Terra’s Bitcoin Romance
The Ultimate Guide to Stablecoins, Part 2: Terra, LUNA, UST, and Anchor
Stablecoins play a critical role in the cryptoeconomy, embodying the security guarantees of decentralized finance while also providing the price stability of more traditional financial assets such as fiat currency. This series details the mechanisms that power stablecoins.
Terra, Luna, and UST
From Coingeek.com
Recently, Terra has emerged as one of the more buzzworthy projects in crypto for its juicy APYs, charismatic founder, and degenerate bets. Unique to Terra is the centrality of stablecoins to its ecosystem: since its inception, Terra was built to be a blockchain that prioritizes price stability as a core ten. The abstract of its white paper states:
While many see the benefits of a price-stable cryptocurrency that combines the best of both fiat and Bitcoin, not many have a clear plan for the adoption of such a currency. Since the value of a currency as a medium of exchange is mainly driven by its network effects, a successful new digital currency needs to maximize adoption in order to become useful. We propose a cryptocurrency, Terra, which is both price-stable and growth-driven. It achieves price-stability via an elastic money supply, enabled by stable mining incentives. It also uses seigniorage created by its minting operations as transaction stimulus, thereby facilitating adoption. There is demand for a decentralized, price-stable money protocol in both fiat and blockchain economies. If such a protocol succeeds, then it will have a significant impact as the best use case for cryptocurrencies.
This article examines the multiple prongs that allow the Terra ecosystem to function: the Terra blockchain, Luna, UST, and Anchor Protocol.
The Terra Blockchain
Terra is a blockchain. (The definition of “a blockchain” is beyond the scope of this article.) Much like Cardano, and Ethereum’s Beacon Chain, Terra operates on a proof-of-stake (POS) consensus mechanism, known as Tendermint. Validator nodes secure the network by proposing, checking for, and voting on valid collections of transactions known as “blocks.” Validators “stake” value in the form of the network’s native currency - in this case LUNA - and risk losing some of it if they break the rules of validation. But in return for their stake and security, validator nodes receive LUNA rewards when they successfully propose and vote on valid blocks. It makes sense that Terra was built with the Cosmos SDK, because Cosmos itself is also a POS blockchain.
While Terra is Turing-complete, and therefore supports smart contracts of arbitrary complexity, it does not conform to the Ethereum Virtual Machine (EVM), making it non-interoperable with Ethereum. (Recently, Evmos came out as a Cosmos-based implementation of Ethereum, possibly positioning it as a protocol to bridge Terra and Ethereum).
Thus, you will find that DApps on Luna do not allow for the trading of familiar tokens such as ERC-20’s. Instead, Luna’s DeFi ecosystem centers around its native stablecoins.
The Market Module
Terra has a collection of fiat-currency-based assets baked into its protocol. The two most heavily in use are the Terra US Dollar (UST), and the Terra Korean Won (KRT). Any user of the protocol can exchange the native currency, LUNA, for a stablecoin, or vice versa, using the market module. The market module is the core piece of software in the Luna protocol that facilitates these exchanges. This differs significantly from a protocol such as Ethereum, which recognizes only the native currency (ETH) as a medium of exchange, and thus, swaps for stablecoins can only occur through DEXes and other smart contracts. On the Terra blockchain, users can send a MSG_SWAP transaction to the market module to trade their LUNA for Terra stablecoins directly.
There are two questions this mechanism begs:
How are the exchange rates between LUNA and the stablecoins determined?
How are stablecoins pegged to the value of the underlying fiat currency?
Nodes as Oracles
A neat feature of the Terra blockchain is that the validators also function as price oracles. They are responsible for reporting and voting on the exchange rates between native LUNA and its supported stablecoins. This is implemented by the oracle module through a voting process that is reminiscent of Tendermint PoS consensus. The exchange rates determined through the oracle module are then used by the market module to determine swap rates.
Voting on exchange rates occurs every 5 blocks, or every 30 - 40 seconds. Thus, you will frequently see exchange-rate-vote-related transactions on any Terra block explorer:
MsgAggregateExchangeRateVote transactions on the Terra blockchain.
