Cryptocurrency: Commodified currency as a new category of consumer product
"Making money" means something else when you're in the business of literally manufacturing currency.
Thanks to cryptocurrencies, there are now businesses out there manufacturing their own currency as a consumer product, trying to attract users based on the features they think people want in currency, such as cheap and fast transfers, stable value, censorship-resistance or tokenomics models intended to increase the value of the currency over time.
It's the commodification of money itself, and this kind of thing has never really been done before.
Cynics will point at company scrip as the closest approximation, but despite the superficial similarities (both involve creating a new currency), their aims and functions are polar opposites. Company scrip ended up being used to enforce company monopolies on a captive market of labourers, while currency-style cryptocurrencies are deliberately trying to be used as widely as possible, essentially busting the monopoly currently held by fiat currencies.
We find a closer approximation a few centuries further back, where different coins were used around the world and valued based on their gold content. Here, we can see examples of coins becoming more popular and widely used based on their functional characteristics, such as the tenth-century tarì currency, which attracted users and spawned imitations around the world based on its small size, which made it more convenient and portable than competitors.
But as plain physical tokens, coins don't really have much room for additional functions or extra user-friendliness, while cryptocurrencies do. Plus, the value of those coins was typically based on their gold content, so they all had a uniform valuation method. But now that we're in the fiat currency era, there are a lot of different ways for a new currency to value itself such as fiat currency pegs, market value or various redemption systems.
The lack of precedent in cryptocurrency, deep regulatory uncertainty, the impossibility of predicting consumer response to commodified currencies, the breadth and depth of possibilities allowed by digital currency compared to physical money and the all-around sheer novelty of the commodified currency space all come together to create a difficult, unpredictable and utterly wild ride for any startup who wants to get into the business of making money by making money.
One of those startups is Terra, a South Korean stablecoin startup. One of the things that makes it different is that it's actually being used as money.
Terra's CHAI app is the fastest growing payment app in South Korea, and it has an eCommerce alliance which includes 25 partners across Asia with a combined gross merchandise volume of US$50 billion per year. CHAI can be used online or at thousands of convenience stores around South Korea and just yesterday (19 December 2019) Terra brought on Rahul Abrol, Uber's former APAC head of strategy, as its own.
Terra's customers have used its currency for millions of transactions worth tens of millions of dollars, and now it's eyeing Singapore, Taiwan and Thailand for its next phase of expansion.
Another thing that makes Terra different is that it's very deliberately approaching the cryptocurrency space from the perspective of commodified currency, and building a new currency as a consumer product.
"A lot comes down to making the right design decisions, and thinking hard about what properties you want your currency to have and where you want the value to accrue," says Terra head of research Nicholas Platias. "So for us, we thought very hard. We went through a bunch of iterations of the protocol and a bunch of white papers before we concluded what we wanted to do."
This process led to a paired algorithmic stablecoin system, consisting of the down-to-earth fiat-pegged stablecoin called Terra, which is the actual coin that's used for payments and transactions, and a volatile system token called Luna, which metaphorically circles the ecosystem, reflecting its light upon it.
The Earth and the moon
Luna acts as a gateway for people to organically manage Terra supply and demand, and keep it at its peg price. At its core, it's a gateway through which people can exchange Terra and Luna at the intended peg price.
"The supply of Terra is adjusted to make sure the price is always at the peg," Platias says. "What that basically means is that demand for Terra goes up, then the protocol needs to issue some amount of Terra. Conversely, if demand goes down it needs to buy some back."
"That happens via Luna. If the price of Terra goes above the peg, people have an incentive to buy Terra from the protocol in exchange for Luna at the peg price... Conversely, if the price of Terra goes below the peg, then the market has an incentive to do the opposite, which would be to trade in Terra for Luna... either swap is facilitated by the protocol."
For example, say Terra is pegged at $1. If demand for Terra grows relative to its current circulating supply, its market value could rise to $1.01. Conversely, if Terra usage shrinks, its price could drop to $0.99.
In the first case, people have a reason to exchange Luna for Terra through the gateway, because they're essentially getting $1.01 of currency for every $1 put in. In the case of the latter, people have a reason to buy up Terra, shrinking its circulating supply in the process, whenever its prices drop under $1, because they know they can exchange it for Luna at a price of $1.
At the same time, network transaction fees are distributed among Luna holders, so the overall goal is to create a high quality currency product for all users, with Terra and Luna circling each other in a stable orbit, and both serving a useful purpose.
