Is LUNA a giant Ponzi scheme?

LUNA is the native token of the Terra Blockchain. One of the goals of the Terra Blockchain is to provide decentralized algorithmic stablecoins for the DeFi ecosystem. The most famous stablecoin from Terra is TerraUSD (UST).

But how exactly does this algorithmic stablecoin work?

Like other stablecoins, UST aims to maintain a steady value of $1. As an algorithmic stablecoin, however, this is not covered by a deposited security, but is dependent on created market incentives and arbitrage in order to be able to maintain its targeted value of 1 USD.

This is done by providing the on-chain option at any time to exchange UST and Luna at a fixed exchange rate. More specifically, you can burn (destroy) a dollar’s worth of Luna at any time and mint (create) a UST for it. Conversely, a UST can be burned at any time – in return, the protocol minted a dollar worth of Luna.

Terra USD: Stability through arbitrage

This possibility of minting and burning exists at all times, regardless of exchange rates in other markets (e.g. centralized exchanges such as binance Etc.).

So if the UST rate deviates from the targeted value of one US dollar, an arbitrage opportunity arises immediately. This is best illustrated with an example:

UST=1.05 USD

Assumption: We own 1 Luna with a market value of 100 USD.

Strategy: Burn 1 Luna (value: 100 USD) for 100 UST, sell UST on offchain exchange for 105 USD

Profit: $5

Result: Selling pressure on UST increases, price tends back to 1 UST=1 US dollar

UST=0.95USD

Assumption: We own 1 Luna with a market value of $100.

Strategy: Buy 100 UST on off-chain exchange for 95 US dollars, minting Luna worth 100 US dollars (here = 1 Luna)

Profit: $5

Result: increased demand for UST, price tends back to 1 UST = 1 US dollar

These are the mechanics of an algorithmic stablecoin – the supply of UST and Luna is dynamically regulated and the incentives are set in such a way that the price of UST tends towards $1 again and again.

Challenges with algorithmic stablecoins

So Luna’s role appears to include absorbing UST’s price volatility. So far so good. So what is the danger of algorithmic stablecoins?

Well, UST is not the first algorithmic stablecoin of its kind. A look at comparable projects paints a bleak picture:

Conclusion: The stablecoins of these projects have no value today, although they should have a value of 1 USD.

Stablecoins: how does such a failure come about?

The major threat to such projects is a scenario where UST is trading below $1 (e.g. on exchanges like binance or Uniswap – the exchange rate on-chain always stays the same). As we have learned, arbitrageurs then buy UST, burn it on-chain for Luna and sell Luna off-chain. This increases the price of UST, but at the same time there is strong price pressure on Luna. If this price pressure becomes too high, a death spiral can occur, which results in the results shown above.

Because: If the price of Luna falls unexpectedly quickly (e.g. due to realized regulatory risks or capital flight to another ecosystem or similar) and investors lose confidence or fear that the targeted exchange rate of USD 1 cannot be maintained, they burn their UST for Luna to then sell it afterwards. However, we have learned that for each burned UST Luna worth 1 USD must be mined – as the Luna price falls, more and more Luna have to be mined for each UST burned, which can lead to a vicious circle and hyperinflation.

Anchor Protocol: Another key piece of this debate

Anchor is the largest loan/loan protocol in the Terra ecosystem. It is characterized by extremely high interest rates on the UST stablecoin (about 20 percent per year). It is therefore not surprising that anchor is a strong driver of demand for UST – around 70 percent of all UST in circulation are deposited on the anchor protocol and generate interest.

At the same time, borrowers deposit tokens like bLuna (bonded Luna) or bETH (bonded ETH) as collateral and borrow UST from the anchor protocol. While these borrowers are required to pay interest on the UST they borrow, due to ongoing incentive programs, they receive Anchor Protocol tokens at the same time — effectively, they are paid to borrow in UST

The question now arises as to how Anchor can finance the 20 percent interest rate on the stablecoins. (In comparison: In most other DeFi ecosystems, a maximum of 11-13% interest can currently be expected for stablecoins).

Rough overview of Anchor’s expenses and income

expenditure: Sum of all deposited UST multiplied by 1.2 = annual interest to be paid out

revenue: Interest income through forgiven UST credits (note: since the incentive programs mentioned above are implemented with the protocol’s own token, there is minimal to no additional costs for Anchor)

+

Staking income, which can be achieved with the bLuna and bETH deposited as collateral.

As can be surmised from Figure 7, Anchor’s revenues are currently smaller than its expenses, which is why the protocol needs to draw on its reserves to cover the deficit and continue paying such attractive interest rates on UST. The anchor team has already had to increase reserves twice so that the current growth strategy with the high subsidized stablecoin interest rates can be continued.

The crucial question now is how stable the Terra ecosystem is when the 20 percent interest on UST can no longer be maintained and as a logical consequence at least part of the capital flows to other chains.

Terra USD a Ponzi scheme?

This is where Luna’s Ponzi criticism comes in. Luna’s price is artificially inflated by Anchor paying an unsustainable 20 percent interest on UST over the long term. This causes large amounts of Luna to be burned, causing Luna’s price to increase. However, if Anchor has to lower the offered interest on UST, investors withdraw their funds, which leads to an increased burn rate of UST, causing Luna to be mined. This Luna will then be sold off.

In combination, on the one hand, the Luna price drops due to the sale and, on the other hand, the Luna supply increases exponentially because more and more Luna has to be mined per UST burned. The price pressure on Luna occurs twice. The losers are the other users of the Terra ecosystem, who bought Luna at increased prices to use the Terra blockchain.

In addition, a possible liquidation cascade on the anchor protocol and the resulting price pressure on Luna also represent a potential systemic risk.

Arguments of the LUNA advocates

At this point, Luna supporters will argue that Luna (in contrast to other algorithmic stablecoins) has an entire ecosystem with differentiated use cases such as payment of gas fees, staking, etc. behind it. The close link between the Luna Coin and the success of the Terra ecosystem as such means that the coin will be forced to participate in the success of the ecosystem in the long term – the only way is up so to speak.

The Anchor Team also recently increased its reserves to USD 450 million, a not inconsiderable cushion that could also be used in an emergency situation to maintain UST’s target price. This is rumored to have happened as early as this January, when UST after the Drama about Wonderland Finance veered off course or slumped even more sharply than was already the case.

At the same time, it was announced that additional coins (such as SOL or ATOM) will soon be accepted on the Anchor protocol as possible collateral for loans, so that the protocol will open up additional revenue opportunities in the future if the holders of these coins take out loans on Anchor and pay interest on them.

At the same time, funds are currently being raised for a BTC fund of around 3 billion. BTC purchases of around 1.3 billion US dollars have already taken place and are probably partly responsible for the current price increase. This BTC fund has the sole purpose of defending the UST rate during critical market times. The strong independence of BTC from the Terra ecosystem – especially compared to Luna or other assets – creates extremely strong protection for UST.

Terra USD: The bet remains exciting

Opinions in the crypto world are divided; one thing is certain: the Terra ecosystem is not without risk. If you want to benefit from the attractive interest rates from UST or otherwise participate financially in the various applications on the Terra Blockchain, you simply have to do so with the certainty of the risks involved.