Author: Xu Xiaopeng, Researcher at Mint Ventures

This year, the market value of Luna has skyrocketed like a rocket and has recently become the focus of the industry again. Terra's co-founder and CEO Do Kwon and crypto KOL Sensei Algod have placed a million-dollar bet on whether Luna's price can stand above $88 a year later (later Do Kwon requested to raise the bet to $10 million).

As one of the most powerful public chains to rise this year, Terra has high research and discussion value.

Mint Ventures also released its first research report on Terra, titled "Terra: The Rise of the Stablecoin Legion," in early August 2021. Since then, we have been closely following the development of the Terra ecosystem.

This article is our current thoughts on Terra and is intended to spark discussion.

Summary of Views

● Despite having the shadow of a Ponzi scheme, Terra is not a traditional Ponzi scheme at this time.

● The real point of divergence in the market regarding Terra lies in the rationality of its public chain development model. Supporters believe that Terra's high-interest deposits are similar to customer acquisition and retention subsidies in the internet sector. Although there are massive losses in the early stages, from the overall user lifecycle perspective, the subsidized money will eventually be recouped from the long-term prosperity of the ecosystem; opponents argue that Terra's subsidy + public chain token & stablecoin pegging development model is difficult to stabilize and will ultimately lead to death in a negative spiral during a significant drop in Luna's price.

● One of Terra's challenges is the insufficient "economic bandwidth" of its token Luna, which makes UST more fragile than DAI.

● Another challenge for Terra is that its public chain + stablecoin growth business cycle may be interrupted by various internal and external factors, causing the spiral to turn from upward to downward. As investors in Luna and UST, one needs to pay close attention to these factors.

This article is for discussion purposes only and may contain biases and errors in facts, data, and viewpoints. Please do not use it as an investment basis, and we look forward to more investors providing differentiated views and participating in the discussion.

Beginning of the Main Text

Before debating whether Terra is a Ponzi scheme, it is necessary to reach a consensus: what is a Ponzi scheme?
Section 1: What is a Ponzi Scheme?

A Ponzi scheme is a financial model that pays returns to earlier investors using the capital from new investors. The name comes from Charles Ponzi, an Italian-American immigrant who set up an investment scam. He fabricated an investment project claiming that funds raised could be used to buy European postage stamps (which were very cheap locally) and sell them in the U.S. for a profit (where they were very expensive). With promises of high investment returns (40% in three months), he attracted over 40,000 investors in about a year, but the scam was eventually exposed, and Charles Ponzi was imprisoned.

1.1. Forms of Ponzi Schemes

Not all fundraising activities that ultimately fail and cause investor losses are Ponzi schemes. Even with external funding support, business failures remain a high-probability event in the commercial world.

Most Ponzi schemes can be categorized into two types:

1. Ponzi schemes that were fraudulent from the start

This subjective intent often reflects in subsequent actions. One of the most important points is that the project party did not invest the money into the business project or actual operations it claimed, such as Charles Ponzi not actually using the money to buy European postage stamps, and the well-known domestic scam project Plustoken not using the raised BTC and ETH for the so-called arbitrage. This type of Ponzi scam is not aimed at running a business; spending money on these activities would only unnecessarily increase operational costs. Even if there are occasional actual business operations, they are more for show.

2. Initially legitimate business plans that later turn into Ponzi scams

In this case, the project party did not initially intend to defraud when raising funds, but issues with the business model and failures gradually pushed it onto the path of Ponzi fraud. For example, the once-popular P2P lending and the frequently collapsing long-term rental apartment projects mostly had founders who did not start with fraudulent intentions. The investment funds and rents received were indeed invested in operations, such as normal supply chain finance projects or acquiring rental rights for reasonably priced urban housing. However, due to various internal and external reasons, such as fierce competition, inherent flaws in the business model, and deviations in operational modes, the project party began to actively or passively move towards fraud, investing the money of investors and users into models that were fundamentally unsustainable in the long term or simply constructing a capital pool to implement a typical Ponzi scheme of using new funds to pay old ones, further attracting more public funds. Ultimately, if the project party cannot reverse this situation and return the project to a healthy business model, due to cash inflows not covering outflows, a Ponzi scheme cannot avoid the fate of collapse.

