Since the end of January, the Terra ecological non-profit organization Luna Foundation Guard (LFG) has purchased more than $1 billion in bitcoins, and the current balance of bitcoins held on its addresses has reached 27,784. (Note: data on March 28) So, what is LFG doing to buy so many bitcoins?
In effect, LFG is creating a “Bitcoin Reserve” designed to be pegged to stablecoins on the Terra chain, such as UST.
The question now is, how exactly will this “Bitcoin Reserve” created by LFG work? And what impact will it have on LUNA, Terra ecology, and even Bitcoin? Next, let’s find out.
First, and a very important point, that is: neither Bitcoin reserves nor LUNA can be used as collateral for UST stablecoins. Unlike other stablecoins that are backed by fiat currencies or backed by overcollateralization of crypto assets, UST is a “pure” algorithmic stablecoin.
UST maintains “stability” through arbitrage systems and protocol mechanisms, and in the process, LUNA acts as a reserve asset. Market participants can mint UST by burning an equal amount of LUNA tokens, and vice versa. If you were to mint $1 worth of UST stablecoins, you would need to burn an equivalent amount of LUNA.
- If the demand for UST in the market exceeds the current supply, then UST can actually be traded off-chain at a higher price than the anchor price, such as $1.01. At this time, if arbitrageurs burn LUNA on the chain to mint UST, and then trade on the open market Trading, then you can profit from the difference.
- If the transaction price of UST is lower than 1 USD, then arbitrageurs can actually perform “reverse operations”, for example, arbitrageurs can exchange UST back to LUNA, which is equivalent to buying 1 UST for less than 1 USD and obtain LUNA $1 worth of LUNA, just sell LUNA on the open market to make a profit.
In other words, LUNA plays a similar role to “gold”, you can mint gold into any coin and then use those coins (equivalent to a medium of exchange) to do what you want. On the other hand, since these coins have gold in them, you can actually melt these coins and re-extract the gold, so UST is basically LUNA, which also has intrinsic value.
Of course, you will see a positive feedback loop in LUNA. If the demand for stablecoins in the market is getting higher and higher, then more and more LUNA will be destroyed on the supply side. At this time, the demand for LUNA will increase. It will also grow, so its price is likely to rise (LUNA’s value is actually equivalent to the value of the Terra blockchain). The advantage of LUNA’s positive feedback loop is actually an incentive for holders and validators, because it is they who are “absorbing” the demand for stablecoins in the market and therefore take on a lot of volatility risks. If the market demand for stablecoin contracts grows, LUNA will be minted accordingly; and when the market demand is stable, the LUNA price will drop under pressure.
So here comes the problem.
By design, the LUNA price does not appear to be a critical element for the Terra protocol to secure UST pegs, especially with a large number of arbitrageurs in the market. On the other hand, there also appears to be a “psychological connection” between LUNA price performance and the UST anchoring relationship.
In this case, we might see another phenomenon known as a “death spiral.”
Once the market demand for UST falls, the price of LUNA will fall with it. Once the price falls, the market will lose trust in LUNA and possibly UST, and then there will be a UST sell-off. At this point, in order to ensure the peg value, more LUNA has to be minted, and as a result, the value of LUNA will be further diluted and the price will continue to fall.
The next question is, how to solve the “death spiral” problem? In fact, this is the reason why LFG wants to introduce a “Bitcoin Reserve”. According to LFG, Bitcoin acts as a “release valve,” meaning that UST will be attracted to the on-chain exchange for LUNA, by reducing the supply of LUNA and restoring the peg in real time during periods of severe deflation, which can inhibit Opportunity to arbitrage outside of the Terra protocol.
The Bitcoin Reserve will not be the endorsement of the UST stablecoin, but will act as a market participant to solve the problem of UST supply contraction. In this way, the pressure on LUNA as an asset is reduced, and the death spiral caused by market uncertainty can be effectively avoided. But how exactly is it done?
Simply put: Since Bitcoin acts as a reserve, market participants are bound to have a greater incentive to interact with the “Bitcoin Reserve” than to mediate the peg by burning UST, meaning “Bitcoin Reserve” Gold” becomes a decentralized UST buyer.
According to Jump Crypto’s proposal, an entirely new on-chain mechanism could be added to the Terra blockchain, ensuring that 1 UST is always exchanged for $0.98 worth of Bitcoin. Now, market participants can buy bitcoin from the bitcoin reserve at a discount if UST trades below $0.98 off-chain!
Frankly speaking, this is a brand-new virtual automated market-making mechanism, which we can call “Defender”. After all, is there such a good way to buy bitcoin in the crypto market before UST trades above $0.98. The Bitcoin Reserve will add UST and distribute BTC, so the UST peg will be backed by a “hard back”.
Once UST is pegged, market participants are obviously more willing to sell BTC at a high premium and receive UST. This model is critical because in the long run, the Bitcoin Reserve will not have an impact on LUNA burns. As mentioned above, the Bitcoin Reserve acts as a “release valve” to relieve inflationary pressures arising from the exchange of UST for LUNA.
Most likely, no UST will be minted until the defenders have used up their holdings. But it should be noted that the only way to create more UST stablecoins is still to burn LUNA, because you can only create more UST by burning LUNA, you will not be able to mint UST through Bitcoin.
After reading this, you may have some doubts, so let us understand this mechanism more intuitively by answering the following two questions.
1. Can UST be obtained with Bitcoin mortgage? The answer is “no” as Bitcoin Reserve is just a new mechanism to “defend” the peg.
2. Will the amount of LUNA burned to mint UST be reduced with the Bitcoin reserve? The answer is “no”, LUNA is still the only way to create a UST stablecoin.
However, adding Bitcoin reserves should have a certain impact on the LUNA destruction mechanism, but this problem is not difficult to solve. For example, the partially destroyed LUNA can be used as a “seigniorage” in the future to increase the “defender” reserve. In fact, Terra’s stability mechanism already includes a “seigniorage”. Whenever LUNA is burned to create UST, the system will collect this fee, and this part of the income will eventually be paid to those who staked Luna on Terra Station. Miners and community liquidity pools. Of course, the amount of LUNA that creates more reserves through seigniorage will not be very large, so it will not have a significant impact on LUNA burning or price fluctuations, which we can see in the original seigniorage capture mechanism.
There is no doubt that Terra has built a very elegant system, although it may take us a while to understand.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/what-is-the-luna-foundation-going-to-do-to-buy-1-billion-in-bitcoin/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.