Everyone and their mom is talking about LUNA and UST. What's happening?
Bitcoin and the Anchor Rate
On the 14th of March 2022, Do Kwon, founder of Luna and a former Stanford University computer science grad announced on twitter “UST with $10B+ in $BTC reserves will open a new monetary era of the Bitcoin standard. A P2P electronic cash that is easier to spend and more attractive to hold.”
On the 22nd of March 2022, Luna purchased $125m worth of Bitcoin for its reserve. This was the starting point for the $10B bitcoin bet on stablecoins and Terra’s transitioning from an algorithmic stablecoin to a bitcoin-backed stablecoin.
Ask not what Luna can do for you, but what you can do for Luna
In this article, I’ll try not to be biased and just give the facts as they are. I’ll try to explain the anchor rate as it is, the terra ecosystem, some ponzinomics, concepts of stablecoins and the advantages/disadvantages of what the Terra Protocol is about to do (or should i say has started doing?).
To fully understand what’s happening, we first need to understand the foundation of the Terra protocol. We need to understand how and why Luna and Terra are intertwined.
Terra is a layer-1 open-source blockchain protocol with smart-contract functionality that works as a payments-focused fintech ecosystem using algorithmic stablecoins, the stability of whose value is maintained by internal algorithms while Luna is the native token of Terra, a blockchain developed by the Korean firm Terraform Labs.
The objective of the Terra blockchain is to create stablecoins, tokens designed to combine the decentralized nature of cryptocurrencies with the stability of fiat money. LUNA is a key piece to this system and is described as a staking or protocol token that absorbs the price volatility of Terra stablecoins. Hence, ensuring that supply and demand for it are always balanced.
The blockchain implemented a dual token system between the stablecoin terraUSD (UST) and LUNA to achieve this aim. USTs are minted by burning LUNA and can also be swapped for LUNA. For example, if the UST value goes above $1, the equivalent value of LUNA would be burned, which mints more UST, making it less valuable. Whereas, if the UST price drops below $1, they are swapped for LUNA which in turn makes UST more valuable. Luna and UST rely on each other for stability. Burning LUNA coin is essential to this dynamic as it incentivises users by giving LUNA its value and UST its stability.
As the TVL of the Terra ecosystem grew, there came the quest/zeal to become a leading ecommerce stablecoin payment and DeFi service provider. To incentivize the incoming adopters of DeFi, Web 3.0, and non-fungible tokens (NFTs) on the ecosystem, in came “Anchor Protocol”.
What is Anchor Protocol?
Anchor Protocol is a fixed yield platform with borrowing yields and frictionless access. decentralized money market built on Terra that offers UST depositors a stable 20% annual percentage yield (APY). Borrowers can collateralize UST loans using bonded LUNA (bLUNA), Terra's native token. It works like a regular bank account. Users can take out loans and deposit savings to earn a yield.
Anchor Protocol has an interest rate objective that's known as the Anchor Rate. In order for the desired Anchor Rate objective to be reached, the smart contract will intuitively divide the block rewards from the bAssets that are serving as collateral. These rewards are divided between the depositor and the borrower. It was founded to increase demand for Terra's native stablecoin UST, by offering a 20% yield to lenders. This allows traditional finance participants to integrate with DeFi because Anchor has an API that fintech platforms, exchanges, and B2B businesses can integrate and offer interest-bearing savings accounts. Anchor also serves as an inter-chain source of liquidity for users looking to borrow various layer-1 native tokens. It establishes a benchmark for a fixed and unlevered USD-pegged yield within crypto. Yields earned from the borrower's interest payments and the staking rewards of the collateral they deposit to borrow are distributed to stakers.
But can this 20% be maintained forever?
Any normal investor on hearing about the Anchor rate would first ask “How can this be maintained? Is this even real?
Isn’t that insane? If that’s just a brazen, degenerate and impulsive bet from Kwon or a sincere conviction in his project, time will tell. Right now, let’s analyze why people feel the Anchor rate is pure ponzinomics (and why others feel it’s not).
Remember I said no BS? I’ll try to stick to that.
Red pill, Blue pill
The terms "red pill" and "blue pill" refer to a choice between the willingness to learn a potentially unsettling or life-changing truth by taking the red pill or remaining in contented ignorance with the blue pill.
I’ll state the facts and leave you to decide which pill is the red pill and which is the blue pill. I’ll be quoting some gigachads that definitely know more than I do. It’s all a learning process. You learn from me as much as I learn from others. It’s a cycle, so let’s get on with it!
There have been a lot of concerns about the ability of the UST to maintain peg and the most vocal of them all, is @algodtrading. He likens it to a ponzi. UST maintains stability through the simple swap mechanism that I explained earlier. If UST becomes less valuable than $1, buyers can scoop it up and use the swap mechanism to sell for $1 hence, making a profit. This is done until the peg is regained.
