Thread by @terra_money

1/ Extreme volatility produced a series of collateral effects across the Terra ecosystem, primarily derived from the short-term peg deviation of $UST and its impact on the volatility of $LUNA and levers of the Terra protocol. There’s a lot to unpack, so let’s dive in 👇

2/ Let’s start with the basics. The Terra protocol mechanism is quite simple:

When the supply of Terra stablecoins (like UST) goes up, the LUNA supply goes down.

When the supply of Terra stablecoins goes down, the LUNA supply goes up.

3/ As an algorithmic stablecoin network, Terra is akin to a decentralized, open-source central bank.

medium.com/dragonfly-rese…

4/ Assets (LUNA) and liabilities (UST) maintain parity by the Terra protocol acting as a market maker, inflating the LUNA supply during UST contractions and deflating the LUNA supply during UST expansions.

medium.com/terra-money/in…

5/ Terra primarily achieves this via the on-chain swap mechanism that is baked into the protocol. Users can always go to protocol to swap $1 worth of LUNA for 1 UST and vice versa. The system is designed to handle $20 million of redemptions (UST → LUNA) with a 2% spread.

6/The sharp price declines in LUNA were compounded by the sell-off of LUNA due to large amounts of liquidations on @anchor_protocol. During the market volatility, redemptions from LUNA → UST exceeded $80 million at times, forcing UST to trade at a discount on multiple venues.

7/ This is primarily because the on-chain swap spreads inflated to 7 - 9% during the worst period, making the classic time-based arb opportunity fundamentally unprofitable on-chain since redemption slippage exceeded expected profits from the arbitrage.

https://twitter.com/THORChain/status/1396703164787613697

8/ On Terra, the time-based arb can be accomplished via the on-chain swap protocol rapidly and (during normal market conditions) profitably with minimal slippage. Users simply swap LUNA → UST (elevating peg pressure on UST) and wait for the peg to normalize to make a profit.

9/ However, with swap spreads so large, the incentive to perform the time-based arb was curtailed significantly. At a spread of 500 - 700 bp for much of the day, the peg needed to be defended but the incentive to do so via the on-chain swap mechanism was low.

10/ Additionally, the “fast arb” opportunity, where users swap UST → LUNA, sell LUNA to a stablecoin not trading at a discount (e.g., USDT, USDC), and then buyback UST amplified both the directional movement of LUNA’s sell-off and the widening of the swap spread.

10/ LUNA’s sharper price fall compared to other assets is a function of Anchor building up leverage on LUNA/bLUNA with cascading liquidations leading to market sells of LUNA -- fueling reflexive stress on the UST peg.

11/ The “Death Spiral” of a bank run applied to Terra’s “seigniorage shares” style monetary policy is also not an apples-to-apples comparison.

https://twitter.com/aklamun/status/1396615719228424196

12/ Yes, short-term reflexivity is a characteristic trade-off of algorithmic stablecoin designs, amplifying directional movements both ways, particularly during times of market stress and liquidity issues as investors rush for the exits.

insights.deribit.com/market-researc…

13/ However, Terra is designed with explicit, real-time levers to combat the negative effects of endogenous collateral models (increasing tax rate on txs + cashflows to stakers) that traditional banking models cannot match.

14/ Plagued by the cumbersome nature of stress-induced decision-making of human agents in times of market volatility, it’s why central banks are exploring CBDCs. Algorithmic, calibrated adjustments of economic parameters are more effective than faxes and suits in meetings.

15/ Currently, LUNA can easily shoulder the outstanding liabilities of UST, it just needs time to recalibrate and confidence restored -- something that will take more than a weekend.

https://twitter.com/THORChain/status/1396703167740403712

16/ UST’s demand is not a function of speculation like many other algo stables either. Instead, it serves as a lynchpin for the entire ecosystem, where the demand for using Terra envelops the demand for UST.

17/ As long as we create useful applications that people use on top of Terra, a strong locus of demand will always exist.

https://twitter.com/THORChain/status/1396703174925250560

18/ And the use cases are already there. CHAI has more than 2 million active users in Korea, @mirror_protocol offers synthetic exposure to equities for people in financially disenfranchised regions, and Anchor continues to offer a high-yield savings vehicle.

19/ Terra’s protocol doesn’t formulate explicit collateral of LUNA backing the outstanding liabilities of UST either. LUNA just gets rekt more if the outstanding supply of UST is larger than the assets (LUNA).

https://twitter.com/aklamun/status/1396615724622356480

20/ The protocol will keep arb opportunities open. Even if the incentives to do so are dislocated during ephemeral market turmoil, the incentives eventually re-align and the system heals.

21/ UST’s discount and peg deviation are to be expected in the short-term -- especially with the scale of volatility experienced. It’s the price that LUNA stakers are willing to pay -- absorbing short-term volatility based on longer time-horizons as investors and supporters.

22/ We just went through one insane market shock. But guess what? The peg is gradually normalizing again and will continue to do so as volatility subsides. Remember, volatility at this scale is ephemeral, not permanent.

23/On-chain swap spreads are healing (ranging between 3 - 4%) as liquidations on Anchor wind down, arb opportunities on third-party venues incentivize buying UST, the market for LUNA becomes oversold and diamond hands, gloriously holding the line, glean a profitable opportunity.

24/ The drawdown in the price of LUNA, UST peg deviation, and collateral effects across the ecosystem in such extreme market volatility is about as intense of a stress test in live conditions as can ever be expected. We just experienced a black swan.

25/ Despite sharp dislocations, the on-chain swap spread is mending, UST peg is normalizing, and UST’s role as a centerpiece of demand for the Terra ecosystem has not changed -- buttressing the growth of the Terra economy as the system bounces back from distress.

26/ Designing open protocols that deterministically perform the functions of a central bank natively on the internet is impossible without stress tests. Without them, Terra would be subject to stagnant growth, little intrigue, and no technical innovation.

27/ Luckily, open crypto protocols are supported by thoughtful communities. They can be altered and improved based on the filtered information of a concerted effort of a decentralized community of supporters, vastly expanding their capacity to handle further stress.

28/ Just look at Jump Trading’s recent proposal, now live as prop 90, which will significantly dampen the downward reflexivity experienced during the recent market volatility. The proposal is already past the threshold quorum, with 100% of votes reporting “Yes.”

29/ Despite the extreme volatility, we will continue to build with only the highest aspirations for our community and onboarding the masses to a more inclusive and open financial system. Don’t count at Terra just yet, we’re only getting started.