Price Stability
Terra ensures that stablecoins remain pegged to their underlying fiat currencies by enabling arbitrage through their market module. Assuming the Terra oracle module is working correctly, anybody can exchange $1 worth of LUNA for 1 UST. So, if there were a DEX on which UST were trading for, say, $1.05, an arbitrageur could make 5 cents of free money by:
Exchanging $1 worth LUNA for 1 UST via the market module.
Selling 1 UST for $1.05 on the DEX.
Similarly, if UST were priced at $0.95 on a DEX, an arbitrageur would make free money by:
Buying 1 UST for $0.95 on the DEX.
Exchanging 1 UST for $1 worth of LUNA via the market module.
The stability of the market module incentivizes arbitrageurs to keep UST pegged to $1.00. This structure is quite similar to the FRAX stablecoin, which uses FXS and collateral as the medium of exchange.
Aside: Who are the Arbitrageurs?
The fact that arbitrageurs can take advantage of market dislocations in UST does not necessarily imply that they will, or even that they exist. Thus, we must ask – who are the entities partaking in the economic activities needed to keep the Terra stablecoins at their peg?
I do not know the answer to this question, but I have several hypotheses:
Protocols can create arbitrage technologies in-house. For example, the Celo blockchain relies on Hummingbot to “improve efficiency and price discovery.”
Protocols can partner with sophisticated trading firms to create such arbitraging technology. This is a win-win, because the trading firm makes easy profits, and the Terra stablecoins maintain their peg.
Arbitrageurs naturally flock to profit-making opportunities. This is probably also the case, as any low-hanging fruit for free money gets scooped up quickly in a free market.
Anchor Protocol
Anchor Protocol is a borrowing and lending DApp built on Terra. Anchor was built by Terraform Labs - the engineering arm of Terra - so it is reasonable to view it as a native app for Terra.
The headline fact is that Anchor offers 20% APY on its UST deposits, through its “earn” product. This means you can theoretically get 20% annual returns on your dollars, far exceeding the typically sub-1% rate of savings accounts in traditional banks.
If you’ve read The True Sources of DeFi Yields, you should be highly skeptical of this 20% APY: such an appreciation in value is extremely difficult to achieve, and can lead to inflation. Yet, Luna Foundation Guard (LFG) Councilmember Remi Teto asserted his confidence that this rate would last for at least 2 years:
With 11.2 billion UST locked, this means that a staggering 2.2 billion UST needs to be paid out every year to Anchor Earn depositors.
The UST market.
So how does Anchor subsidize this APY? It consists of three parts: bAsset yields, borrowing costs, and the yield reserve.
bAsset Yields
Anchor is fundamentally a borrowing and lending protocol. On the Borrow side, users can deposit collateral, and in return, they can take out a UST loan whose value is a percentage of the collateral (the loan-to-value ratio, or LTV). The types of collateral that Anchor accepts are known as bAssets.
There are currently two bAssets: bETH and bLUNA. Each represents liquid staked positions on the Lido platform. As mentioned above, both Terra and Ethereum’s Beacon Chain are PoS networks; thus, staking LUNA or ETH with a validator results in rewards. Lido is a platform that facilitates “liquid staking” by issuing tokens in exchange for the staked LUNA / ETH.
The yield accrued from these staked assets pays for part of the yield distributed to UST earners. Currently, the math works out as follows:
Lido issues 3.9% APY on ETH, and 7.0% APY on LUNA.
There is $1.3B billion worth of bETH, and $4.5 billion worth of LUNA deposited.
Thus, Anchor earns $1.3B * 0.039 + $4.5B * 0.07 = $367 million from these bAssets.
$367 million / $2.2 billion = 16.7% of the amount required per annum to service UST yield.
Borrowing Costs
When borrowers take out loans from Anchor, they are required to pay interest on the loan. If their LTV gets too high - as can happen when the interest goes unpaid for too long - then their collateral position is liquidated. This is a dynamic similar to other lending protocols such as AAVE and Compound.