For a complete lifecycle analysis of Ponzi finance, interested readers can refer to the article "A Guide to Understanding the Development and Lifecycle of Ponzi Schemes" by Alan, author of the public account "Dai Observation."

The two development paths of Ponzi schemes can also be summarized in the following diagram:

Image source: "Ponzi Financing, Negative Interest Rates, and Bitcoin | Token Observation" Section 2: Is Terra a Ponzi Scheme?

My current conclusion is: Terra's ecosystem has the shadow of a Ponzi scheme, but I believe it is too early to classify it as a "Ponzi scheme."

The reason for saying that Terra has the shadow of a Ponzi scheme is that it has adopted classic Ponzi behavior: attracting public deposits with high interest.

2.1. How Much Deposit Subsidy Does Terra Offer on UST?

In the Terra ecosystem, the lending protocol Anchor acts as a "state-owned bank," promising an ultra-high interest rate of 19%-20% on demand deposits to attract public deposits (in the form of UST). According to Coingecko data, the current total circulation of UST is $15 billion, with the official fund's community pool holding $2.1 billion, while the UST deposited in Anchor amounts to $10.4 billion, accounting for 80.6% of the total market value of UST excluding official funds. Most of the circulating UST is aimed at obtaining Anchor's high interest.

So, how much does Anchor need to spend each year to maintain a 19%+ interest rate on demand deposits? We can do a simple calculation:

Anchor's main income includes: loan interest + PoS rewards from collateral (currently bLUNA and bETH) + liquidation penalties.

Anchor's main expenses include: deposit interest.

Using the current (March 17, 2022) Anchor loan amount and interest rate as a baseline, we can estimate Anchor's net expenditure:

Data on Anchor's loans and interest rates, source: anchorprotocol March 17, 2022

Anchor's annual net expenditure is: total income - total expenditure = (25.76 * 11.77%) + (42.73 * 7.15%) + (10.47 * 4.8%) - (104.05 * 19.5%) = -$1.37 billion

^1^ Anchor loan interest, APR see https://app.anchorprotocol.com/

^2^ bLUNA's Staking yield, APR see Terrastaion

^3^ bETH's Staking yield, APR see https://launchpad.ethereum.org/en/

^4^ Anchor deposit interest, APR see https://app.anchorprotocol.com/

It is important to note that considering that Anchor itself provides high ANC token subsidies to borrowers and is overall in a loss state, to maintain the price of ANC tokens, Anchor also faces additional costs for maintaining the price of ANC tokens, which is to address the selling pressure on ANC tokens.

In other words, Anchor needs to bear an expenditure of about $1.37 billion each year, not considering income from liquidations, the costs of maintaining the price of ANC tokens, and team salaries.

Clearly, Anchor alone cannot bear this expenditure.

Just this February, as Anchor's reserve pool was about to run dry, Terra's ecosystem fund LFG (Luna Foundation Guard) announced a grant of $450 million UST to Anchor to replenish its reserve pool.

This confirms one point: Anchor is different from other lending protocols; its essence is a component of Terra's planned economy. Its current business operation is not aimed at pursuing profit but is a product subsidized by Terra's official funds to expand the scale of UST.

2.2. Key Controversy: Can the Dual Wheel Model of Stablecoin + Public Chain Succeed?

However, just because "Terra is attracting deposits with high subsidies" does not necessarily mean that Terra is a Ponzi scheme.

Even though the subsidy scale of $1.37 billion is enormous, considering Terra's current market value of over $30 billion, the ecosystem fund's short-term reserves exceeding $3 billion, and the support from various institutions and consortiums, this expenditure is not unsustainable in the short term.

As mentioned in the earlier "Forms of Ponzi Schemes," to constitute a Ponzi scheme, either the initial subjective intent must be fraudulent, with the raised funds not being invested in the claimed business projects; or the project, despite not having subjective intent to defraud initially, continues to invest and promote despite its business model having obvious fatal flaws, attracting public investment in its project or payment for its services.

Let us assume that Terra Labs and its real-name team behind the Terra ecosystem do not have subjective fraudulent intent. Unlike pure crypto Ponzi schemes like Bitconnect, this assumption is mainly based on:

● The core team members use real names.

● The project ecosystem has visible growth and investment.

