UST’s Counterattack

In the unpredictable market environment of 2022, stablecoins have taken center stage.

Stablecoins play a very valuable role in the Crypto space because they allow holders to keep "cash" in the ecosystem while leveraging the financial superpowers of blockchain and DeFi. Stablecoins are also one of the fastest growing verticals in the Crypto space, with the total market value of stablecoins increasing by 115% over the past year and 2,950% since January 2020 .

Above: Supply growth of major stablecoins. Source: The Block

The most notable recent stablecoin is Terra’s UST, which is the third-largest stablecoin by market cap, with a supply of over $17.7 billion . UST is powered by the Terra blockchain and its native asset, LUNA , which has grown by more than 15,100% since the beginning of 2021, with a market cap of approximately $34 billion, ranking eighth among all crypto assets.

This of course begs the question: How did Terra become so successful? How fast is UST growing compared to its competitors? What risks does the protocol face?

The following article will attempt to answer these questions.

01. How does UST work?

First, let’s take a deeper look at UST so we can better understand how it works, how stability is achieved, and the role LUNA plays in it.

UST is an algorithmic stablecoin pegged to the US dollar . In order to mint UST, users must destroy an equal value of LUNA (i.e. $1:$1); similarly, in order to redeem LUNA, users will have to destroy an equal value of UST. This means that UST is not backed by external collateral assets, but relies on market incentives to maintain stability .

Let's look at a simple example to see how this works.

Assume that the price of UST is $1.01, which is higher than the anchor price of $1. This means that the demand for UST stablecoins exceeds the supply . In this case, in order to lower the price of UST, arbitrageurs will be incentivized to destroy $1 of LUNA to mint new UST, thereby capturing the profit from the $0.01 difference between UST's target anchor price (i.e., $1) and the current price (i.e., $1.01).

Similar arbitrage opportunities exist when UST is trading below its $1 peg, meaning that the supply of UST stablecoins exceeds demand . If the price of UST is $0.99, arbitrageurs are incentivized to destroy UST to mint $1 of LUNA and pocket the difference. This will reduce the supply of UST, helping to increase the price of UST to its $1 peg.

While this mechanism is relatively simple, it has so far proven to be very effective in expanding UST supply .

UST is very capital efficient because it does not require any collateral backing to mint new UST , which increases the convenience of UST in supply growth compared to other stablecoin designs (such as over-collateralized stablecoins). Stablecoins based on over-collateralization, such as DAI, rely on the growth of people's debt demand for supply growth. This mechanism of UST has also proven to be largely effective in keeping the price of UST near its anchor price , as the protocol has never fluctuated more than $0.02 since the crash in May 2021.

Another key insight that can be seen from this mechanism is that it ties the value of LUNA to the demand for UST . All else being equal, as the demand for UST increases, more LUNA will be destroyed, which will put upward pressure on its price. If the demand for UST decreases, LUNA will be minted to satisfy users for redemption, putting downward inflationary pressure on its price .

Above: Changes in LUNA’s total supply at the end of each month (bar chart) vs. LUNA price (yellow curve). Source: Smart Stake

While this mechanism is highly reflexive, it places LUNA squarely on the growth of UST demand and has caused LUNA to be in a deflationary state for 9 consecutive months . As shown in the figure above.

02. LUNA and Terra blockchain

As mentioned above, Terra is a stablecoin protocol and also an L1 (first layer) blockchain protocol.

The network is built on the Cosmos SDK and uses Tendermint Proof-Of-Stake (PoS) as its consensus mechanism, with validators of the network securing the network by staking LUNA. Terra recently became compatible with IBC (Inter-Chain Communication Standard), which enables Terra to exchange assets with all other blockchains in the Cosmos ecosystem.

Although Terra's validator limit is 130 , LUNA holders can stake their assets on behalf of validators in the network, allowing small holders to participate in the network's staking process. Unlike other PoS blockchains, LUNA stakers can only earn gas fees and swap fees because the network does not have LUNA inflation staking rewards .

LUNA validators have governance rights over the system, voting on network upgrades and parameter changes. The most recent important vote was the Columbus-5 upgrade of the protocol, which removed the UST seigniorage (the fee incurred by minting new UST) for LUNA stakers. For a quorum to be reached, 40% of LUNA stakers must participate in the vote on the proposal, and at least 66.6% of voters must agree to pass.