One of the main competitive advantages this offers Terra, as a commodified currency product, is "revenue" of a sort from seignorage.
Seignorage is the difference between the cost of manufacturing a currency, and the face value of the currency itself. If it costs 10 cents to make a dollar, the manufacturer of that dollar gets 90 cents in revenue for every dollar made.
Collateralised stablecoins like Tether don't get the benefit of seignorage, Platias points out. It simply costs one dollar to produce one dollar worth of Tether.
"On the contrary, if you look at Terra, that situation is very different, because the cost of production is much smaller," he says. "Basically we do keep a certain cash buffer in order to supplement the main stability mechanism, but the vast majority of the currency that is issued comes from seignorage."
If you want to "manufacture" currency the way that Terra does, using a system that gives you a much lower cost of production is common sense. Platias also credits much of Terra's growth to this factor, because it makes it possible for Terra payment platforms like CHAI to offer compelling cashbacks and other bonuses to users.
"That's what positions us to be able to acquire users in a much more compelling and fast way compared to what something like Tether would be able to do," he says.
"I think that the key 'growth hack', if you will, that Terra has used and CHAI has leveraged by receiving Terra seignorage, has been precisely that idea."
The idea is that Terra can use seignorage revenue to give cashback to users, which results in more growth, which results in more seignorage, which results in more users and so on. Throughout, it offers the usual digital currency benefits of low fees and fast transfers.
This potential growth, of course, needs to be factored into Terra's tokenomics. Fortunately, the system is designed so the Luna and Terra tokens should run along the same trajectories, growing in use and value together, or declining in use and value together.
"The interesting implication here is that, actually, the supply of Luna goes down when there's expansion. And so that should create an upward price pressure for Luna, because essentially it's a form of buyback," Platias notes.
Conversely, when use of Terra shrinks, people should theoretically pump Luna back into the market, which will dilute its total supply and theoretically reduce its total value.
This is a practical dynamic overall, because the market value of Luna maintains the value of Terra, so it's good to have them running in the same direction. The value of Luna should follow the growing use of Terra, creating a virtuous feedback cycle.
It's hard to make growth predictions in the commodified currency business because there's not a lot of precedent out there. But based on the team's best guesses, Terra use is growing above par, Platias says.
"The best we can do, to be honest, is look at the growth rates of similar payment companies. And I would say Terra is probably beating expectations," he said.
In that context, it's quite interesting that Luna prices have taken a thrashing since launch.
Usage of the Terra stablecoin has increased dramatically, which should theoretically drive Luna prices higher. But interestingly enough, the opposite is happening.
It's still nowhere near posing a hazard to Terra's stability though, Platias notes.
"What one wants to look at, is what is the market capitalisation of Terra relative to Luna," he says. "At the moment, Luna's market cap – even though the price has decreased quite substantially over the past few months – it's still substantially higher than the market capitalisation of Terra, which would basically mean that Luna alone should be very strong collateral even if the price were to reduce further. And on top of that, there's a cash buffer."
The Luna token's free market drubbing is an excellent example of one of the pitfalls of the exciting new commodified currency industry. On paper, everything is working well and Terra's growth should be accruing "revenue" to Luna.
But in practice, some of the numbers may have been off.
The most obvious sign of a potential miscalculation may be the fact that the Terra network is still perfectly secure, functional and growing even with Luna values at about a sixth of their initial market price.
It's hard to account for the speculative future value of the Luna token, but from a strictly functional perspective, this suggests that the Luna token simply started off overpriced and is now dropping to meet its practical value. If Luna keeps falling and Terra keeps growing, then at some point, their paths should cross and the Luna supply will shrink as intended.
At the same time, payments themselves don't really lock up Terra tokens, so there's little practical incentive to hold them. It's quite possible for even a relatively low market cap stablecoin to support a comparatively enormous payment network if the coin is used for payments alone.
In the future, actual functions that lock up Terra tokens may help drive Luna's value more effectively than use solely for payments can, Platias suggests.
Lessons for commodified currency designers
In this case, market movements aren't just for speculators to make money. These assumptions of value, and market behaviour, are key to the actual functionality of the product. Luna is an integral part of the network, so it's important to make sure it's working and being valued as intended.