● The project operates on a public chain, with relatively transparent and traceable financial information (although the transparency of Terra's on-chain data is still significantly lower than that of Ethereum, BnB chain, etc.).

● The project has received continuous attention and investment from well-known global funds since its inception.

Of course, the above conditions still do not completely prove that the Terra team does not have the intent to build a Ponzi scheme; they merely significantly reduce the likelihood.

If Terra is not a subjective Ponzi scheme, does it meet the second criterion of a Ponzi scheme: continuing to invest and promote despite the business model already having obvious fatal flaws, attracting public investment in its project or payment for its services?

We believe this is the key point of contention; there is a divergence of views on Terra's public chain development model.

Supporters argue: Terra's high-interest deposits are similar to customer acquisition and retention subsidies in the internet sector. Although there are massive losses in the early stages, from the overall user lifecycle perspective, the subsidized money will eventually be recouped from the long-term prosperity of the ecosystem; opponents argue that Terra's subsidy + public chain token & stablecoin pegging development model is difficult to stabilize and will ultimately lead to death in a negative spiral during a significant drop in Luna's price.

This is also the core point of the million-dollar bet between Terra's founder Do Kwon and crypto KOL Sensei Algod on whether Luna's price can stand above $88 a year later.

So, what is Terra's business logic?

In simple terms, Terra is a public chain ecosystem built around stablecoins, and its business goals can be summarized in two points:

● Promote the large-scale adoption of its stablecoin represented by UST, replacing centralized stablecoins like USDT and USDC.

● Promote the prosperity of the Terra public chain, providing a platform for the development of Web3 economy for open finance and other applications.

Whether it is stablecoins or public chains, the project party can benefit from their development and indirectly extract rents, which is why stablecoins and public chains have always been the hottest tracks for entrepreneurship in the crypto business field.

However, unlike most standalone stablecoin projects and standalone public chain projects, Terra has deeply bound its stablecoin with public chain business. Specifically, this is reflected in:

● Terra's public chain ecosystem provides initial application scenarios for stablecoins, solving the biggest problem of stablecoins—cold start.

● Stablecoins like UST need to destroy Terra's token Luna to mint, meaning the larger the issuance scale of stablecoins, the greater the deflation of Luna, and the smaller the total supply. Conversely, when UST is redeemed back for Luna, the supply of Luna will increase.

● Luna is essentially the invisible collateral for stablecoins like UST. The higher the market value of Luna relative to stablecoins, the better the trading depth, the more sufficient the collateral, the smaller the risk of stablecoins losing their peg, and the lower the cost of maintaining consensus, and vice versa.

Based on the above three points, we can conclude: UST is the engine of Luna, and Luna is the stabilizer of UST; the two interact, and when the trend is positive, it is easy to form a positive spiral; conversely, it is easy to fall into a death spiral.

2.2.1. Luna's Weakness: 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, the founder of Bankless, emphasizing that the key to public chain competition lies not in "TPS" but in economic bandwidth. Economic bandwidth is determined by the circulating market value, trading depth, and decentralization degree of the public chain token. The higher the circulating market value, the better the trading depth, and the higher the degree of decentralization, the greater the economic bandwidth of the public chain token, enabling it to support a larger economic ecosystem.

We can compare the economic bandwidth of the top public chains:

From the above table, Luna ranks among the top in terms of total token market value and trading depth, with its recent trading depth even surpassing that of BNB, which has twice its market value.

So, how does this economic bandwidth compare to the $15 billion issuance scale of UST?

We can compare UST with DAI, which currently has the second-largest issuance scale:

We find that in the ratio of stablecoins/collateral, although UST's 0.463 is 16.4% lower than DAI's 0.627, making it seem that the LTV (loan-to-value ratio) is lower and safer, when combined with the economic bandwidth concept mentioned above, the economic bandwidth of DAI's main collateral assets is far superior to that of UST's collateral assets.

Over 40% of DAI's collateral is ETH, followed by USDC, which accounts for over 34.4%, and then WBTC.

Composition of DAI's collateral, source: Daistats

DAI's collateral, composed of ETH + WBTC + USDC and other stablecoins, has an economic bandwidth (total asset market value and trading depth) that is far superior to that of Luna. From this perspective, UST's security is indeed inferior to that of DAI.

