Thread by @0x_armin

#UST tanked like shit. #Terra is in a crisis. But do you know the initial plan for long-term #LUNA growth?

Here's part 2 of the breakdown on Terra Luna whitepaper. 10x your #crypto understanding in 5 minutes.

Let's dive in. 🧶 1/n

In our last breakdown, we talked about how maintaining #stablecoins liquidity and stablecoins peg are key to preserving global purchasing power.

We have discussed the magic mechanisms that preserve liquidity and peg. However, we stopped at a key problem. 2/n

Short term volatility of #UST is now transferred to long term volatility of #LUNA!

We then hinted at a math sorcery that will preserve LUNA's long term stability.

But before we dive into details of math sorcery, we need to talk about something else. 3/n

There are 2 components that preserve long term LUNA stability.
(a) Transaction fees
(b) LUNA supply

Let's talk about each of them in greater detail. 4/n

Transaction fees are self-explanatory. When you conduct transactions on the #Terra blockchain, you will need to pay a small amount of fees (0.1% to 1%) to miners. 5/n

#LUNA supply needs more elaboration. Now, each miner needs to hold LUNA to do mining for the blockchain. And the bigger the proportion of overall LUNA supply they hold, the more rewards they can expect to get. Confused? 6/n

Think of having lucky draw entries. The more entries you have, the more likely you are to win some prizes.

Back to transaction fees and LUNA supply. 7/n

Combining both of them gives us unit mining reward.

Unit mining reward = transaction fees / #LUNA supply

Or back to our lucky draw analogy. The expected prize of each entry is total prize / number of entries.

But there is a fundamental problem with unit mining reward! 8/n

Let’s examine what happens when (1) the economy expands and (2) the economy contracts.

Case (1):
(a) People conduct more transactions (more exchange of goods and services) -> increase in total transaction fees.

Can you guess what happens to total #LUNA supply? 9/n

Increase in #UST demand (to use in transactions) -> upwards pressure on UST to #USD peg -> burn LUNA to maintain peg (this is the magic mechanism. Read part 1 of our breakdown!) 10/n

https://twitter.com/0x_armin/status/1521469626701414400

Let’s do some basic math. If unit mining reward = total transaction fees / #LUNA supply, an increase in total transaction fees and a decrease in LUNA supply leads to an increase in unit mining reward.

That seems like all nice! But what happens when economy contracts? 11/n

The reverse mechanism happens. We end up having less total transaction fees and more LUNA supply. Using our basic math, we see that unit mining reward will decrease! What does this mean? 12/n

Unit mining reward moves in same direction as economy! And why is this bad?

Because we humans love stability. And miners are humans too. What will they do with such unstable #mining rewards? 13/n

The unstable mining rewards will incentivise miners to move in and out of the #Terra ecosystem. And because miners contribute to the security and stability of Terra, those two factors will be compromised! 14/n

Think of having police officers in your neighbourhood- too many of them, they will end up catching petty crimes. Too few, and you have crimes going unsolved!

This is where the math sorcery comes in. 15/n

Basically, we want to control
(a) Total amount of transaction fees by controlling percentage of fees per transaction
(b) #LUNA supply by controlling percentage of LUNA burnt when users swap 1 USD worth of LUNA for 1 #UST (see magic mechanism in part 1 if you’re unsure) 16/n

I’m going to do some hand waving for our math sorcery (it’s sorcery after all). But the main idea is simple: we use the ratio of unit mining reward in the last time step (R_prev) and unit mining reward (R_now) in this time step to decide how much to change (a) and (b). 17/n

So if (R_prev / R_now) < 1 (ie unit mining reward is increasing), we decrease transaction fee percentage and proportion of #LUNA burnt.

If (R_prev / R_now) > 1 (ie unit mining reward is decreasing), we increase transaction fee percentage and proportion of LUNA burnt. 18/n

This math sorcery tampers the correlation between economy growth and unit mining reward. And as the overall #Terra ecosystem grows, the unit mining reward is expected to grow, albeit in a more stable way. 19/n

This leads us to our final question! How can we be sure that the #Terra ecosystem will grow? Well, this is answered in the whitepaper as well! Stay tuned for our final installment.

If you like this breakdown, please follow me and retweet this thread! 20/n