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Huobi Research

UST Confidence Index: Building on Risks and Demands

Authored by Dave Chan, Researcher at Huobi Research Institute

Abstract

LFG and Terraform Labs together purchased a total of more than US$ 1.758 billion BTC and US$230 million AVAX into its reserves to back the market value of UST. Earlier, Terraform CEO Do Kwon revealed his plan to exchange his UST reserve for US$10 billion of BTC in order to back UST’s market value, driving up Luna burn rate to mint UST.

UST is the most widely adopted decentralized stablecoin. As far as UST adoption goes, the market now questions whether UST can sustain its 1:1 to peg to the USD. A depegged ratio will greatly undermine Terra’s confidence together with Luna, causing a potential Luna sell-off.

Therefore, the UST confidence level indicator was developed, quantified and modelled. The purpose of the indicator is to quantify how much extent UST is financially healthy in order to relieve the worries from investors, with the consideration of seven factors to quantify market risks and demands.

In section 2 of this report, a leading indicator role by UST confidence level is illustrated. It shows a pullback using supply dynamics between liquid circulating supply out of illiquid non-circulating supply.

1. Introduction

As at the date of this article, the Luna Foundation Guard and Terraform Labs purchased more than a net value of US$1.758 billion BTC and US$230 million AVAX respectively, with each holding an equivalent amount of UST pool to purchase US$100 million AVAX tokens. LFG now has a bitcoin reserve to UST supply ratio of 0.09973, meaning to which LFG has potential 10x purchasing power over acquiring more bitcoins to its reserves in the future.

This is one of the elements to incentivize UST utility and cultivate market confidence. Therefore, we quantified market parameters to model a UST confidence index:

Later in section 2, we will explain the ways to quantify and model UST’s confidence based on 7 factors of demand and risks. But first, we need to understand the relationship between UST and Luna.

Originally, without the reserve, the UST marketcap is backed by Luna burning or selling UST back to the Luna pool. The marketcap of UST is minted from the burn of an equivalent market value of Luna. Luna market cap is used to support UST value when market has more supply of UST than demand. Therefore, Luna’s circulating marketcap is used to support the market value of UST. When UST suffers from a price depegged ratio of 1:1 UST to USD, UST will be sold to Luna to cover the arbitrage value and restore 1:1 UST-USD ratio. Luna’s price and confidence is thus also affected by UST’s market confidence.

2.UST Confidence Index Building on Risks and Demand

Explaination:

Assumptions:

  1. Range of circulating market cap may deviate due to price action
  2. Assume AVAX value is added immediately to the whole LFG and Terraform Lab’s reserve
  3. Assume both of LFG & TFL purchases reserves at similar amount at a close timeframe, like what’s mentioned in Do Kwon’s tweets

The use of Terra Luna confidence level index can be used to assess the seven factors mentioned above based on the demand and supply of UST and Luna’s value as a whole. If there is an increased demand for burned Luna and UST, the level goes up. This could be considered as a HODL confidence level.

As seen from the charts, UST confidence level indicator acts as a leading indicator before the pull back of the Luna circulating marketcap twice. It detected aggressive vesting from illiquid staking pool to liquid circulating supply twice, thereby increasing circulating supply of Luna.

Considering its effectiveness, each of the seven factors within the quantification of the UST confidence indicator is described below:

2.1 Factor 1, Factor 2 and Factor 3

Factor 1 assesses the burn demand of Luna in the illiquid vesting pool, based on the perspective of

the whole burn on total Luna supply. This is to assess the confidence on UST with the demand to burn from illiquid non-circulating supply and if possible, vesting pool from early Luna investors. There we can assess whether early investors are burning Luna in exchange for UST in order to increase demand for UST and demands to burn Luna to reduce its supply. The equation for factor 1 is 1- (total supply/ genesis supply) = (total illiquid and liquid Luna burned) / total supply.

Factor 2 measures the confidence level in Anchor and measure the level of demand of UST locked in Anchor reserves and depositors, and to understand if much of UST will come from depositors and create a large supply to influence the UST peg. The equation is:

[UST marketcap of (Anchor UST reserve + Anchor UST deposit)] / UST marketcap.

Based on above charts, Luna suffered from a large price volatility during the period from 10 to 26 January 2022, owing to the market’s lack of confidence on Anchor protocol. Such lowering of confidence level of UST triggers a massive withdrawal of UST deposit from the market, affecting Luna’s face value and confidence on the Terra chain. Therefore, the second factor quantifies Anchor protocol’s influence on UST and Luna price level.

Factor 3 measures how much Luna is needed as a net demand due to staking mechanism — the (staked Luna supply marketcap — staking rewards) / circ. Luna supply. So, the real demand from staking less staking reward will be calculated as a portion of a circulating marketcap of Luna, where staked Luna is the illiquid circulating marketcap inside the net circulating marketcap.

2.2 Factor 4, Factor 5, Factor 6 and Factor 7

Factor 4 estimates the demand on Luna from cross chain activities, mainly from Wormhole. The equation is defined as Wormhole UST marketcap / UST marketcap, so that the demand for UST across other blockchain layers is quantified, as a portion of total UST marketcap.