However, the problem with DAI is that a high proportion of its collateral is controlled by centralized institutions. Whether it is USDC or the wrapped asset WBTC, both are guaranteed and controlled by centralized institutions, making them more vulnerable in the face of regulation.

However, if we exclude regulatory factors and only consider the ability of stablecoins to resist losing their peg during significant market fluctuations, UST is currently clearly inferior to DAI, fundamentally due to: Luna's insufficient economic bandwidth.

2.2.2. Increasing Economic Bandwidth: The Business Cycle of Stablecoin + Public Chain

So, how can Luna increase its economic bandwidth?

In my view, like most public chains, the total market value and trading depth of Terra and its token Luna are determined by the breadth and depth of its consensus, which in turn is driven by narratives based on the following aspects:

● Quantitative narratives—core business data: TVL, the number of active and non-zero asset addresses on-chain, transaction counts and values, the number of web3 projects and developers. These objective data build the foundation of the narrative and are easily comparable.

● Qualitative narratives—various stories and logical reasoning: for example, as the Cosmos ecosystem develops, Terra's stablecoin is more likely to be applied in the larger ecosystem; for example, UST entering the Aave lending market creates more financial scenarios, etc.

To promote the narrative and build stronger economic bandwidth, Terra has established a self-reinforcing business model based on its stablecoin + public chain dual-wheel model, in the following sequence:

1. First, create DeFi scenarios within the public chain and provide subsidies (represented by Anchor), shaping the demand for stablecoins.

2. Demand drives the minting scale of UST, attracting users.

3. Improve the ecosystem's data performance, such as TVL, address counts, transaction activity, and the number of projects participating in the ecosystem.

4. The improvement of indicators enhances the attractiveness of Luna's narrative.

5. Based on improvements in consensus and fundamentals, it promotes cooperation with more leading projects.

6. The enhancement of narratives and consensus increases Luna's trading breadth (the number of investors and regions) and trading depth, gradually pushing up the price.

7. The controlling party obtains funds through cashing out or destroying Luna.

8. The cash obtained continues to subsidize [Step 1], promoting the above cycle.

In this cycle, the main expenditure phase of this business model is [Step 1], while the main income phase is [Step 7]. As long as the income from [Step 7] is sufficient to support the subsidies in [Step 1], this cycle can continue, helping Terra move towards its two major business goals:

● Promote the large-scale adoption of its stablecoin represented by UST, replacing centralized stablecoins like USDT and USDC.

● Promote the prosperity of the Terra public chain, providing a platform for the development of Web3 economy for open finance and other applications.

The better these two goals are achieved, the lower the cost of maintaining the above cycle, manifested as an increase in external third-party scenarios for stablecoins, expanding the acceptance range; more native web3 projects and developers flock into the Terra ecosystem, spontaneously building more applications 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 lies in the narrative construction process of Steps 3-6, where the maintenance cost of Luna's token price becomes increasingly high, leading to insufficient income and funds from [Step 7] to support the subsidies in [Step 1].

Possible factors causing this issue include:

● A collapse in crypto asset prices. The narrative value and valuations of projects across the entire sector are severely impacted, and the stablecoin and public chain that Terra is part of are no exception.

● Unexpected internal events (e.g., Abracadabra affected by scandals). Such events lead to a sharp drop in Luna's token price and loss of liquidity, triggering potential collateral shortfalls for UST, resulting in a death spiral, and the team is powerless to intervene.

● Regulatory shocks. Regulations limit Terra's ability to obtain more financial means to maintain project operations and respond to sudden situations, or regulation itself becomes an unexpected event.

● The above business cycle has not actually attracted enough developers and users into the Terra ecosystem, leading to a negative shift in market perception of Terra's narrative, or significant changes in the existing public chain valuation framework.

If you are an investor in Luna or a holder of UST, you need to be very vigilant about these situations.

2.2.4 Terra's Response: Launching the Protector Fund, Increasing Non-Luna Reserve Assets

If we summarize the current core issues of Terra, they are mainly two:

● Luna, as the collateral for the ecosystem stablecoin UST, appears relatively weak compared to the current $15 billion and still growing total market value of UST due to its insufficient economic bandwidth.

