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Why is Terra buying such a huge amount of Bitcoin?
Founder Do Kwon announced that the accumulation is part of a plan to usher in a new era of money with Bitcoin as the standard. This core idea is not new. Bitcoin is as much a hard asset as gold, and it's heartening to see entrepreneurs have a high level of confidence in Bitcoin. But then, Do Kwon also believes that Avalanche and other tokens form solid collateral.
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Building a Stronger Foundation for UST
Terra is one of the leading emerging Layer 1 blockchains dedicated to DeFi, second only to Ethereum in terms of TVL. One of the newer players to enter the market in the past 2 years, Terra Protocol has quickly replaced Binance Smart Chain, Avalanche, Solana, Fathom, Tron, and Polygon.
One of the most successful dApps on the Terra chain is Anchor Protocol, a high-yield savings and lending protocol with $16.5 billion in total value locked, more than half of all TVL on Terra. The main attraction of the Anchor Protocol is that it rewards UST depositors with approximately 19% APY. UST is Terra’s native USD-pegged stablecoin, and unlike fiat-collateralized stablecoins like USDT and USDC, it is an algorithmic stablecoin. The peg uses a math-based mechanism and applies to the native LUNA token, allowing the stablecoin to theoretically be pegged to the U.S. dollar.
Over the past few years, there have been many algorithmic stablecoins that have come and gone. They have been notoriously difficult to maintain during periods of high volatility, especially when there is downward pressure, which is when traders looking for a safe haven during a crypto storm need them most. However, if an organization succeeds in launching an algorithmic stablecoin, the rewards could be substantial, as these stablecoins can scale infinitely to keep up with the ever-growing demands of DeFi applications and now the metaverse economy.
Of course, that would change if Bitcoin continues to be adopted in global finance and established as a currency and reserve asset. If something like this happened, there would of course be no need for a fiat-pegged stablecoin, as BTC would be the original stablecoin, pegged only to itself. Like standalone dollars, so to speak, but better.
But back to reality. Buying BTC is tied to a weakness of algorithmic stablecoins: when the going gets tough, arbitrage isn't always attractive enough to maintain the peg. When this happens, Terra needs to step in to restore the peg as it has done in the past (as does MakerDAO's own algorithmic stablecoin, DAI). This is why the Luna Foundation Guard has been accumulating bitcoins in large quantities and rapidly. The plan will establish a total of $10 billion in Bitcoin as a reserve asset to increase confidence in the UST stablecoin that Terra will have the means to prevent a death spiral from happening.
However, this comes without any guarantees. In the next few months, Bitcoin may crash further, followed by a run on UST. But as Do Kwon said in the Unchained interview: "I'm kind of betting that it's more likely that this reserve will be sufficient to withstand a drop in UST demand in the event of a long-term rise in Bitcoin."
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BTC may destroy UST
There must be several factors happening simultaneously for BTC to break UST, but that doesn't mean it won't happen. Anchor Protocol is one of the biggest reasons for UST demand right now. 19% APY for a stablecoin is quite high when looking closely at the debit side of the equation. At present, the annual interest rate offered to borrowers is only 11.81%. Only when the interest collected from the loan exceeds the interest paid to the deposit, the lender can continue to borrow. The gap between lender and debit APY is covered by a reserve fund, which is rapidly being depleted as the amount locked in Anchor increases.
As noted by recent criticism of UST, if Anchor yields lower than competitors, users may be eager to exit, unloading their LUNA and UST in the meantime. Of course, this is where the Bitcoin reserve asset comes in, but some believe this could make matters worse. What if BTC reserves actually increased the likelihood of a run? Bitcoin reserves can also be seen as an incentive to attack UST in order to snap up Bitcoin during a downtrend. While this would have to be a coordinated attack by several Antarctic blue whales, it could happen.
This is one reason why not everyone supports the Terra initiative. A death spiral could now affect Bitcoin and every other cryptocurrency they say they want to buy, not the risk of taking control of the Terra ecosystem in case of failure.
about the author
about the author
About AAX Academy
About AAX Academy
AAX serves trading users, innovators, NFT artists, high-net-worth investors and users without bank accounts around the world. With the mission of realizing the practical application of digital assets, AAX is committed to making stable currency benefit everyone.
AAX Academy is a user education channel created by AAX, which aims to help more users learn novice tutorials and understand the basics of blockchain.
AAX serves trading users, innovators, NFT artists, high-net-worth investors and users without bank accounts around the world. With the mission of realizing the practical application of digital assets, AAX is committed to making stable currency benefit everyone.