Validators also play another key role in the system, they are responsible for voting on the exchange rate between LUNA and UST (that is, the price of LUNA) . Instead of relying on third-party oracle systems such as Chainlink, Terra uses LUNA validators as its oracles , which means that LUNA validators are incentivized to vote correctly on the price of LUNA . In return, these validators will receive a portion of the exchange fees between UST and other stablecoins and between UST and LUNA.

By using its own sovereign blockchain, and a network of oracles within the system, Terra is able to achieve decentralization as it does not rely on any external entity for the system to function properly.

03. Adoption & Growth Strategy

As discussed by Terra founder Do Kwon, the core idea behind UST’s growth strategy is to emphasize creating utility and demand for UST , which helps build a strong network effect for UST.

Here are some of the strategies Terra has already adopted.

1. Anchor & Terra DeFi

One of Terra's most successful ways to increase the utility and usage of UST is Anchor . As a money market on Terra and Avalanche, Anchor allows UST holders to deposit UST assets into it and obtain a current fixed 19.46% APY yield . Users can also borrow UST by pledging Terra or Avalanche chain's L1 assets (currently including bLUNE, bETH, bATOM and wasAVAX) to pledge .

The staking rewards accumulated by these L1 assets, combined with the interest paid by Anchor Protocol borrowers, help generate a portion of the 19.46% interest rate paid to Anchor Protocol depositors, with the difference made up of Anchor Protocol’s so-called yield reserve, which currently holds over $267 million in UST.

Above: TVL (total locked value) growth in the Anchor protocol. Source: DeFi Llama

This deposit yield offered by the Anchor protocol is much higher than the typical yields offered by other major money market protocols, so this has helped the Anchor protocol attract $15.2 billion in TVL (total value locked) and made Anchor the first major demand driver for UST.

Nonetheless, Anchor could pose a risk to the stability of UST due to the protocol ’s proposed lower yields and the fact that the protocol’s yield reserve is decreasing by $4 million per day, causing the reserve to be completely depleted in approximately 2 months , which could result in capital outflows from the Anchor protocol and potentially large-scale redemptions of UST .

While Anchor currently holds 75.9% of Terra DeFi ’s $20 billion TVL , there are other DeFi protocols on the Terra network that have clear traction, such as decentralized exchange Astroport and synthetic asset protocol Mirror , which together hold over $2.5 billion in TVL. The ability to have UST play a role in these other Terra-native protocols could help offset potential supply shocks that could occur if Anchor yields are reduced .

2. Active multi-chain expansion

Another way Terra generates demand for UST is by increasing the supply and utility of UST on many other blockchains . By leveraging cross-chain bridge solutions such as Wormhole, Terra has successfully established liquidity for UST on networks such as Ethereum, Avalanche, Solana, and Fantom .

Especially on Ethereum, Terra has achieved a lot of integration, which may make UST one of the largest stablecoins on the Ethereum chain. At the time of writing, the supply of UST on the Ethereum network has exceeded 755 million US dollars .

For example, Terra recently announced a proposal to create a 4pool on the decentralized exchange Curve , which will consist of four stablecoins: UST, FRAX, USDC and USDT. The pool aims to become the base trading pool for the most liquid DEX in DeFi (Curve) , replacing the current base pool 3pool on the platform (consisting of DAI, USDC and USDT).

Two major stablecoin issuers, Terra and Frax, are working with [Redacted] Cartel on the 4pool initiative, and at the time of writing, they collectively hold a large number of CVX tokens , which is the governance token of Convex Finance, which controls the majority of Curve’s native token CRV . Because of this, 4pool has already been launched on the Fantom blockchain , with over $31 million in TVL on the chain, and 4pool seems to have a solid opportunity to change the competitive landscape of Curve liquidity.

In addition to Curve, Terra has begun integrating with other Ethereum DeFi protocols , such as Rari Capital’s Fuse , a permissionless money market protocol, and Terra is injecting UST liquidity into the Fuse pool.

3. Forex Reserve

Another recent factor driving Terra's growth is the creation of the " Forex Reserve ". The Terra ecosystem development organization Luna Foundation Guard (LFG) announced on February 23, 2022 (see the figure below) that the non-profit organization has raised $1 billion from major entities such as Three Arrows Capital and Jump Crypto through the sale of LUNA tokens , aiming to hoard Bitcoin (BTC) as a backing to help maintain UST's anchor .

