of these projects, with end-to-end transparency being the natural consequence.

Before Terra’s collapse, the underlying depegging risks were well publicised. But if data transparency is so much better within blockchain, why were so many investors blindsided by UST’s demise?

Don’t join for FOMO

After Terra’s collapse, I spoke to several crypto funds and retail investors who were burnt by the episode. The real tragedy was not the amount of money that was lost in the process, but the way in which they had lost it. Most of them had access to data and information on how the UST project worked, and therefore, were well aware of its inherent risks, the potential for collapse and the irreversible spiral that would ensue once the peg unraveled.

Yet, most of them thought they could pull the plug in time when the worst case scenario transpired, or simply assumed that the community would develop a solution to rectify it or figure out solutions to address the risk.

Just like any other asset class, the world of crypto is home to various types of investors. Firstly, there is the group of long term investors with deep conviction. Delphi Digital is a good example in the context of Terra, they were highly convinced by the investment thesis and lost money due to errors in judgment.

Secondly, there is the trader group who makes a living by timing the market and making investment returns from scalping off price movements.

Thirdly, there is the ‘innocent’ group who treats the words of others as gospel, and in this case, was fooled into believing that UST was a bank grade product as stable as the US dollar.

Finally, there is the group which FOMOed and stayed around for the high yield returns, trusting in their ability to outrun others when the system collapsed. In a way, the last group went in knowing that it was somewhat of a gamble, but committed anyway.

Surprisingly, based on my small survey size, the last group of FOMO investors actually constituted the majority. This seems different from the Great Financial Crisis, when there were more investors falling in the third ‘innocent’ group, thinking that the property market was only going to go up based on the limited data they could base their judgment on.

To me, this aptly sums up the situation facing many crypto investors. Regardless of the number of warnings that have been issued and all the signs pointing to a potential catastrophe, humans let greed dominate their decision making process when it comes to money management. This is something that no amount of technological innovation can change. Emotion bridges the gap between one’s rational thought and action, and investors have to alter their behavior so as to avoid catastrophic risks that could put them out of the game once and for all.

Critical Thinking is key to discerning true innovation from the perpetual motion machines

Being a professional investor is tough, and many within the industry would say that investing is an art rather than a science. It requires a large amount of fundamental research at the pre-investment stage, and the discipline to stick to your principles once the investment decision has been made.

Technology is making part of the job easier, particularly in alleviating challenges related to obtaining accurate, real-time data, relevant analytics, and even expert insights. However, critical thinking skills cannot be substituted by technology, and one must learn to discern which types of information are critical to making a decision. This is especially true in today’s fast changing world, whereby an overload of information, rather than its scarcity, is the real challenge.

While it is always difficult to discern the true innovation from the perpetual motion machines, it is always useful for investors to adopt a system-level view rather than plunging first into the product’s intricacies. This is particularly critical in the crypto world, as complicated token economics tend to confuse even the best amongst us.

The advice is timeless: Know what you are investing in, start with the first principles, conduct fundamental analysis, and keep your greed or fear in check. Once you have checked the ‘list’, you will have more confidence to hold contrarian views relative to the market.

If you feel uncomfortable swimming against the tide, and are prompted to join the FOMO crowd, my recommendation is to turn to an inspiration, such as Michael Burry, who had endured an imaginable amount of stress when confronted by his angry clients for betting against the housing bubble.

Terra’s collapse will certainly leave an indelible mark on the crypto ecosystem, affecting amongst others, investors’ risk appetite and community participation. Calls for greater regulation have also been expedited, as witnessed by the bills governing blockchain technology and crypto assets that have been proposed by members of the US Congress.

The European Central Bank has also called for greater scrutiny given the correlation of crypto assets with the rest of the financial world. Coupled with the challenges in the macroeconomy, these headwinds suggest that the crypto asset class could experience yet another dragged out winter.

Personally, I remain bullish on crypto assets in the mid to long term, given the fundamental shifts in consumer behavior. A winter might not necessarily be bad. In fact, it might be good for the crypto ecosystem to cut some “excess fat” and strengthen its “core muscles”. Also, the winter is a good time for investors to hibernate in some peace and quiet, consolidating their learnings and preparing for the changes ahead.

Like the article? Read the rest of the Crypto Watch Column here.

Edited by: Elise Tan and Jing Zhe Ang

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