Factor 5 and 6 are used to quantify the potential buybacks of UST or Luna in the event of a liquidity crisis. The governance proposal will be further discussed in section 3 of this report. Basically, the reason for acquiring such a large number of BTC and AVAX tokens is to strengthen the peg of UST to USD 1:1 ratio, and to restore the market confidence in Luna and UST in case of a depeg. As mentioned earlier, LFG and Terraform Labs have acquired up to a net value of US$2 billion BTC and AVAX tokens to restore from UST’s depeg. The reserve amounted to about US$2 billion can back up 11% of the US$16.7 billion UST marketcap, or 6.5% of the total of US$30.73 billion Luna marketcap. This means that even if UST is depegged to 0.9:1 UST to USD ratio, the LFG could slowly buy back the UST from the free market, until the ratio is restored to 1:1. Apart from that, if UST is algorithmically sold to the Luna pool, Luna marketcap will decrease while Luna supply increases. LFG could slowly buy back Luna to restore its market value to the previously bought UST to USD1:1 ratio.

3. Explanation of LFG’s Holding a Less Volatile Asset to Back up Confidence of Luna & UST

LFG’s holding bitcoin has two ways to restore market confidence of Luna and UST. The first is explained below. In a high volatility market, UST’s supply to market could influence UST’s peg. During a liquidity crisis, LFG’s could slowly buy back devalued UST back to its original 1:1 ratio with its BTC reserves, followed by a sell of UST back to bitcoin as a “reserve as arbitrage” after its ratio restoration. As a result, LFG has gains on arbitrage while restoring UST’s peg value. This is also mentioned as a way of keeping bitcoin as LFG’s long-term reserve in Jump capital’s governance proposal:

The second way to increase confidence in Terra chain is to buy back Luna or UST using a less volatile asset to avoid the volatility of Terra’s main asset. The reason to use bitcoin to restore its value is because, firstly, bitcoin is a less volatile asset than Luna, and can be used as a stabilizing tool to buy back Luna or UST to instill market confidence. Using bitcoin to buy back UST immediately after its depeg can prevent Luna being sold at large volatility.

While part of the Luna is used to buy back UST, the market sentiment draws down Luna’s circulating marketcap. Luna loses up to 75% of its market value after the depeg, therefore it is a more volatile asset than bitcoin. While Luna is the main holding asset for Terra’s chain, using its main holding asset to buy and sell for UST often and increasing the main asset portfolio’s volatility would not be advantageous to attracting investors as they look for a more stable price appreciation. Therefore, using a less volatile asset like bitcoin to buy back UST can avoid Luna’s maximum price drawdown, thereby restoring Luna’s market confidence and attracting long-term investors. Holding LUNA long-term would likely increase demand and drive its price up, adding long-term sustainability to its peg to UST. Therefore, using a less volatile asset like BTC to sustain UST’s peg and cultivate Luna’s confidence will be a great advantage for the Terra chain ecosystem.

4. Advantages and Disadvantages of Holding Assets in Reserves and Probabilities in the Future

Both Terraform Labs and LFG are holding assets to secure UST and Luna to increase the market’s confidence. While there are more possibilities for holding onto Terra assets it comes with pros and cons.

The first advantage is cross chain security and decentralization if BTC can be bridged to the Terra chain. Wallets need to be decentralized in a large extent so that the number of bitcoins can be considered as community- owned. LFG could use smart contracts to hold the portfolio of assets in different wallet addresses, so as to lower the probability of hack, enhancing cross chain security and decentralization.

The second advantage in holding assets as reserves is that it provides additional liquidity for the Terra chain, thereby attracting investors and developers. Buying AVAX and Bitcoin at lower prices or during a bear market allows a chance for the LFG community to take loans after unrealized capital gains at a margin. Although LFG is a nonprofit organization, Terra participants can also establish a new proposal on reserve or asset utilization. With respect to realized capital gain, if the community chooses to sell or liquidate their reserves on a profitable basis, funds can be drawn to invest or used to help develop other chain’s communities. For example, funds can be drawn to Apollo DAO as decentralized hedge funds. Both realized or unrealized profit with borrowed loans can also be used to buy back Luna as a burn demand to store the capital gains into the Terra’s own unique asset — Luna. Such capital can also be distributed to Luna validators as locked staking rewards with a definite unlock period, say six months until unlocked, thereby reducing the circulating supply and rewarding Luna validators with locked rewards or investors with capital gains. Apart from that, using the reserves to buy back Luna could resolve its supply shock tension. As seen from below figures, circulating supply is burned to less than half of the total original circulating marketcap to mint skyrocketing UST market value.

It is not sustainable in the long run to let investors realize there is not much Luna to be burned. If there is less than 10% of the circulating supply of Luna on the market, price could easily be affected since most of the supply is locked and not available on the market for any selling pressure or buying behaviors. Luna is now only 40% from the original marketcap to be reduced to less than 10% of the circulating supply. Therefore, to consider long term minting and burning relationship, Luna marketcap has to appreciate, so that more UST can be minted before the total circulating supply is reduced to less than 10%, where whales have a glimpse to use their net worth for future price manipulation. Luna supply will become more elastic and sustainable, relieving investor’s concern.

