Commentary on Terra USD’s BTC reserve
UST <> BTC Forex Reserve Pool
The Terra ecosystem has experienced tremendous growth recently. The market capitalization of UST grew from $180 million at the start of 2021 to almost $15 billion in Mar 2022, while price of Luna (LUNA) soared by 138-fold.
Recently, a lot of hype has circled around the Terra ecosystem with regards to Luna Foundation Guard’s (LFG) announcement of establishing a decentralized TerraUSD (UST) Forex Reserve denominated in Bitcoin (BTC) in Feb 2022.
A common criticism of algorithmic stablecoins is their reflexive nature and the hypothetical risk of a “bank run” scenario.
In normal times, the LUNA<>UST tokenomic structure is designed to keep the price of the algorithmic stablecoin steady at 1 USD. If the price of UST dips below 1 USD, users can purchase that UST at a discount and trade it for 1 USD of LUNA. The arbitrage play means the UST gets burned, helping bring the price of UST back to its intended peg of 1 USD.
However, under stressful conditions, UST may lose its dollar-peg when the market demand to swap out of the stablecoins outstrips the market’s collective willingness to hold them. The imbalance will result in tremendous selling pressure on UST and cause the price of the algorithmic stablecoin to deviate from its intended peg (The Death Spiral). A “bank run” scenario on UST would be a demise for LUNA, since LUNA’s fortunes are closely tied to UST.
The addition of BTC reserve pool is expected to mitigate that risk to some extent and will be used to backstop short-term UST redemptions during a “bank run” scenario, given that the BTC reserve pool can provide an additional avenue to maintain the peg in contractionary cycles that reduces the reflexivity of the system.
Instead of redeeming UST by minting LUNA, there is now the option to swap UST to BTC instead. Having this alternative to swap UST to BTC during a “bank run” scenario is extremely important. The BTC reserve pool serves as a “release valve” for UST redemptions, thus reducing the risk of UST selling off into The Death Spiral. This means that less total LUNA is minted into circulation as people may choose to swap to BTC instead during periods of contractions.
Below are the key pointers summarized from a proposal by Jump Trading regarding how LFG may deploy its BTC reserve to defend the UST peg, followed by an illustration of the reserve model.
- Asymmetric parameterizations: BTC reserve pool that facilitates rapid BTC liquidity to support UST during downwards peg deviations. E.g., 1 UST can be swapped to $0.98 worth of BTC.
- Users would then have to swap $1.00 worth of BTC to 1 UST once the crisis passes.
- The size of the reserve pool will be around $2.5 billion in BTC at launch. (Do Kwon is looking at $10B+ BTC reserve as the end goal)
- The BTC reserve should help to distribute liquidity in an emergency and express the stiff backstop of $0.98 for UST across different exchanges.
- There is an implementation of daily BTC redemption caps, suggested to be around 10–30% of total reserve size initially.
Significance of BTC Forex Reserve Pool
Over a longer time horizon, as UST experience many waves of expansion and contraction, more LUNA will be burned in aggregate. This increases the value of LUNA, which also contributes to the health of the stablecoin’s peg. The BTC reserve pool will be replenished with more BTC over time, due to the proposed asymmetric parameterizations of the BTC reserve pool.
Since the announcement, the spot price action of LUNA has been largely promising and signals restoring confidence to the Terra ecosystem. LUNA has returned a staggering return of more than 100% within a span of 20 days, outshining other major digital assets.
LUNA’s leadership over its peers coincides with the timing of LFG’s decision to create a BTC reserve pool as an additional layer of security for UST.
On the derivatives side of things, data on LUNA perpetuals displayed signs of bullishness ensuing the BTC reserve pool announcement.
Historically, crypto funding rates tend to correlate with the general trend of the underlying asset. The correlation does not indicate that funding rates dictate spot markets, but rather the reverse is true in most cases.
The theoretical understanding that negative funding rates translate to a bearish market sentiment is somewhere invalid in this case.
Prior to the BTC reserve pool announcement, funding rates on LUNA perps across multiple exchanges were quite neutral, with Open Interest (OI) at the lowest since the start of the year.
Following the announcement, OI on LUNA perps pullulated across exchanges, with funding rates diving into negative territories starting 23 Feb.
The negative funding rates suggested that the price on LUNA perps were deviating greatly from its mark price (spot), with LUNA spot price trending higher. This discouraged LUNA perp short sellers from holding onto their positions, and shorts liquidations were looming.
The point of inflection was when the negative funding rates were at the lowest and started turning less negative on 27 Feb (-0.18%), with many short positions being liquidated as spot price continued trending higher. The bullishness was confirmed as OI remained elevated even after the shorts were liquidated, implying that there was an offsetting amount of long perps positions being opened.
The Bitcoin Standard
The use of BTC reserve marks a paradigm shift in the tectonic crust beneath the ecosystem of stablecoins, with Twitter users screaming a new monetary era of Bitcoin Standard. Are we witnessing the start of a stateless universal monetary system?
Before diving into the topic of using Bitcoin as an asset reserve backing stablecoins, one must understand what gave rise to stablecoins and the various types of stablecoins that currently exist in the market.
Suffering from price volatility, cryptocurrencies don’t often make the perfect fit for the needs of the general public. Stablecoins prove to be a promising alternative as they complement crypto features with the stability of established fiat currencies.
Stablecoins are classified as asset backed stablecoins and non-asset backed stablecoins (seigniorage coins). Like its name suggests, the first type can be backed by fiat, other cryptocurrencies, or commodities. Asset backed stablecoins derive their intrinsic value from the backing of such real word assets.
