This Crypto Just Sold a Billion Coins To Avoid a 'Black Swan' Event

In this video clip from "The Crypto Show" on Motley Fool Live, recorded on Feb. 23, Fool contributors Jon Quast and Travis Hoium discuss the public blockchain protocol Terra (LUNC -3.18%) and its recent sell-off to avert a very rare event with significant consequences.

Jon Quast: What's so interesting here is the real-world utility. What is it? It is the stable coin, TerraUSD. This is supposed to always be worth one U.S. dollar. What is the advantage? Why not just use a dollar? Well, if you're using a dollar online, the credit card purchases are probably getting hit with a 3% fee. By contrast, TerraUSD can reduce that to under 1%. There is incentive here to use this coin, especially if it can be a stable coin.

The way that it does this, the way that it maintains it without having reserves is that it has this other coin called LUNA. As the value of a TerraUSD deviates from $1, you can switch back and forth from LUNA. New coins are burned and created in the process, and what this does is it regulates supply and demand of the TerraUSD so that the supply is always in line with the demand so that the price is at one dollar, which is really interesting, it has worked so far over time. What's going on? The founders here talking about, we are worried, we are aware of the possibility of a "black swan" event. You're familiar with this term, Travis, right?

Travis Hoium: Yeah. Very much an outlier event.

Quast: I believe the term was coined by Nassim Nicholas Taleb, the author of Antifragile, also the author of Black Swan. I believe he coined the term. Basically, it's a very rare event with significant consequences. I think we can summarize it that way. There are scenarios. Let's say that the entire cryptocurrency market is just tanking.

For whatever reason, something happens and there's not a single coin out there that is up, they're all dropping by double-digits in a short amount of time, in that scenario, there's theoretically an arbitrage opportunity for TerraUSD, but nobody is willing to take advantage of that opportunity because the entire cryptocurrency world is falling apart. In that scenario, the stable coin will lose its peg, and in so doing, faith in the entire system is lost. If it can't maintain that one-dollar peg, then nobody is going to have the incentive to use it.

This has never happened so far, but it could theoretically happen. The founder is here saying, "You know what, let's have some reserves at hand that we can deploy to remedy the situation if this one in a million situation happens." Just what they were able to do, they were able to sell a billion of LUNA tokens. Now, if you hold LUNA tokens, that probably sounds a little bit unsettling because all of a sudden there's all these tokens out there held by these private investors.

Well, they are required to hold them over a four-year vesting period. They're not just going to go ahead and dump them onto the market tanking LUNA's price, this has a time element in place. There's time to grow this whole ecosystem here. With this billion dollars, Terra's LUNA Foundation Guard will be buying Bitcoin (BTC -1.89%) and other altcoins and holding them in reserves.

They are fundamentally different from the U.S. dollar government-backed currency. The thought process here is if we have one of these outlier events, we're going to have funds that are going to be diversified and ready to put to use to maintain faith in the system and TerraUSD at a dollar.

Hoium: My question for this is if the black swan event is that there's a correlated sell-off in all of these digital crypto assets, and your answer is to buy assets that would also be correlated with that sell-off. That seems a little strange to me.

The argument here, I think from their perspective would be Bitcoin is a hedge. But we've seen over the last six months that Bitcoin really trades more like a high-risk asset like a growth stock like the board is supposed to. Inflation is going up, the value of Bitcoin is going down. If it was a hedge, we should see the opposite happening.

On the same token, this is what the financial crisis in 2008-2009 taught us, was that great you own bonds instead of all stocks, but stocks were down and bonds were down. There was no safe place, there was no uncorrelated asset. I think that's just an interesting thing to point out with this, that I understand why they think this would be a good hedge or backstop, but if Bitcoin drops from where it is today to $5,000, then I don't see how it answers the problem at the end of the day.

Quast: I think that's really fair, Travis. To be honest with you, I don't know if they are thinking about other black swan scenarios in this as well. The reasoning, the argument that I read was that the entire cryptocurrency market is tanking, and that is the black swan event that we are hedging for. I don't know if they have other ones in mind because to your point, this does seem a little bit like circular reasoning.

If the entire thing is tanking, then wouldn't Bitcoin itself be tanking. I think that's really fair. I guess at the same time, Bitcoin probably wouldn't be worth zero. They'd still have some firepower to work with to get their peg back in order, but it is an interesting point and a point well taken there.

Hoium: Their answers to regulators have been interesting as regulators try to dive into what they're doing and how they are pegging versus other stable coins are pegging.