If you’ve read this far, I can assure you that what you’re thinking, is right!. The $12b UST in circulation, is backed only by $luna orderbook (though, stablekwon is trying to change that but we’ll get to that aspect later). As algod argues, UST can probably sustain a $1-2b market sell order but what happens if there’s more? Do people just assume that demand will infinitely keep exceeding supply? What if supply exceeds demand? What happens if people start mass panicking and maybe start redeeming UST for LUNA and then for USDT?
There’s a high probability that if supply should at any point fully exceed demand, that it would be a race to the bottom and LUNA order books would not be able to absorb the massive selling pressure from UST. Of course, there is a cap on the daily amount of UST that can be redeemable for LUNA but don’t you think it’ll create more panic? Being forced to hold a plunging asset because of a cap might seem dangerous and somewhat predatory to some and most will probably start depositing to CEXes to sell.
UST liabilities currently equate to 45% of circulating LUNA market cap and with such rapid UST adoption, this rising floor is a vector of vulnerability.
UST deposits are redeemable for LUNA and LUNA pays depositors 20% via the Anchor rate. But the real issue here is that depositors are not creating organic value for LUNA. It is true that it benefits from UST adoption through swaps and usage fees but we can’t expect the stake rate at 6.7% and borrow at 19.5% to last forever. Common now, even my gran at home, knows it can’t!
So, why hasn’t the rate been lowered?
It hasn’t been lowered because it’s the mechanism allowing UST to be re-collateralized. This is exactly why algod says it’s just a ponzi. Normal stablecoin rates are 1-3% but the Anchor rate offers about 7-20x more than that!. Like all ponzinomics, this has allowed a ton of demand to come flooding in and increased confidence.
The Luna Foundation Guard (LFG) has started using this insane demand to shore up their LUNA reserves by effectively swapping LUNA at market price from their treasury by burning it for UST and then swapping it for Bitcoin. The LFG spent $450m to shore up the yield reserves of Anchor so as to give them at least another 6 months of runway.
It seems to be working, as it has allowed them to generate an additional $1.2b in bitcoin collateral on top of their $1b raise. With a market cap at $15b and $2.2b in collateral, this has increased the collateralization ratio of UST to 14.6% as of today. If LFG were to do this again with the $10b @stablekwon mentioned, the CR would go up to 49% and all of a sudden, you have a large portion of UST collateralized.
With such collateralization, we can start lowering the Anchor rate to make it more sustainable and relative to the market. So, as more protocols and use cases for UST are developed, they can lower the rate and offset demand lost from Anchor deposits. It might slow down the demand for UST but as @floodcapital suggested, there can be a bullish case here as the Anchor rate bootstraps the entire ecosystem and allows Terra to re-collateralize UST.
Using tradfi terms here, we know that increasing deposits at a bank doesn’t increase a bank’s valuation nor should UST deposits. So, burning UST for LUNA shouldn’t create value as well. It just engineers higher LUNA prices through supply and demand mismatches.
But hey, before we start feeling a little too bullish, what are the dangers or advantages associated with collateralizing a stablecoin (UST) with a volatile coin like $BTC? Isn’t this also risky? Isn’t this like other algorithmic stablecoins that failed?
Yes, it can be argued that the reason $UST needs a $BTC reserve is to reduce risk but don’t people use these stablecoins because they feel it has almost no risk? Why then is it to be collateralized with yet another highly volatile asset? Well, this part is the part I’ll leave to the giga chads to answer. Find their tweets here , here and here. So, will $UST backed by $BTC change the stablecoin market forever? That is left for you to answer.
Sure, algod has been like a lone voice rebelling against a hopium-filled retail cult but if what he’s saying is true, a late implosion for LUNA would be catastrophic for the ecosystem. Capital would be reclaimed for more productive users as systemic risk contagion sends us back to the long and dreadful crypto winter.
UST is a liability of LUNA.
BTC can become a liability of UST.
Usage fees and LUNA renting of UST for swap is the only value creation.
Burning of tokens is not value creation.
Insolvency risk increases as UST grows but LUNA price doesn’t.
Watch out for UST backing per LUNA market price as that’s where one would expect non-linear price moves.
Narratives change quickly in the crypto ecosystem. Once the war chest is exhausted, hell can quickly break loose.
Using Bitcoin as reserve, can reduce the risk level of both UST and LUNA by several magnitudes. If it does so, then it totally decimates a ton of the bearish scenarios.
If things work out well, the Luna(tics) can on-board the Bitcoin maxis and other Defi ecosystems en masse.
To me, this all boils down to the end game. As much as there are some bullish innovations to be seen in this whole UST scenario, no one knows the fate that might befall us tomorrow. The largest depeg risk still remains the redemption issue and the Anchor rate. If there is no sustainable end state, then, it would all come tumbling down. To be bullish UST or not, one has to truly understand the tradeoffs involved as there are as much risk involved as there are upsides.