Seigniorage-style stablecoins (aka algorithmic stablecoins), on the other hand, make use of a Seigniorage Shares system and utilizes special algorithms to manage supply to keep prices within their intended peg.
An ideal stablecoin, be it asset backed, or non-asset backed, should be decentralized, stable and scalable.
Although they are stable and somewhat scalable, asset backed stablecoins (such as USDT) expose users to the volatility of the underlying assets and the risk of censorship, as they are often issued by centralized entities.
Ultimately, DeFi cannot follow through with its cardinal rule of decentralization while using stablecoins that can be censored by any one entity.
Meanwhile, algorithmic stablecoins are often decentralized and independent of any central authority, given that there is no reliance on collateral/backing. This decentralized nature of algorithmic stablecoins is also the very reason that gives rise to the unstable nature of their prices. Algorithmic stablecoin prices fluctuate around their pegging through periods of supply expansions and contractions.
By introducing the BTC reserve for UST, LFG has established a hard stop backing for UST (at $0.98) using the decentralized, digital gold. This gives UST the stability which is lacking in many algorithmic stablecoins in the market and bypasses the risk of censorship that is inherent in asset backed stablecoins issued by centralized entities.
Also, the size of the BTC reserve pool is public and on-chain, this promotes UST’s credibility and instill confidence in users. Surely the LFG does not want the kind of attention that Tether had gotten a few years back.
The establishment of the BTC reserve pool backing UST is just part of strategic plan in making the UST interchain.
Discussion on UST and Value of LUNA
Similar to financial assets, the value of a US dollar can be dissected into both its intrinsic and extrinsic value.
The end of the Bretton Woods system in the 1970s had brought the dollar’s convertibility into gold out of existence and introduced the free-floating exchange arrangement of currencies between nations. Since then, most countries have adopted fiat monies that are freely exchangeable between their currencies.
Fiat money is a currency that lacks intrinsic value and is established as a legal tender by government decree. Being the fiat money it is, the US Dollar is backed by the creditworthiness of the US government, which is somewhat conjectural as we are cognizant of the unlimited printing power at the disposal of the Federal Reserve.
So, what makes the US dollar the reserve currency of the world?
Economic size, deep and liquid capital markets, military might, and existing networks/alliances are some of the tangible, measurable properties that contribute to the extrinsic value of the dollar. These factors are products of US’ geoeconomics power, which support the dollar’s hegemony in the modern world.
By applying the above mental model, one can gain a methodical way of assessing LFG’s grand strategic plan in making the UST interchain.
The use of BTC reserve pool to support UST during downwards peg deviations essentially contrive an artificial intrinsic value of $0.98 for every 1 UST. The differential between the market price and its intrinsic value of $0.98 represents the extrinsic value that the market is pricing in for UST. This extrinsic value comes from the perceived use cases of UST within the Terra ecosystem and beyond.
Only way for UST to survive and sustain in the long run is to ensure that the market demand to swap out of UST does not outweigh the market’s collective willingness to use/hold them.
Below is a framework by Neel Somani, to understand the sources of demand that drive the extrinsic value of UST. I chanced upon it after I have completed writing this commentary, and I decided to add it to this piece because I find it so powerful in explaining what I am trying to deliver here.
Please do have a read on his piece, it is fascinating. Here is the link to the article.
And Do Kwon has highlighted this way back in 2018.
The UST master plan is to increase adoption and build a robust ecosystem that provides multiple use cases for the stablecoin.
Here is the breakdown on the first part of the plan; increasing demand for UST.
Often, many stablecoins are often over-collateralized (think 100% for USDC and USDT while 150% for DAI) and this is very capital inefficient in terms of scaling.
Increasing the demand floor (adoption) would help to reduce the cost of issuing UST, essentially bring down the collateralization ratio to below 100% (Refer to solvency rule).
What would be a better way to increase UST adoption besides offering ~20% APY on stablecoin farming? This is where Anchor Protocol comes in, with its high APY a vampire attack and draining liquidity from every stablecoin farm on-chain.
Everyone knows that the ~20% APY on Anchor Protocol is not sustainable and it would be adjusted to a dynamic rate in the long term, but it is not a matter of concern for UST at all.
And here comes the breakdown on the second part of the plan; providing multiple use cases for UST.
The reason why Terra is more resilient than other algorithmic stablecoins is because there’s a vibrant economy that’s being built on the Terra blockchain. & I think that’s the best defense algorithmic stablecoins can have against death spirals. — Do Kwon in 2021.
To ensure that there is a steady increasing, everlasting demand floor for UST, the ecosystem supporting UST must continue to expand and provide legitimate use cases for the stablecoin.
To summarize, the BTC reserve increases the intrinsic value of UST. While the Anchor yields will decline over time, as more protocols launch on Terra, we’ll see staking yields climb.
The growth in utility (DeFi yield) from new use cases must be able to compensate the fall in the Anchor earn rate. This way, more LUNA would have to be burnt to mint UST into circulation to satisfy such an increase in demand.
Without this, the solvency rule would not balance, and UST would fall into the Death Spiral.
So, what is cooking on Terra ecosystem and beyond?
Here is a nice Twitter thread on Terra ecosystem for the Threadoors, by 0xCha0s: https://twitter.com/0xCha0s/status/1503195854366289920
First Medium article from me and I am looking forward to sharing more on my DeFi journey.
Apologies in advance as I am not really a good writer.
Appreciate any constructive feedback and discussion in the comment section.
Have a great week :)