Dialogue with Luna founder Do Kwon: The Bitcoin Bet of UST

Source: "Unchained Podcast" Ep.335

Organizer: 0x137, Rhythm BlockBeats

Since January 27, the Bitcoin holdings in addresses marked as Luna Foundation Guard (LFG) have been steadily increasing, with an average addition of about 3,000 BTC every two days.

Luna Foundation holding data, Rhythm will continue to update

Terra has developed into a significant ecosystem in the crypto industry that cannot be ignored, with its TVL only second to Ethereum, and UST has become the fourth largest stablecoin. However, as the ecosystem continues to grow, many people are also beginning to worry about the risk of the LUNA death spiral.

Previously, Tether's USDT also held some BTC as collateral, leading many to view LFG's recent purchase of BTC as support for the "LUNA Ponzi."

However, UST is very different from USDT; UST aims to become the world's largest decentralized stablecoin, which requires UST to maintain a neutral asset identity. In this context, incorporating BTC into the UST backing system has significance that goes beyond simple economics.

Recently, Terraform Labs CEO Do Kwon was interviewed by the well-known crypto podcast "Unchained Podcast," where he answered questions regarding the new UST backing mechanism and Anchor yields. Rhythm BlockBeats has organized and translated the relevant content as follows:

About the New UST Backing Mechanism

How does the new mechanism work?

LFG recently announced that it is launching a large-scale foreign exchange reserve through BTC. LFG has provided $3 billion in startup capital, but LFG hopes that BTC reserves will become an important part of UST's market value in the coming year.

Previously, users needed to exchange 1 USD worth of LUNA for 1 UST, aiming to absorb fluctuations in demand for decentralized stablecoins through the contraction of LUNA. Currently, this mechanism in Terra is very successful, with UST already becoming the 4th largest stablecoin, with a market value of $16 billion. According to current trends, it will soon surpass DAI to become the 3rd largest stablecoin.

Do Kwon stated that we can view this new mechanism as a fragmented foreign exchange reserve. Previously, to mint 1 UST, you needed to burn $1 worth of LUNA. Now, the difference is that when 1 UST is minted, a portion of LUNA will be burned, while the remaining portion will be used to purchase external ecosystem assets (currently BTC) to ensure decentralized foreign exchange reserves. This ratio is not fixed; it will currently depend on the real-time price of UST against BTC, i.e., the volatility of BTC, with the specific ratio determined by the DAO.

When the BTC reserves reach a certain level, such as 40%, the probability of LUNA experiencing a death spiral is greatly reduced. Although LUNA remains a core component for stabilizing UST, BTC reserves can effectively slow down the speed at which newly minted LUNA enters the market in extreme situations.

In the long term, LFG plans for the Terra protocol to become the world's largest single BTC holding address. This means that LFG is betting on the future performance of BTC prices. In this way, the future BTC reserve ratio will be much higher than the ratio when LFG purchased BTC today, and it will have a stronger ability to respond to future fluctuations in UST demand.

Why make this change?

Do Kwon explained that, first, from an economic perspective, the LUNA-UST system is already sufficient and becoming increasingly robust. However, it must be acknowledged that in the case of extreme changes in market demand, LUNA faces the risk of a death spiral, where the price of LUNA drops while the market value of UST contracts significantly.

The initial use case of LUNA was relatively limited, with Terraform Labs being the largest developer within the ecosystem, but now Terra has become a vast ecosystem, with TVL only second to Ethereum, and applications within the ecosystem involving leverage, options, foreign exchange, interest rate swaps, memes, etc.

In this context, the demand for UST can no longer be accurately estimated. At the same time, a large amount of UST has been transferred to other public chain ecosystems, whether on Curve on Ethereum, Saber on Solana, or Trader Joe and Pangolin on Avalanche, UST is the largest stable pool by TVL.

Many export-oriented economies build their own diversified foreign exchange reserves to cope with short-term demand fluctuations of their own currencies. From this perspective, it becomes a natural choice for Terra to build its own foreign exchange reserves. Of course, to align with Terra's decentralized philosophy, LFG will establish a smart contract to assist users in the exchange process between BTC and UST.

Secondly, from a diplomatic perspective, which is rarely discussed, Terra's goal is to become the largest decentralized currency system in the crypto industry. UST will not only be used in the Terra ecosystem but will also expand to ecosystems with active developers and users, such as Solana, Avalanche, and Polygon.

