How Bitcoin Will Keep UST's Peg (The Defender Mechanism)


The Terra blockchain is based on the Luna and its stablecoins, most notably TerraUsd (UST). However UST mint takes place via Luna. Terra Foundation is trying to limit Luna's importance in the UST peg.
The foundation headed by Do Kwon to stabilize UST's peg is raising $ 10 billion in Bitcoin to build its reserve. All this serves to stabilize the UST peg.
Remember that UST, unlike dollar-collateralized stable (like USDC, or USDT), is completely algorithmic. How does it work?

1) 1 UST is created (mint) by burning 1 $ of the Luna
2) The burn of 1 UST creates 1 $ of the Luna

This is the "seigniorage" mechanism on which the Terra-Luna-UST ecosystem that exploits the Luna reserve is based.
What happens if UST loses the peg with the dollar? There is the incentive to buy or sell it in the market to mint or burn Luna:

1) If UST exceeds $ 1, I can burn Luna, create Ust and sell it spot earning the difference (if it's worth $ 1.02, I get it by burning 1 dollar of Luna)
2) If UST falls below $ 1, it is bought on the market, burned to get $ 1 Luna, then sold spot

Using UST continuously lowers Luna's supply due to burns. On the other hand, a contraction in demand for UST translates into an increase in the supply of Luna with a lowering of the intrinsic value of Luna (and of the price itself). Critics call it "the death spiral": if Luna collapses, trust is also lost in UST, which could face the depeg due to sales. You have to consider that by burning UST, more Luna is created, the price goes down further.

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Therefore, this reserve mechanism with the Luna acting as a "guarantee" could fail when it falls in value too quickly: for example, the 1 dollar redeem of the Luna could be not very convenient (if the collapse is fast, the Luna would fall well below $ 0.96 so it wouldn't be cheap).

 

BITCOIN RESERVE TO KEEP THE PEG: THE DEFENDER MECHANISM
So what will this reserve of Bitcoin do? It will serve to limit the selling pressure on Luna in bearish phases and to absorb the UST contraction (the reserve will be used to buy UST!)

1) Depeg downwards: with 1 UST you can always redeem $ 0.98 of Bitcoin so if 1 UST drops to $ 0.97 or below, I redeem and buy $ 0.98 of Bitcoin on the market (if you think about it it is convenient because UST is below $ 0.98 and yet I get $ 0.98 worth of Bitcoin, as if I bought it at a discount)
2) Depeg upwards: in this case 1 UST is always worth 1 dollar of Bitcoin so if 1 UST exceeds 1 dollar (perhaps reaches 1.02 or more) it is better to exchange 1 dollar of Bitcoin for 1 UST and then sell UST spot

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However, it should be considered that Bitcoin will not be used to create UST: the only way will always be to burn $ 1 of the Luna. Bitcoin will not become UST's collateral! UST will continue to maintain its peg, again through seigniorage and spot buying / selling incentives.

 

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