Chi Protocol vs Terra Luna
A fully LST backed stablecoin vs a non collateralized stablecoin
In this article, I will be highlighting the key differences between Chi Protocol’s USC and Terra’s UST. Let’s first explore the basics of these stablecoins:
What is Chi Protocol? Chi Protocol is an Ethereum-based protocol that issues a decentralized and capital-efficient stablecoin called USC. Its primary aim is to bring stability, scalability, and sustainable economic incentives to the decentralized finance (DeFi) ecosystem. USC is fully backed by LSTs (Liquid Staking Tokens) as collateral, and it employs a dual stability mechanism to maintain its price at $1.
What is Terra? Terra is an open-source blockchain that serves as a hosting platform for decentralized applications (dApps) and offers a range of developer tools. It utilizes a proof-of-stake consensus mechanism and relies on two primary assets: LUNA, which is the native staking token of the Terra protocol, and UST, a USD-pegged stablecoin that operates without the need for collateral.
These two projects have distinct approaches and goals within the blockchain and DeFi space, and understanding their differences is essential for anyone looking to understand the innovation brought by Chi Protocol.
The downfall of UST
In May 2022, the UST depeg event marked a significant and catastrophic moment in the crypto world, resulting in the loss of $18 billion in Total Value Locked (TVL) within just one week. This de-pegging crisis was primarily driven by a series of events, including intense UST selling pressure on the wormhole-UST/3CRV market and Terra Form Labs’ efforts to restore balance by withdrawing UST.
Throughout the collapse, the price of LUNA, which served as the primary buffer against UST’s volatility, followed up with the UST death spiral. There was a total supply of one hundred million LUNA before May 7. As the price of UST continued to plummet, more LUNA tokens were being minted to compensate for the instability. By May 11, one billion LUNA had been minted, followed by two hundred billion on May 12, and a staggering six trillion in just the initial hours of May 13.
UST Stability Mechanism — A Capital-Efficient, Collateral-Free Model
The UST virtual automatic market maker (vAMM) was made to ensure that 1 UST, regardless of its market price, maintained a value of $1 in LUNA. This AMM was based on the ability to correct any price deviations of UST through a UST-LUNA supply mechanism and on-chain arbitrageurs.
When UST’s market price exceeded the peg, let’s say at $1.10, arbitrageurs had the opportunity to buy $1.00 worth of LUNA and exchange it for 1 UST. Subsequently, they could sell the UST on the market, profiting from the difference between the UST market value and the target price of $1. This process would be repeated until the UST price returned to $1.
Conversely, in the situation where UST’s market price fell below the peg, say to $0.90, the 1 UST could be exchanged for $1.00 worth of LUNA and arbitrageurs would capitalize on the difference between the target price of $1 and the market value, repeating this process until the peg was restored.
Despite lacking intrinsic value backed by real assets, algorithmic stablecoins like UST possessed a unique and valuable property: capital efficiency. Unlike other on-chain stablecoins in the DeFi space, UST could be minted with just $1 worth of LUNA, whereas alternatives often demand users to deposit more than $1 worth of a different asset, such as ETH. The capital efficiency property is what pushed UST to achieve extreme growth, reaching billions in size and even surpassing DAI in terms of market capitalization.
Centralization of Terra
While UST was presented as a decentralized stablecoin, this was definitely not the case. Luna Foundation Guard, the centralized organization behind Terra, was directly involved in partially holding a mixed basket of assets and performing on and off chain swaps to manipulate the price of UST and LUNA.
Additionally, via withdrawals from the main pool on Ethereum, Terraform Labs weakened the stability of their own stablecoin. With reduced liquidity, it became even more easy to cause price instability, ultimately leading to the final collapse.
The Terra project’s failure highlights the fragility of algorithmic stablecoins, as seen in the earlier collapse of Iron Finance in June 2021. Both Iron Finance and Terra shared a similar stability mechanism and faced similar vulnerabilities.