Moreover, using reserves as a cashflow generating machine would instill anchor’s confidence, thereby securing more UST deposit in anchor protocol and sustaining its yield rewards. As seen from below charts, 20% of the yield rewards amount up to 800% of Anchor’s yield reserve. While keeping the donation from Terraform Labs’ Luna to provide yield reserve is considered less sustainable long-term, using LFG’s bitcoin and other tokens such as AVAX or even ATOM & OSMO reserve is seen as a probable way out to providing 20% anchor yield. As different chains such as AVAX and OSMO is bridged to Terra, a 63% staking reward on OSMO and 9% staking reward on AVAX could increase market confidence on Anchor. As 20% of fund withdrawal due to yield reward stands at US$2.4 billion, Do Kwon’s ambition to acquire up to US$10 billion bitcoins can provide solutions to resolve Anchor’s yield. As Anchor’s UST deposit begins to flatten, acquiring US$10 billion bitcoins with 50% loan to value ratio buying 50% OSMO and 50% AVAX can provide a liquid staking yield of 17%. Liquid staking is launched on OSMO and about to be launched in AVAX. Therefore, the 50% loan deposit as staked tokens can be

refunded to LFG immediately, thereby not affecting LFG’s capital to restore UST’s depeg.

On top of liquid staking’s strategy on keeping its firepower to restoring UST 1:1 peg, diversifying Terra’s reserve to hold other different chain tokens can provide continuous demand over the market, leading to the appreciation of the capital gains of LFG’s portfolio and other chains. As tokens such as AVAX and MATIC provide burning mechanism from transaction fees, LFG acquiring such a large amount of tokens can initiate massive market buybacks on those chains. Therefore, such reduction on market supply will drive up the capital portfolio of LFG and other chains.

5. Conclusion

The UST’s indicator assists investors in evaluating the market’s current confidence in UST. Combining with other trading strategies, traders and investors will benefit from this unique asset. Much of the market dynamics are reflected into the confidence level and investors are advised to utilize their own skills to harvest the value of the asset.

In addition, Terra’s market confidence and investment opportunities come along with LFG’s and Terraform Labs’ purchase of BTC, AVAX and possible other assets in the future. Such acquisitions can provide more liquidity to enhance Luna supply elasticity, diversify Terra’s revenue streams and reserve risk portfolio to sustain developed Terra protocols and drive market demand for multi chain capital gains at an enhanced level of security and decentralization.

In the long run, Luna supply becomes more elastic, confidence in Terra is sustained, and more investors will hop on the Terra chain alongside Terra’s unique proposition to be the reserve currency in a decentralized economy, akin to the Fed’s USD.

Disclaimer

1. The author of this report and his organization do not have any relationship that affects the objectivity, independence, and fairness of the report with other third parties involved in this report.

2. The content of the report is for reference only, and the facts and opinions in the report do not constitute business, investment and other related recommendations. The author does not assume any responsibility for the losses caused by the use of the contents of this report, unless clearly stipulated by laws and regulations. Readers should not only make business and investment decisions based on this report, nor should they lose their ability to make independent judgments based on this report.

3. The information, opinions and inferences contained in this report only reflect the judgments of the researchers on the date of finalizing this report. In the future, based on industry changes and data and information updates, there is the possibility of updates of opinions and judgments.

4. The copyright of this report is only owned by Huobi Blockchain Research Institute. If you need to quote the content of this report, please indicate the source. If you need a large amount of reference, please inform in advance (see “About Huobi Blockchain Research Institute” for contact information), and use it within the allowed scope. Under no circumstances shall this report be quoted, deleted or modified contrary to the original intent.

5. The copyright of this report is only owned by Huobi Blockchain Research Institute. If you need to quote the content of this report, please indicate the source. If you need a large amount of reference, please inform in advance (see “About Huobi Blockchain Research Institute” for contact information), and use it within the allowed scope. Under no circumstances shall this report be quoted, deleted or modified contrary to the original intent.

About Huobi Research Institute

Huobi Blockchain Application Research Institute (referred to as “Huobi Research Institute”) was established in April 2016. Since March 2018, it has been committed to comprehensively expanding the research and exploration of various fields of blockchain. As the research object, the research goal is to accelerate the research and development of blockchain technology, promote the application of blockchain industry, and promote the ecological optimization of the blockchain industry. The main research content includes industry trends, technology paths, application innovations in the blockchain field, Model exploration, etc. Based on the principles of public welfare, rigor and innovation, Huobi Research Institute will carry out extensive and in-depth cooperation with governments, enterprises, universities and other institutions through various forms to build a research platform covering the complete industrial chain of the blockchain. Industry professionals provide a solid theoretical basis and trend judgments to promote the healthy and sustainable development of the entire blockchain industry.

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Blockchain industry top think tank, affiliated to Huobi Group.

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Huobi Research

Huobi Research

Blockchain industry top think tank, affiliated to Huobi Group.

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