Is Luna a giant Ponzi scheme?

Things are good on crypto-Twitter: After @algodtrading recently introduced the algorithmic stablecoin UST or Luna as a Ponzi (pyramid scheme) designated had, it was the next bet with users @stablekwon to come: If Luna’s price drops below the current one within a year, @stablekwon owes Twitter user @algodtrading US$1 million – and vice versa. @Giganticrebirth also joined the @algodtrading site and increased the bet to 10 million each, so a total of 22 million now awaits the winner(s) in a multi-signature account (viewable on-chain here: escrow account) .

What exactly is this bet – and what are the pros and cons of UST/Luna actually being a gigantic Ponzi scheme?

LUNA, the Terra Blockchain and algorithmic stablecoins

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 best-known Terra stablecoin is TerraUSD (abbreviated: UST).

But how exactly does this algorithmic stablecoin work?

Like other stablecoins, UST aims to maintain a stable value of $1. As an algorithmic stablecoin, however, this is not covered by a registered title, but depends on the market incentives and arbitrage created in order to be able to maintain its target value of 1 USD.

This is done by providing the on-chain option at any time to swap UST and Luna at a fixed exchange rate. Specifically, you can burn (destroy) a dollar’s worth of Luna at any time and create (create) a UST for it. Conversely, a UST can be burned at any time – in return, the protocol minted a dollar from Luna (see Figure 1).

Figure 1: Burn and mint mechanism by Luna/UST.

Terra USD: Stability through Arbitrage

This possibility of minting and burning exists at all times, regardless of exchange rates on other markets (e.g. centralized exchanges like Binance, etc.).

Thus, if the UST rate deviates from the target value of one US dollar, an arbitrage opportunity presents itself immediately. This is best illustrated with an example:

Example 1: VAT=1.05 USD

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

Strategy: Burn 1 Luna (value: 100 USD) for 100 UST, sell UST on an off-chain exchange for 105 USD

Profit: $5

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

example 2: VAT = 0.95 USDAn image containing text, a device, a gauge.  Automatically generated description

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

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

Profit: $5

Result: increase in demand for UST, the price returns 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 such that the price of UST tends towards $1 again and again.

Challenges with algorithmic stablecoins

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

Well, UST is not the first such algorithmic stablecoin, a look at comparable projects paints a bleak picture:

Figure 2: Failed algorithmic stablecoin project Empty Set Dollar.
Figure 3: Failed Basis Cash algorithmic stablecoin project
What went wrong with the price of the $IRON finance / $TITAN token?  This is not a coin toss but a bank run.  First, the token was massively pumped after a billion - Twitter feed of
Figure 4: Probably the best-known algorithmic stablecoin project: Titan/IRON.

Conclusion: The stablecoins of these projects have no value today, when they should be worth 1 USD.

Stablecoins: how does such a failure happen?

The big danger for such projects is a scenario in which the UST is trading below one US dollar (for example on exchanges like Binance or Uniswap – the on-chain exchange rate always remains the same). As we learned, arbitrageurs then buy USTs, burn them on-chain for Luna, and sell Luna off-chain. This increases the price of UST, but at the same time there is strong pressure on Luna prices. If this price pressure becomes too high, a death spiral can occur, resulting in the results shown above.

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

Figure 5: Development of a vicious cycle: Luna price falls, people lose trust in Luna, UST is burned against LUNA, LUNA is sold, LUNA price falls.

Anchoring protocol: another key element of this debate

Anchor is the largest lending/lending protocol in the Terra ecosystem. It is characterized by extremely high interest rates on the UST stablecoin (about 20% per year). It’s no surprise, then, that the anchor is a strong driver of demand for USTs – around 70% of all USTs in circulation are deposited on the anchor protocol and attract interest.

Figure 6: Value of Deposited Capital (TVL) on Anchor.

At the same time, borrowers deposit tokens like bLuna (bonded Luna) or bETH (bonded ETH) as collateral and borrow USTs from the peg protocol. Although 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 – in effect, they are paid to borrow in UST.

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

Rough overview of Anchor expenses and income

spent: Sum of all VAT deposited multiplied by 1.2 = annual interest payable

revenue: Interest income per UST Credits (Note: Since the above-mentioned incentive programs are implemented with the protocol’s own token, additional costs for Anchor are minimal to zero)

+

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

An image that contains text.  Automatically generated description
Figure 7: The ratio of capital deposited (green) and lent (white) on the anchor protocol diverges strongly.

As shown in Figure 7, Anchor’s income is currently less than its expenses, which is why the protocol must dip into its reserves to cover the shortfall and continue to pay such attractive interest rates on the UST. The anchor team had to increase the reserves twice so that the current growth strategy with the high subsidized stable interest rates could be continued.

The critical question now is how stable the Terra ecosystem is when the 20% interest in UST can no longer be sustained and therefore at least some of the capital flows to other chains.

Terra USD a Ponzi scheme?

This is where Luna’s Ponzi review comes in. Luna’s price is artificially inflated by Anchor paying an unsustainable 20% interest on long-term UST. This causes large amounts of Luna to burn, causing Luna’s price to increase. However, if Anchor has to reduce the interest offered on the UST, the investors withdraw their funds, which causes the burn rate of the UST to increase, which results in the exploitation of Luna. This Luna will then be sold off.

In combination, on the one hand, the price of Luna drops due to the sale and, on the other hand, the supply of Luna increases exponentially because more and more Luna must be mined by UST burned. Price pressure on Luna happens twice. The losers are the other users of the Terra ecosystem, who purchased Luna at premium prices to use the Terra blockchain.

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

Arguments of the defenders of LUNA

At this point, Luna proponents will say that Luna (unlike other algorithmic stablecoins) has an entire ecosystem with differentiated use cases such as paying gas fees, staking, etc. behind him. The close connection 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 over the long term – the only way is up therefore, to say.

The Anchor Team also recently increased its reserves to $450 million, a sizeable cushion that could also be used in an emergency to maintain UST’s price target. Rumor has it that it happened as early as January, when UST was on the verge of veering off course, or even falling more than it had already, following the Wonderland Finance drama.

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 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 Bitcoin fund of around 3 billion. BTC purchases of around US$1.3 billion have already taken place and are likely partly responsible for the current price increase. This BTC fund has the sole purpose of defending the UST rate during critical market times. BTC’s strong independence from the Terra ecosystem – especially from 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 of the UST or participate financially in the various applications of the Terra Blockchain, you simply have to do it with the certainty of the risks involved.

About the authors

Manuel Jungs is a German language researcher Newsletter Insight DeFi. Known for his detailed analyses, he wants to competently and concisely inform a broad mass of people about the events, opportunities and risks of the new decentralized world around Bitcoin and Co. He is also active on Twitter On my way.

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