Currently, the UST borrow rate for Anchor is 11.7%. However, to incentivize borrowing, Anchor partially offsets this by rewarding its native governance token, ANC, to borrowers. In other words, Anchor pays its debtors to borrow. At current prices, the reward rate comes out to 8.7%. Thus, the net borrowing rate for UST is 11.7% - 8.7% = 3%.
Currently, there is 2.8 billion UST worth of outstanding debt. Hence, the net amount collected from Anchor UST loans is $2.8B * 0.03 = $84M, which corresponds to $84 M / $2.2B = 4.0% of the amount required per annum to service UST yield.
Yield Reserve
We have accounted for $451 million of the $2.2 billion, or roughly 21%, of the funds required to service Anchor’s UST debt. Where does the other $1.75 billion come from?
The answer is Anchor’s “yield reserve”, which is… exactly what it sounds like. It is a reserve of UST-denominated assets used to pay off Anchor’s UST yield. And as recently as in January, Anchor’s yield reserves were dangerously close to being depleted, sitting at $35 million:
However, since then, the reserve has received a $450 million “top-up” from the Luna Foundation Guard, and now sits at 405 million UST. (Where and how the Luna Foundation Guard came up with this money, I am not sure - it may have come out-of-pocket, or through appeals to Venture Capital firms).
Analysis
The astute reader will notice that we are still nowhere near the amount of UST required to service Anchor’s Earn yield. Even if Anchor used its entire yield reserve towards servicing its debt, this would still only account for $900M / $2.2B = 41%. We are still missing $1.3B worth of yield payments per annum.
Of course, the above calculations were made at current-day prices. The following circumstances would change the dynamics considerably:
If the price of ETH and LUNA went up (in US dollar terms), then bAsset yields would also increase.
If demand for UST borrowing increased, then borrowing costs would also increase.
If the yield reserve accrued value faster than it was depleted, then it could potentially serve as a backstop for greater yield.
Of course, Anchor governors could simply decide to lower the yield.
It is in the context of point 3 above that BTC comes into play.
BTC Backing
Recently, Terra founder Do Kwon announced in a Twitter Space with Udi Wertheimer that Terra would be purchasing up to $10 billion worth of Bitcoin as a “reserve asset” for the Terra ecosystem. (In fact, there is speculation that yesterday’s pump in BTC price was due to such a purchase.) The details are currently sparse, and whether this Bitcoin would actually be used to service Anchor debt remains to be seen.
However, directionally, the maneuver indicates Terra’s positive outlook on Bitcoin’s future value. The ideal reserve asset has positive returns with relatively low risk, and in the universe of decentralized currencies, Bitcoin fits this profile the best. It would also be an interesting application of cross-chain collateralization. Anchor Protocol’s key innovation is its use of yield-bearing proof-of-stake assets across different blockchains (i.e. bETH and bLUNA) to fund yield on stablecoins. Backing UST and its yield with Bitcoin would bring this to another level, as Bitcoin is seldom seen as an active participant in DeFi (despite the existence of such assets as wBTC and renBTC).
If this happens, the relevant questions to ask might be:
Will UST be backed by BTC 1 to 1? What is the collateralization ratio?
Would there be a redemption mechanism for converting UST for BTC?
How will BTC be represented on the Luna blockchain?
Conclusion
The attractive 20% yield on UST stablecoins offered by Anchor are not funded by the revenues it currently generates. This situation poses the risk of UST depegging from the US dollar through cascading selling if Anchor is unable to service its debt. However, the introduction of Bitcoin into the Terra ecosystem could provide a strong, trustworthy backing to UST’s value.
Anchor resides within the Terra blockchain, which is notable for making stablecoins native to its protocol. The arbitrage mechanism it uses to ensure price stability is facilitated by the market module and enforced by market participants, similar to FRAX. Despite the inherent risks it poses, Terra’s ability to gain widespread adoption through the eye-catching headlines generated by its ecosystem participants makes it an entertaining narrative to follow.
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So ... summarising your blog ... the word is maybe. Maybe this will work. Alongside another maybe: maybe there are Elves at the end of my garden.