Crypto trading has taken the back seat in the digital economy in 2022, with the market remaining under the bears' control for most of the year. Furthermore, traders have seen their faith rocked by the consecutive failures of centralized exchanges. These intermediary marketplaces have been the powerhouse of the industry since its humble beginnings. Now, they seem to crumble under mounting allegations of scams, lawsuits, and solvency concerns. Meanwhile, they make a convincing case for the imminent decentralization of crypto…
Bitcoin underwent a sudden surge this week, and looks ready to break the $45k resistance that has kept the crypto market quiet for months. Strangely enough, an altcoin protocol appears the likely cause of the price action.
Terra recently decided to fundamentally change the nature of its UST stablecoin’s price support – by backing it with Bitcoin. As such, they’ve recently begun their plan to absorb as much as $10 billion in Bitcoin off the market.
Terra is a highly popular blockchain protocol running on fiat-pegged stablecoins. It launched in January 2018 and means to provide the wide acceptance and adoption of fiat money with the power of decentralized finance. Today, it’s one of the top 3 smart contract platforms in terms of both TVL and usership.
Most stablecoins today have the backing of a centralized third-party that holds fiat currency. An example of this would include Tether, which has gone through various lawsuits and dubious events casting doubt on whether it actually owns the reserves required to back the asset.
TerraUSD – Terra’s most popular stablecoin – functions rather differently. Until now, the protocol has supported its dollar-peg algorithmically by allowing users to burn $1.00 worth of Terra (LUNA) – the protocol’s staking and governance token – to mint one TerraUSD. Likewise, users can redeem their TerraUSD holdings for a dollar worth of LUNA at any time.
The supply of LUNA regularly expands and contracts in order to keep TerraUSD’s peg, even as the price of LUNA fluctuates. Today, one LUNA costs about $90, and is the 8th most valuable crypto by market cap.
However, as Terra co-founder Do Kwon notes, this model comes with some tradeoffs. The coin is highly-decentralized. However, in comparison to coins like Tether, it faces some price stability issues, especially if the system is put under pressure.
Specifically, if too many people try to redeem their TerraUSD at once, a hypothetical ‘debt spiral’ could occur with the LUNA token it’s paired with. Luna’s value would begin to collapse as more of the token prints out to meet user demand.
The Bitcoin-Backed Alternative
In an interview with The Best Business Show host Anthony Pompliano, Kwon explains why Terra has decided to back TerraUSD using Bitcoin from now on.
Originally, Terra’s devs had more control over the “pipes” and use cases of the platform. However, as the ecosystem expanded, they decided that its primary stablecoin needed a more robust stability mechanism.
After some steady Bitcoin purchases, Terra now owns close to a billion dollars in Bitcoin within its reserves. That’s alongside $1.6 billion in Tether, and another billion in UST.
Terra plans for these reserves – cumulatively worth around $3 billion at the moment – to eventually be worth $10 billion, and entirely in Bitcoin. This will be possible by modifying UST’s minting mechanism such that some percentage of LUNA will not simply burn. Instead, the protocol will exchange it for Bitcoin to place in reserves.
Currently, the market sees a demand for TerraUST of $100 to $200 million new tokens per day. Under the new plan, this massive demand has been facilitating Bitcoin purchases from Terra in the realm of $125 million per day. For reference, this is about 3 times as much Bitcoin as is entering network supply through mining every 24 hours.
“I think for a very long time UST supply is gonna keep growing,” said Kwon during the interview. “I think there’s massive demand for decentralized stablecoins. So I think, on a lot of days, we will see more Bitcoin being locked up in this on-chain reserve than the miners are putting out in the market.”
Preventing a Bank Run
Naturally, the phenomenon appears very bullish for Bitcoin right now. With thousands of Bitcoin going under lock in Terra’s reserves each day, Bitcoin’s price has been climbing to mid-$40,000.
As Pompliano noted, the price movement is reminiscent of Grayscale Bitcoin Trust’s arbitrage trade, which gobbled up to 150-200% of Bitcoin’s incoming daily supply before the asset moonshot from $9k to over $60k from 2020 to 2021.
Yet Grayscale’s GBTC shares aren’t as easily redeemable as UST. For Terra, swift redemption could theoretically cause an influx of arbitrage traders redeeming their UST at once to collectively tank Bitcoin’s price, in a reverse of the pattern that we see today.
However, Terra disincentivizes this by only rewarding UST redeemers with $0.98 in Bitcoin, rather than the whole peg. This ensures people use the machine only to de-peg, and not to destabilize the system.
The Best Reserve Asset
Kwon concluded that using Bitcoin is good for UST’s health and helps build credibility with the Bitcoin and altcoin communities. After all, if there’s one cryptocurrency the entire industry can trust, it’s Bitcoin:
“You can say whatever you want about Bitcoin, but at the end of the day, it is the soundest and most credibly neutral asset in the digital asset space. There’s no equal”.
Terra still has a long way to go before it accumulates its $10 billion reserves. Should it follow through, this would lead the reserve fund to own more Bitcoin than MicroStrategy.