At the time of writing, the reserve currently holds over $1.81 billion in BTC , with the goal of eventually reaching $10 billion and diversifying into other crypto assets , such as the $100 million LUNA/AVAX token swap it has initiated with Avalanche developer Ava Labs. This means that as of now, UST is backed by 15-16% of other crypto assets.

superior Figure: Growth of the number of BTC held in the address of Luna Foundation Guard (LFG), the Terra ecological development organization. Source: BitInfo Charts

The reserve has helped support its price in the cryptocurrency market and has driven demand for UST , likely due to spurring confidence in UST’s ability to maintain its peg and its ability to meet people’s redemption needs, as UST’s market cap has increased by 45% and LUNA’s price has increased by 81% since the announcement of the creation of the reserve .

04. Status of UST

Now that we understand how UST works and the drivers for increasing its adoption, let’s look at some on-chain metrics to see how the stablecoin compares to its competitors.

1. Circulating Supply & Market Share

UST supply has experienced incredible explosive growth over the past year, increasing by more than 987% during this period, with its circulating supply exceeding $17.7 billion at the time of writing. As shown in the figure below:

Above: The growth of UST stablecoin supply over the past year. Data source: The Block

This makes UST the third largest stablecoin, behind USDT and USDC. Considering that the other two stablecoins (i.e. USDT and USDC) are backed by fiat reserves and issued by centralized entities, this makes UST the largest decentralized stablecoin in all cryptocurrencies , more than twice the size of its closest competitor DAI .

UST’s market share has grown dramatically over the past two quarters . The protocol currently accounts for 9.8% of the total stablecoin supply , an increase of more than 4 times from 2.1% since October 2021. As shown in the figure below:

Data source: The Block

UST's competitive positioning relative to other decentralized stablecoins highlights its astonishing growth in market share. According to data from The Block, UST accounts for the majority of decentralized stablecoin supply : UST's supply accounts for 52.7% of the total supply of $33.6 billion of the eight largest cryptocurrency-backed stablecoins and algorithmic stablecoins . This is more than double the 19.9% ​​in October 2021. As shown in the figure below:

Data source: The Block

2. Growth rate

As its growing market share indicates, UST has been growing at a faster rate than its competitors. A closer look at those growth rates shows just how big the difference is.

The following chart shows the supply growth rate of the top ten stablecoins by market capitalization over the past two quarters , including centralized stablecoins, decentralized stablecoins, stablecoins backed by fiat currencies, stablecoins backed by cryptocurrencies, and algorithmic stablecoins. As we can see, UST has led the growth rate in the past 6 months among the top ten stablecoins, with its supply growing by 547% . During this period, only two stablecoins expanded at a rate of more than three digits, the other being FRAX .

Data source: CoinGecko

This means that UST has grown 4.4 times faster than the average of the 10 selected stablecoins over the past 6 months, and 14 times faster than the entire stablecoin industry.

Data source: CoinGecko

In this rapidly expanding, long-term growing stablecoin space, UST has proven itself to be the fastest horse .

05. Risk Factors

Now that we’ve highlighted UST’s massive growth and the keys to its success, let’s take a moment to highlight some of the risks facing the protocol.

1. Inflationary Death Spiral

Perhaps the biggest risk Terra faces is a so-called " death spiral ," as has happened with stablecoins such as Iron Finance. This scenario involves a run on UST (i.e., mass redemptions), often as a result of the stablecoin falling below its peg , and has happened to other algorithmic stablecoins. If this happens, LUNA will be minted at higher and higher prices, causing more UST holders to lose confidence and further inflating the supply of the asset until it loses all value.

2. Limited number of validators

As mentioned above, UST’s level of decentralization depends on the Terra blockchain network that secures the stablecoin. Given that Terra only supports 130 validators, this could be a centralization vector if the protocol faces significant regulatory scrutiny.

3. Anchor yield decreases

If Anchor’s deposit yield falls, causing UST outflows from the Anchor protocol, the stablecoin will face redemption risk, which could trigger inflation if UST holders choose to allocate their funds elsewhere.

4. Competition

Competition in the stablecoin space is fierce. Terra will need to continue to grow and iterate on the protocol and build its network effects to defend its competitive position.

06. Conclusion

As the largest decentralized stablecoin, UST has taken the Crypto world by storm.

With a native asset, LUNE, accumulating value through market demand for UST, and an aggressive strategy to drive demand generation, utility, and build network effects, as well as impressive growth rates, Terra appears poised to continue its lunar dominance.