Unlike the native users cultivated within the Terra ecosystem, users in other public chain ecosystems have a diminished level of trust in LUNA's backing. At this time, using BTC as part of the backing or reserves can effectively enhance these users' trust in UST, as few in the crypto industry would question BTC's value storage capability.

In other words, BTC's role is to make UST a more neutral asset to facilitate its expansion into various ecosystems.

How to achieve the transition of the mechanism?

The completed foreign exchange reserves will be controlled by a smart contract, allowing people to deposit bridged BTC to mint UST, and vice versa.

Specifically, we can view this smart contract as a DEX that only accepts two pools: one pool stores UST, and the other stores BTC, while external oracles will provide real-time pricing for BTC to this DEX. Users deposit BTC and exchange it for UST based on the exchange rate provided by the oracle.

When users deposit UST, they can only redeem 99% of the BTC, with the 1% price difference ensuring that the foreign exchange reserves will only be activated when UST decouples.

There are several common questions people have:

The first question is about the security of cross-chain bridges. A significant reason for the security risks associated with cross-chain bridges is the overall competitive environment of the market. A cross-chain bridge project needs to quickly support various L1 and L2 public chains to capture market share. This causes the team to spend most of their time on cross-chain integration and business development, leaving insufficient time to ensure the security of the underlying technical architecture.

Unlike the multi-signature scheme of WBTC, LFG is screening for the most trustless bridging methods in the direction of light clients.

Although cross-chain bridges have "inherent problems" that cannot be overcome, LFG hopes to create a more secure cross-chain bridge between BTC and UST reserve contracts after removing market competition factors. Prior to this, all BTC purchased by LFG was stored in a multi-signature wallet controlled by the committee.

LFG is currently reviewing various proposals for BTC cross-chain projects, such as Axelar in the Cosmos ecosystem and the Block Stacks community. It plans to initially adopt a diversified cross-chain solution and then filter out one or two high-quality solutions that perform well over time.

The second question is about the future value capture of LUNA. Many people are concerned that incorporating BTC into the UST backing mechanism will reduce LUNA's value capture ability. However, LFG believes that with the help of BTC, the new backing mechanism can gain more users' favor and trust, helping Terra to expand the UST pie, which is not a bad thing for LUNA.

For BTC, Terra's new backing mechanism effectively leverages its property as a value storage asset and builds secondary application scenarios on this basis, allowing BTC to contribute more to the industry without "doing anything," such as in DeFi, NFTs, DAOs, etc.

Additionally, from a diplomatic perspective, LFG will also consider incorporating the L1 native tokens of various ecosystems into LUNA's foreign exchange reserves to provide a better user experience. Users will no longer need to perform cross-chain transfer operations but can directly mint UST using native tokens like SOL, AVAX, etc.

About Anchor Protocol

Will Anchor yields be adjusted downwards?

Recently, Terra has conducted a governance vote regarding Anchor yields, aiming to change Anchor yields to a dynamic metric. Under this new calculation mechanism, the protocol will evaluate changes in its yield reserves monthly and set specific yield targets based on the Delta of these changes. For example, if Anchor's yield reserves decrease by 5% in a given month, the yield provided by the protocol will also decrease by 5%, from 20% to 19%, and vice versa.

It is worth noting that even if Anchor adopts a dynamic yield metric, its monthly yield changes are relatively small because the protocol's yield reserves do not experience drastic changes in the short term.

Is Anchor sustainable?

Interestingly, in the early days of DeFi Summer, many people thought that Anchor's 20% yield was too low and unattractive compared to other opportunities that offered hundreds of percent, making it difficult to capture market share. However, the Anchor team saw the problems that DeFi would face when the market cooled and borrowing demand declined. Now that the market has indeed cooled, the same group of people has begun to question the sustainability of the 20% yield.

The Anchor team's definition of "sustainability" is not about its "yield," but rather its "effectiveness," meaning whether Anchor can continuously bring growth as a tool to regulate leverage demand in the crypto market. However, this does not mean that LFG does not intend to lower the current 20% yield; rather, it indicates that this will be a long-term, steady process.

Additionally, to maintain and increase borrowing demand, Anchor will continue to develop cross-chain capabilities. Anchor has already expanded to the Avalanche ecosystem and will soon support bATOM, bSOL, and bMATIC, with new staking asset yield opportunities remaining consistent.