Algorithmic and undercollateralized stablecoins have proven to be a failure since they must rely on positive transactional demand to fucntion effectively. Furthermore, their lack of intrinsic value makes them highly fragile, especially when subjected to volatile market conditions.
USC Stability Mechanism — Dual Stability Mechanism, Capital Efficiency and Full Collateralization
Chi Protocol’s primary objective is to scale the DeFi ecosystem with the introduction of USC, a stablecoin that generates a yield and preserves capital efficiency. It addresses the challenges associated with arbitrage-based stablecoins, like UST, by achieving full ETH collateralization, regardless of market conditions.
To achieve this, Chi Protocol has implemented an open-source Quadratic Automated Market Maker (AMM) on top of Uniswap. This smart contract autonomously interacts with the liquidity pool to maintain the price of USC at $1, while ensuring that the system remains entirely collateralized through reserves. Anyone can engage with the Quadratic AMM via the arbitrage contract (the main smart contract of Chi Protocol), making arbitrage easily accessible to every market participant.
The AMM operates as a three-token mechanism, relying on ETH, USC, and CHI. In response to any deviation in USC’s price from $1, adjustments are made either to the protocol’s reserves or the supply of stablecoins. These adjustments align the assets with the stablecoin debt in response to market dynamics reflected by the USC price.
For instance, if USC’s market price on Uniswap is above $1, say at $1.10, the arbitrage contract can mint USC, sell it for more than $1, and then buy ETH or CHI, depending on market conditions:
Excess Reserves
When the protocol holds an excess of reserves, the newly minted USC is initially exchanged for ETH. Subsequently, the ETH received from the swap, minus the arbitrage profits, is converted into CHI. The function caller receives the arbitrage profits in ETH, and the CHI amount received from the swap is burnt.
Deficit Reserves
In scenarios where the protocol faces a deficit in reserves, the newly minted USC is exchanged directly for ETH. The function caller is rewarded with arbitrage profits in ETH, and the ETH received from the swap, minus the arbitrage profits, is added to the reserves.
Example: Let’s consider an instance where 100 USC needs to be minted to restore the peg to $1, while the current price is $1.10. After minting new USC, the arbitrage contract sells 100 USC on Uniswap for approximately $110 worth of ETH. If there’s an excess of reserves, $100 worth of ETH is swapped for CHI, and the received CHI is burned. Conversely, if reserves are in deficit, the $100 worth of ETH is added to the reserves. In both cases, the function caller receives $10 ($110–$100) worth of ETH.
In the opposite scenario, where the Uniswap market price trades below the peg, say $0.90, the arbitrage contract can purchase USC for $1 worth of ETH or CHI, and burn USC or yield it based on market conditions:
Excess Reserves
If the protocol possesses excess reserves, the arbitrage contract gets the required ETH to restore the peg from the reserves. The function caller receives arbitrage profits in USC from the trade, and the USC obtained from the swap, less the arbitrage profits, is rewarded to the USC staking contract.
Deficit Reserves
When the protocol has a deficit in reserves, the arbitrage contract buys USC with CHI. The function caller is rewarded with arbitrage profits in USC, and the USC received from the swap, minus the arbitrage profits, is burned.
Example: Imagine that 100 USC needs to be purchased to bring the peg back to $1 when the current price is $0.90. If there’s an excess of reserves, $100 worth of ETH is initially exchanged for roughly 110 USC, and after the swap, 100 USC is sent to the USC staking contract. Assuming reserves are in deficit, $100 worth of CHI is swapped for approximately 110 USC, of which 100 USC gets burned. In both scenarios, the function caller receives $10 ($110–$100) worth of USC.
Now, you might be wondering what happens if there’s no transaction activity with USC and the price of ETH changes.
Even in the absence of transaction activity with USC (i.e., the USC market price is approximately $1), there are additional arbitrage opportunities designed specifically to realign the value of the reserves with that of the stablecoin debt. The greater the difference between reserves and stablecoin supply, the higher the reward provided to the arbitrageur.
Excess Reserves
If the protocol has excess reserves, the contract deducts the surplus value between assets and debt from the ETH reserves and exchanges it for CHI. The function caller receives a percentage of the CHI amount obtained from the swap, and the remainder is burned.
