Thread by @danku_r

The @LFG_org is creating a #Bitcoin reserve to defend the peg of @terra_money stablecoins like $UST.

The question is: How does it work & what effect will it have on $LUNA, the Terra ecosystem, or even $BTC?

Let´s check the governance proposal by @jump_ & make a deep dive 👇🧵/n

1/ First, and very important: Neither the #Bitcoin reserve nor LUNA is backing UST as a form of collateral.

Unlike other stablecoins backed by fiat or over-collateralized by crypto assets, UST is fully algorithmic.

2/ UST maintains its peg via a system of arbitrage & protocol mechanisms. LUNA serves as a reserve asset in this process.

Market participants can mint UST by burning an equal amount of LUNA in dollars. Vice versa, 1 UST coin can be burned for the dollar value in LUNA.

3/ Thus, if the demand for UST exceeds the current supply, UST will trade off-chain over the peg. Let´s say it is at $1.01

Arbitrageurs have the opportunity to burn LUNA on-chain, mint UST, and take the difference to the peg as profit on the open market.

4/ Of course, if UST trades under $1, the process goes in the other direction.

Arbitrageurs are incentivized to burn UST to restore the peg. They buy 1 UST for less than a dollar & get 1$ value of LUNA.

To take the profit, the arbitrageur sells LUNA on the open market

5/ In other words, LUNA works like gold that you mint into coins that are more interesting to spend as a medium of exchange.

The coin has still gold in it. Thus, you can melt it back down to gold. UST is basically still LUNA & has inherent value.

https://twitter.com/danku_r/status/1500089339384152064?s=20&t=0LrDeCDnQFSZDbI5_B6gRA

6/ Of course, this leads to a positive feedback loop for LUNA.

The higher the stablecoin demand, the more LUNA disappears on the supply side.

With a regular demand for LUNA based on the value of the Terra blockchain, the price will most likely increase.

7/ This upside is the incentive for holders and validators, as they also take the risk to absorb demand volatility for stablecoins.

If the demand for stablecoin contracts, LUNA will be minted. With stable demand, the price of LUNA will fall under pressure.

8/ And here comes the problem.

By design, the price of LUNA is not crucial for the Terra protocol to ensure the peg of UST; Arbitrage is still possible.

Nevertheless, there is a psychological connection between the performance of LUNA and the peg of UST.

9/ This is the so-called death spiral.

If the demand for UST contracts, LUNA might fall in price.

If the market loses trust in LUNA due to price, it might lose trust in UST & sell. To hold peg, LUNA is minted. You already see where this is going.

https://twitter.com/WestieCapital/status/1496223640534323200?s=20&t=0LrDeCDnQFSZDbI5_B6gRA

10/ And here is where #Bitcoin joins the game. @LFG_org states:

"[Bitcoin] functions as a release valve for swelling pressure to exit UST to LUNA on-chain, dampening the reflexivity of the system by reducing the dilution of the LUNA supply during severe contractions [...]"

11/ The $BTC reserve won´t back UST as a stablecoin. The reserve will act as a market participant that will swallow the supply contraction of UST

By doing this, the pressure on LUNA as an asset is reduced. A death spiral due to market uncertainty is averted. But how?

12/ @jump_ proposed on the Agora Research forum how this can be implemented on-chain.

In a nutshell: Market participants have a higher incentive to interact with the #Bitcoin reserve instead of burning UST to restore the peg.

The $BTC reserve becomes a decentralized UST buyer.

13/ As per the proposal by @jump_, a new on-chain mechanism is added to the Terra blockchain, that ensures to exchange always 1 UST coin for 0.98 dollars of $BTC

Now, market participants can buy Bitcoin at a discount from the reserve, if UST trades off-chain below 0.98 dollars!

14/ I call this new virtual AMM mechanism THE DEFENDER!

Until UST trades over 0.98$, there is no better deal on the crypto market to buy #Bitcoin

The reserve will add UST and distribute $BTC. Thus, there is a hard backstop for the UST peg.

15/ Once UST is trading over the peg, participants will be incentivized to sell $BTC at a premium for UST.

This is crucial, as the reserves will have no impact on the LUNA burn in the long run. This mechanism is just a release valve for swelling pressure to exit UST to LUNA.

16/ Most likely, there will be no UST minted until THE DEFENDER runs out of their UST holdings.

But remember, the only way to create more stablecoins is still only LUNA. You can only create more UST by burning LUNA. You will not be able to mint UST via BTC.

17/ So what does this all mean? Let´s address some of the major questions:

Will UST be collateralized by Bitcoin? No, it is only a new mechanism to defend the peg.

Will this reduce the burn of LUNA to mint UST? No, LUNA will stay the only way to create more stablecoins.

18/ One caveat to the LUNA burn. It might occur that part of the LUNA burn will be taken in the future as seigniorage to increase the reserves of THE DEFENDER.

This is already part of the Terra protocol and was used to fund the community pool.

19/ Nevertheless, the amount of LUNA to create further reserves via seigniorage will be minuscule and have no noticeable effect on the burn or price of LUNA, as shown with the old seigniorage capture mechanism.

20/ Tweety tweets are too much, I agree with you!

Buy no worries sir, I got your back. If you would like to have this in a spoken form, feel free to check out my video on this topic :)