"If you think about the Terra ecosystem, Terra is of course what drives usage, but Luna is sort of the stalwart of this system. It's the asset which enables consensus. It guarantees the security of the proof of stake system, it serves as collateral for Terra," Platias says. "So without Luna, Terra is a completely uncollateralised thing whose value could explode [or implode] at any given moment. And then it's also the asset which, in exchange for those things, receives cash flow and gains value through the growth of the economy."
"So coming up with a system that makes sure all the parts play well together... I think it's crucial."
But what if the markets aren't rational? What if you lay out a perfectly sensible tokenomics system, but the cryptocurrency markets just don't pick up what you're putting down? How do you build a viable product in the face of this challenge?
Flexibility is good, Platias suggests.
"We were, to some extent, surprised about things that we saw. We had to revisit a bunch of our designs," Platias says. "One needs to think long and hard about how to design something before it comes into the world. But then, at the same time, collecting feedback and seeing how the market reacts is absolutely key."
Flexibility, in more practical terms, means being able to make calls like bumping up network fees in an effort to drive more value to Luna, or working towards more DeFi apps that can lock up Terra, to raise the floor price of Luna.
Baek Kim, senior associate at Hashed, one of the largest crypto investment firms in South Korea and an investor in Terra, suggests that educating users on how to best use this unfamiliar new currency product, also plays a role.
"It is not uncommon to see fundamentals and market reaction go other ways in crypto," he says. "We noticed that even with a robust growth in fundamentals, market behaviours of Luna were not correlated. We also learned that many did not clearly understand the mechanism behind Terra's fundamental growth and Luna's value accrue."
"The most questioned challenge to the crypto industry is the valuation framework of networks and validating it with real metrics. Luna is unique in that it allows you to do just that. We can import valuation framework from the traditional payments networks by presenting Luna cash flow as Luna earnings."
A paired stablecoin system like Terra and Luna, which is seeing wide use as an actual currency, presents a valuable opportunity to clearly lay out what should be happening on paper, and see what's actually happening to cryptocurrency in reality.
One of the main lessons for commodified currency designers could be that you can't separate the practical use of your product from the market response. In most other realms, a company's product will work fine regardless of what the markets are doing. But currency itself is a bit different.
It doesn't help, or perhaps it does, that the results to date are a fairly solid bit of evidence to confirm that yes, the cryptocurrency markets are irrational, and trading activity is largely dependent on a range of unpredictable ecosystem factors.
"We were somewhat surprised about the fact that the market isn't quite rational in the way it's behaved," Platias notes. "I guess that should have been a fair expectation for how crypto markets work. But at the same time, you know, it's certainly interesting to see that the rational approach and the actual result differs quite a lot."
"Probably, I think a lot of this comes down to liquidity. Luna, at the moment, only trades at a very small number of exchanges, which are mostly Korean, and basically, the number of retail investors who would be able to participate is, at the moment, quite limited. I think that's created some downward price pressure from some of the early investors locking in profit."
"So I guess that's probably the primary explanation for why the markets behave irrationally."
Telling the future
Another challenge awaiting currency makers, beyond the pitfalls of an irrational market, is the prospect of regulatory intervention. Libra was given a regulatory beatdown the moment it dared show its face, which poses a real risk for other stablecoin projects with global ambitions.
Platias doesn't expect Terra to imminently encounter the same issues as Libra though.
"Libra is an excellent case study for this," Platias says. "On the one hand you have Terra where we're small enough that, I think, no government has taken serious note."
Also, Facebook's connection to the Libra project "is very hard to sever, both practically but also in the mind of regulators", he points out.
"As a government, it's very reasonable to say, look, Facebook has 2 billion users – twice as large as the largest country on Earth. So if Libra kicks off and if they get even half of Facebook users to use it, basically you create a currency that is likely able to compete with every other single government, and couldn't take away the privilege of governments to issue currency – to control their money, which is one of the key ways in which governments wield power."
"I think it's natural and very expected that a company the size of Facebook scares governments a lot, and it grows a very, very hostile reaction. I think we're lucky not to have the baggage that Facebook is carrying."
"I think we'll be more cautious making sure that we don't openly compete with fiat currencies at the moment," Platias muses. "Rather we'll frame ourselves as an open financial system which is focused on payments at the moment, and is supposed to supplement fiat currencies. I think that can get us to a pretty large scale."
"And then after that, God knows."
Disclosure: The author holds BNB, BTC at the time of writing.