Try Quests to earn cryptoThe Nightmare Scenario
In what circumstances would the price and supply of LUNA and the supply of UST constitute a serious threat to UST redemption, i.e. create an imbalance wherein the UST-LUNA exchange mechanism would no longer function properly? What is the likelihood of such a scenario, and how might it be mitigated?
Introduction
What is Terra LUNA
The Terra blockchain is built on Cosmos SDK; a framework that allows developers to create custom blockchains and build their own decentralized applications on top of Terra for various use cases. Terra is a blockchain protocol underpinned by a suite of decentralized stablecoins. The most popular is called TerraUSD, or UST. The stablecoins maintain their pegs through a coin called LUNA. LUNA is a volatile cryptocurrency. The elasticity of its supply keeps the prices of its stablecoins in check.
What is the Nightmare Scenario
The Terra/LUNA Nightmare Scenario is a case when an imbalance wherein the UST-LUNA exchange mechanism would no longer function properly.
Methodology
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We will look at the mechanism that could cause a nightmare scenario with UST and how it could be mitigated.
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We will also look at the metrics to consider when thinking about this scenario.
What is the Market Mechanism?
The Terra protocol’s market module enables users to always trade 1 USD worth of Luna for 1 UST, and vice versa, incentivizing users to maintain the price of Terra. This same principle is true for all Terra stablecoin denominations.
How do arbitrageurs maintain the peg of UST?
When the price of UST goes above or below the price of $1 the anybody can mint ethier UST or Luna for lower than the market price using the market mechanism and sell it on the open market. This has the effect of both making a profit for the arbitrager and moving the price of UST closer to $1.
How can this Mechanism be dysfunctional in the short-term?
If the price of LUNA is falling at such a rate that people think by the time they burn UST to mint LUNA and sell it on the market LUNA price would have fallen low enough that they would lose money rather than make money. If this is the case the price of UST could depeg in the short term because there would be no marginal buyers for UST at or above 1 USD.
How can this Mechanism be dysfunctional in the long-term?
If UST depegs from 1$ and is significantly below 1$ then one of two things can happen. First people lose faith in UST ast a stable coin and dump all the LUNA and UST effectively making the two tokens worthless. or the price of luna stabilizes and arbitagers can come back into the market and make a profit from fixing the UST peg. although it would seem that the maketcap of LUNA must be higher than that of UST to maintain the peg this it not true, the only thing that needs to occur is enough capital from arbitrageurs putting money into the system to make a profit and the price of LUNA to not fall too fast.
LFGs protection of the peg
Currently the LFG is trying to protect the peg of UST. The biggest and most useful action they have taken to protect the peg is their continuous purchase of BTC to help defend the UST peg. Once completed holders of UST will at any point trade 1 UST from $0.99 of BTC. This will help prevent the Nightmare Scenario because if the price of LUNA falls too fast the abitragers can abitage using BTC to keep UST within 1 cent of the Dollar.
The Graph above shows the Market module mint/Burn volume daily inb 2022. Because the LUNA burn is much greater than the UST burn each day this mechanism has been very healthy in 2022.