Thread by @terra_money

1/ A great video clarifying by YouTuber CryptoCents on some of the misconceptions around TerraUSD ($UST) and how the broader Terra economy works.

Check out his profile and give this man a follow #LUNAtics.

2/ “LUNA is not an asset that explicitly collateralizes UST -- it simply absorbs the short-term volatility of UST.”

UST is backed by the demand for the Terra ecosystem, not explicitly the asset price of LUNA collateralizing the system.

3/ Hence, why an FDNV of LUNA approaching the outstanding liabilities of circulating UST does not trigger a “death spiral” bank run characteristic of traditional endogenous collateral models.

4/ The UST algorithmic peg is a function of the parity between the off-chain liquidity of LUNA/UST and the on-chain liquidity parameters for the redemption of UST/LUNA. Let’s run through an explanation below 👇

5/ The on-chain redemption capacity (i.e., minting/burning LUNA/UST on the protocol) is roughly $20 million at 2% spreads. At trade sizes larger than 20m, the slippage increases past 2%. The slippage parameter increases at an exponential rate.

6/ Because of the on-chain redemption capacity’s limit of around $20 million at 2% spreads during recent volatility, it was insufficient to absorb the cascading sell pressure from LUNA (amplified by bLUNA/LUNA liquidations on Anchor), especially as spreads expanded.

7/ Note -- the TFL research team will also be publishing an analysis of the Anchor cascading liquidations in the coming days.

8/ Larger on-chain spreads = further dilution of LUNA and reflexive price action on off-chain trading venues for both LUNA and UST.

9/ However, with Prop 90 from Jump Trading, the on-chain redemption capacity will ratchet up to $100 million at lower spreads, which would have alleviated the cascading sell pressure from LUNA on the UST peg significantly.

10/ It may seem obvious at a cursory glance to simply raise the on-chain liquidity parameters capacity, but the reason that the on-chain redemption capacity cannot trivially be raised is security against oracle manipulation.

11/ Outlined in Jump Trading’s original “On-Chain Liquidity Parameters” proposal below.

agora.terra.money/t/terra-on-cha…

Off-chain liquidity > On-chain liquidity for the system to remain robust against oracle arbitrage manipulation.

12/ This means that the liquidity of LUNA/UST needs to be larger outside of Terra’s blockchain on third-party venues like Kucoin, Curve, etc than via the on-chain swap mechanism baked into the protocol.

13/ The reason is to reduce the attack surface by oracle manipulation of whales while commensurately maximizing the elasticity of Terra’s stablecoin float -- it’s a careful trade-off.

14/ From Jump:

“Conservative on-chain parameters can help protect the system from being bled by arbitrage or manipulation, but can also put a pretty strong cap on how much the float of Terra stablecoins can be increased/reduced by in a given time horizon.”

15/ As off-chain liquidity for LUNA/UST increases, it becomes necessary to calibrate the elasticity of the UST float while maintaining robust security assumptions.

16/ However, let’s run through an example when the liquidity on-chain > liquidity off-chain, pretending 1 LUNA = 1 UST. Note, we will not explicitly account for slippage or trading fees.

17/ For a whale trying to manipulate the oracle price, they would:

- Bid off-chain reference markets up without too much size, pushing up the LUNA/UST oracle price.

- Sell LUNA --> UST on-chain at the increased Oracle price.

18/ - Dump LUNA on the off-chain reference market to bring the Oracle price back down.

- Buy LUNA on-chain (UST → LUNA) at the lower Oracle price rate.

- End up with more LUNA, diluting other holders.

19/ At a more intuitive level, the following steps are executed in sequence:

Raise LUNA price off-chain -> Sell large amount of LUNA on-chain at high price -> Lower LUNA price off-chain -> Buyback LUNA on-chain at the reset lower price.

Make profit, rinse and repeat.

20/ Without an on-chain limitation, the above trade is profitable as the whale can go from off-chain manipulation → on-chain profit repeatedly. With an on-chain limit, however, the size at which the whale can go from UST → LUNA has an upper bound without incurring extreme loss

21/ As a result, manipulating reference market prices off-chain becomes unprofitable. From Jump:

“Having higher liquidity off-chain vs on-chain makes it so that the above attack is unprofitable as it takes more capital to move the price than you can try to exchange on-chain.”

22/ If there was no on-chain liquidity limit in a given epoch, oracle manipulation would be possible to execute repeatedly, dismantling the system’s on-chain security -- diluting LUNA holders continuously.

23/ Hence, why on-chain liquidity parameters are configured to maximize the on-chain redemption capacity (and stablecoin float) WITHOUT sacrificing security.

24/ In the attack described above, if on-chain liquidity < off-chain liquidity then to manipulate the prices of the oracles on-chain, it would cost more to move these prices up and down than the profitability of the attack described.

25/ To accomplish this, the off-chain liquidity curve needs to be adjusted to maintain parity with the on-chain liquidity curve where the on-chain curve is always equal to or slightly more conservative -- rendering oracle mispricing attacks fundamentally unprofitable.

26/ Jump’s proposal accomplishes this via the following:

Expanding the on-chain base pool size (denominated in SDR).
Reducing PoolRecoveryPeriod Parameter (effectively enabling on-chain liquidity to operate at reasonable slippage that scales to the off-chain liquidity ADV)

27/ Since Jump’s first proposal, where the parameters were updated to $20 million in redemptions, the off-chain liquidity of LUNA has increased roughly 30X. As a result, on-chain parameters need to be scaled up as well -- accounting for increasing off-chain liquidity.

28/ Without sufficient on-chain liquidity conservatively matching the expanding off-chain liquidity, LUNA cannot sufficiently absorb extreme volatility, dislocating the UST peg.

29/ Had Prop 90 already been live during the past weekend, volatility from excessive LUNA liquidations on Anchor would’ve been adequately absorbed on-chain, maintaining the UST peg.

30/ Silver lining -- the 30X increase in off-chain liquidity is representative of Terra’s growth and expansion across CEXs and DeFi. It’s a positive sign. Subsequently, calibrating the on-chain liquidity parameters to match that growth comes to the forefront.

31/ Understanding how various levers of the protocol and its ecosystem of apps interact at such a scale crystallizes during excessive volatility that spotlight points of pressure in the system.

32/ As the UST peg normalizes, this is a function of the on-chain liquidity absorbing the volatility off-chain gradually, and as we said, will not happen overnight.

33/ With Prop 90, Terra’s stablecoin elasticity can sustain the extreme volatility experienced much more rapidly, perhaps even without any peg dislocation at all.

station.terra.money/proposal/90

34/ As off-chain liquidity grows, it’s important to work deliberately via governance to maintain the parity of the on-chain parameters relative to off-chain liquidity.

35/ In fact, we could even potentially let this parameter adjust algorithmically based on various parameters like volatility.

Back to work.