Thread by @helloqrius

Spoon🥄feeding time: How does $Luna stable coins keeps its peg?

@terra_money designed an elegant system that ensures Terra stable coins always maintain their fiat peg. Since this is key to Terra ecosystem, let's take a gentle stroll walk through and see how it works.

Small print: this guide is way over-simplified to show the concept. No animals were harm in the production of this work.

First, the basics: keep in mind these 2 facts:
1. To mint a Terra stable coin like UST, you need to burn🔥 the equivalent dollar amount of Terra’s native coin LUNA.
Eg. to mint 10 UST & LUNA = $10 dollars, then you would need to just burn🔥 one LUNA.

2. you can also burn🔥 Terra stable coins to redeem the equivalent value of LUNA.
Eg. If you had 10 UST & LUNA= $5, you would get 2 LUNA for burning🔥 that 10 UST

These 2 facts works together to create arbitrage incentive ensuring Terra stable coins always maintain their fiat peg.
If UST goes high vs USD, traders sell UST , buy USD.
If it goes low, traders buy UST, sell USD.
Peg deviation gets bid down & narrow to stability.

Note: shrimps (likely you?🤷) don't work w/ enough capitals to profit from tiny peg deviations, it's a game for big fishes w/ their trading bots.

Example:

Luna = $10 & BigFish sees 1 UST = $1.10. BF reaches under sofa & got 100k Luna. To profit from this positive peg deviation, BF:
- Sell 100k Luna -> UST to get 1M UST (100000*10)
- Sell 1M UST -> USD to get 1.1MM USD, pocketing 100k USD knowing UST will fall back to 1:1 USD

Why is this? Other traders will bid down peg deviation, eg. other whales who don't mind trading on 1 cents or less difference given large enough amount of Luna. In comparison, fiat forex traders works regularly w/ 1/100 of a cent (basis point), dealing in 100s of $MM.

later, Luna = $10 & BigFish sees 1 UST = $0.95. BF decides to get back into Luna at a discount w/ this negative peg deviation:
- Buy 1M UST w/ 950k UST (1M*0.95)
- Buy 100k Luna w/ 1M UST

BigFish lean backs and thought: $150k round trip profit w/ my precious Luna stack intact… like Ice Cube sez "It was a good day". It sets alerts on peg deviation to look for next opportunity for arbitrage profit again.

These two sequences play out across exchanges, similar to Forex trading, and drive UST price back to peg value.

Substitute UST w/ your Terra stable coin of choice.
Substitute USD w/ your fiat currency of choice.
The concept applies.