● Whether for stablecoins or the Terra public chain ecosystem, both rely on their "stablecoin subsidies—narrative and consensus strengthening—price boosting—cashing out/minting profits—continuing subsidies" business cycle, but this cycle may be interrupted by various unexpected situations.

Terra is clearly aware of these issues and has begun a series of actions, such as:

1. Establishing the Luna Foundation Guard (LFG)

In January of this year, Terra established the Luna Foundation Guard (LFG), also known as the "Luna Protector Fund." The fund's capital comes partly from Luna allocations by Terra's officials and partly from external institutions such as Jump Crypto, Three Arrows Capital, Republic Capital, GSR, Tribe Capital, and DeFiance Capital, with a total financing amount of $1 billion. According to LFG's announcement on March 15 this year, its existing total reserve assets include $2.2 billion in non-Luna assets and 8 million Luna, with an estimated total value of around $3 billion. The main goal of LFG is to expand the Luna ecosystem and maintain the peg of stablecoins like UST. We can understand this ecosystem fund as a more flexible dedicated account, allowing Terra to respond more flexibly to various business issues.

2. Starting to include a more diverse range of asset classes for stablecoins to alleviate the issue of Luna's insufficient economic bandwidth.

Through the aforementioned LFG, Terra has begun to add assets outside of Luna to its reserve pool. For example, the $1 billion financing received by LFG in February was allocated to reserves priced in BTC. Subsequently, on March 5, LFG announced that it would destroy 5 million Luna to mint UST valued at $4.5 to purchase BTC as reserves. Just ten days later, LFG stated that its fund committee voted to destroy another 4 million Luna to mint UST for purchasing external reserve assets. In addition to LFG, Terra's founder and CEO Do Kwon has been expressing intentions to continuously increase BTC holdings, aiming to make Terra one of the largest holders of BTC. On March 14, he stated that he would provide over $10 billion worth of BTC reserves for UST, and on March 17, crypto media Cointelegraph further confirmed this with Do Kwon, inquiring about the purpose of these BTC reserves. Do Kwon stated that they would be used "to address short-term redemptions of UST and as a more diversified asset reserve." Clearly, incorporating BTC into UST's reserves and redemption assets will alleviate the issue of Luna's insufficient economic bandwidth.

Of course, as a participant and investor in the Terra ecosystem and a holder of UST, you may also need to pay attention to:

Aside from simply providing Anchor with reserve funds, can LFG effectively respond to more complex unexpected situations?

How will the incorporation of BTC into UST's reserves and redemption assets be specifically executed? Will asset addresses be made public for community oversight?

All of this still requires continued observation.

Conclusion

In my view, Terra is not a Ponzi scheme on a subjective level but rather an ecological adventure by a group of radical and bold experimenters. The sustainability of Terra's development model is the focus we should pay attention to and discuss.

Terra has initiated a business cycle of "stablecoin subsidies—narrative and consensus strengthening—price boosting—cashing out/minting profits—continuing subsidies" with its new model of stablecoin + public chain. In a bull market, this cycle operates well, allowing it to rise to the 7th largest crypto asset globally in just one year, with its stablecoin UST surpassing DAI to become the largest decentralized stablecoin by market value.

However, despite this, Luna's total market value, trading depth, and degree of decentralization corresponding to its collateral are still insufficient compared to DAI, which is particularly dangerous and fragile in a bear market characterized by liquidity shortages and low market sentiment.

Therefore, investors in Luna and UST should focus not only on the overall price situation in the crypto market but also on changes in UST's reserve and redemption assets. The Terra team has already begun to incorporate higher economic bandwidth crypto assets like BTC into stablecoin reserves, but the execution details have yet to be disclosed.

Additionally, we need to closely monitor regulatory actions regarding the Terra ecosystem and the actual user and developer engagement in Terra's business cycle. If these issues are not properly addressed, Terra may still face the possibility of interrupting its current business cycle and falling into a negative spiral, ultimately being labeled as a "new type of crypto Ponzi scheme."

Whether Terra ultimately goes further and successfully establishes a model ecosystem driven by "stablecoin + public chain" or runs aground in its adventure, it provides a very good observation sample for crypto entrepreneurs and investors.

As I saw one group member say during a discussion about Luna, "Fake it, until you make it."