Example: Suppose the Uniswap market price of USC is $1, the reserves amount to $1,000,000, and the outstanding USC supply is worth $950,000. In this scenario, $50,000 worth of ETH is removed from the reserves and swapped for CHI. The arbitrage reward for the function caller is determined as a fraction of the CHI amount received from the swap, reflecting the surplus value. Assuming roughly $50,000 worth of CHI is received from the swap, the arbitrage reward for the function caller amounts to $2,650 (50/950,000 * 50,000). Finally, the remaining CHI from the post-arbitrage is burned.
Deficit Reserves
Conversely, when the protocol is in a deficit state of reserves, the arbitrage contract calculates the required CHI-to-ETH swap amount needed to close the gap between the stablecoin supply and reserves’ value. Once calculated, the CHI-to-ETH swap is executed and the ETH received is added to the reserves, effectively eliminating the deficit.
Example: Consider a situation where the Uniswap market price of USC is $1, the reserves amount to $950,000, and the outstanding USC supply is worth $1,000,000. In this case, approximately $50,000 worth of CHI is swapped for ETH, and the ETH received from the swap is added to the reserves. The arbitrage reward for the function caller reflects the deficit value and is determined as a fraction of the original CHI-to-ETH swap amount (arbitrage reward = $2,600 (50/950,000 * 50,000)).
Didn’t Terra have some crypto reserves in BTC?
Yes, it did, but it didn’t function in the same way as Chi Protocol. While Chi Protocol utilizes its reserves to back the stablecoin, UST did not follow the same approach. The introduction of BTC by the Luna Foundation Guard was intended as a defensive measure to safeguard the peg, rather than a method to mint UST and collateralize it.
In the case of UST, the only way to create new stablecoins was through LUNA burns, meaning that debt expansion initially relied on the growth of equity (LUNA) without a corresponding increase in assets, such as BTC. As they recognized that a fully algorithmic and non-collateralized stablecoin was likely headed towards a death spiral, they began exchanging their UST holdings for BTC. Unfortunately, this move came too late, as they would have needed to acquire almost the entire UST market cap in BTC to prevent a bank run to translate into an almost infinite minting process in LUNA.
In contrast to Terra, Chi Protocol is designed to ensure that the ETH reserves consistently back the stablecoin supply, even in the event of a market crash. How is this achieved?
Firstly, USC can only be minted using ETH deposits, while the arbitrage contract actively engages in buying and selling USC on Uniswap to maintain its price at $1 USD. This means that the growth of USC can only occur at a rate matching the growth of ETH reserves.
Furthermore, one would expect the CHI market to expand with the growth of USC, as CHI staking receives the LST yield from the reserves. Failure to do so would potentially result in CHI persistently trading at a discount, offering agents the opportunity to earn a higher ETH yield compared to traditional liquid staking tokens. However, the market dynamics will ultimately determine the yield of CHI.
Finally, Chi Protocol is not solely reliant on the demand for USC to respond to market changes. Through additional arbitrage-based mechanisms, fluctuations in the price of ETH automatically incentivize market participants to restore the system’s solvency. In a worst-case scenario, if the price of ETH experiences a sudden drop and the price of USC remains stagnant, the arbitrage contract will use CHI to purchase ETH and close the deficit
Decentralization in Chi Protocol
It’s crucial to emphasize that Chi Protocol operates as a permissionless and decentralized protocol on the Ethereum blockchain, with no central authority holding custody of any assets. This sets Chi apart not only from Terra but also from other protocols, such as Ethena Finance.
That concludes part one of our series comparing Chi Protocol to Terra. We hope you’ve found value in exploring the significant difference between these two protocols. Stay tuned for future posts where we’ll delve even deeper into the topic. If you have any questions, don’t hesitate to reach out on Discord.
Twitter: https://twitter.com/ProtocolChi
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Website: https://chiprotocol.io/
Docs: https://chi-protocol.gitbook.io/docs/background/chi-protocol
