Bailout Fund, Backstop or Bouncy Ball? Here's How LFG's Bitcoin 'Reserve' Might Work
Developers of the fast-growing UST stablecoin say the coin's $1 value peg isn't "backed" by anything – just a blockchain-based algorithm. So why does it need a multibillion-dollar bitcoin reserve in case of an emergency? How would that work?
Luna Foundation Guard (LFG) has been making headlines over the past month as one of the biggest bitcoin (BTC) buyers for a new "reserve," seemingly appearing out of nowhere to scoop up $1.7 billion of the largest cryptocurrency by market value.
But what is the LFG reserve's purpose, and for what would it use the bitcoin?
According to LFG's website, the reserve is set up to support the Terra ecosystem – a blockchain-based project focused around a dollar-pegged stablecoin known as UST and a cryptocurrency called LUNA.
The matter starts to get confusing, though, because the token's design as an "algorithmic stablecoin" means UST is "not backed or collateralized by bitcoin or any other asset," according to a Terraform Labs spokesperson.
So it's a "reserve" for UST – but not backing UST?
With little in writing from LFG to explain how the reserve works, some analysts are drawing their own interpretations.
“To me the LFG reserve is something between an insurance policy and a backstop of last resort,” said Felix Hartmann, head of Florida hedge fund Hartmann Capital. "It is a psychological backstop, similar to FDIC, to comfort people that this in fact is not a house of cards.” FDIC stands for the Federal Deposit Insurance Corp., which insures U.S. bank deposits.
At the core of the matter are crucial questions about fast-growing crypto markets: Will these computer code-based projects built on blockchains actually work on their own without external support, and are they truly decentralized?
Trust the algorithm
But a new breed of "algorithmic stablecoins" like UST exist as "protocols" – basically lines of programming on a blockchain that supposedly will assure the token stays pegged at $1. (The stablecoin is officially known as terraUSD but also goes by UST, its trading symbol.)
Even so, many early versions of algorithmic stablecoins have crashed – Beanstalk being the latest. So questions have arisen about how sustainable UST's growth might be, with a market capitalization that grew by $15 billion in five months. It now stands as the third-largest stablecoin.
The new reserve might serve to address any gaps in the confidence. Kwon has hinted that purchases will not stop until the reserves reach $10 billion, saying that “BTC reserves will open a new monetary era of the Bitcoin standard.”
So how would the LFG bitcoin reserve work?
LFG describes certain elements of the "UST reserve protocol" on its website, but how it would work – or under what circumstances it might kick in – isn't completely spelled out.
According to the website, LFG is a "nonprofit organization established in the Republic of Singapore dedicated to creating and providing greater economic sovereignty, security, and sustainability of open-source software and applications that help build and promote a truly decentralized economy."
It might be no coincidence that "LFG" is a widely used acronym in crypto lingo to express enthusiasm or optimism for a trade. It stands for "Let's f**king go."
CoinDesk asked the Terraform Labs spokesperson if there was anything detailed in writing about the LFG reserve that officials could provide, and she referred us to a March 23 proposal on Terra’s research platform,from a trading firm called Jump Trading, which also happens to be Jump Crypto’s parent company, a lead investor in the LFG project.
It gets complicated – real fast – but the idea in the proposal is that the reserve would provide an additional leg to stabilize UST’s price if it falls way below the peg.
Under the Jump Trading proposal, which has yet to get the green light, LFG would transfer the UST reserve assets to a dedicated reserve pool.
This reserve would be accessible only in “emergencies but not otherwise,” according to the proposal.
The suggested threshold was $0.98 – i.e., if things deteriorated to the point where traders were willing to exchange $1 of UST coins for 98 cents of bitcoin – a 2% downward deviation from the $1 peg. Such a level, according to Jump Trading, would "prevent the fund from being utilized for ordinary movements in the price of UST in favor of extraordinary movements only.”
But if the emergency conditions actually materialized, retail investors could swap their UST for bitcoin (or other assets in reserve pool) at a discount.
The proposal doesn't say this specifically, but ostensibly the mechanism would establish a price floor for UST, and buyers would step in if price falls below $0.98.
“It creates demand for UST by arbitrageurs who can buy UST at, say, $0.97 and convert it for BTC at $0.98," said Jordi Alexander, chief investment officer of Selini Capital. “This should create a more hard floor at $0.98 and prevent a cataclysmic redemption flow into LUNA because at that point, say, UST was going to $0.97, people would arbitrage the price back up.”
Theoretically, the price floor for UST would help to restore the coin's market value back to the $1 peg.
Dustin Teander, an analyst at the crypto research and data firm Messari, said that “in the same way a gym floor provides a firm surface for a basketball to bounce, the reserves provide UST a price floor to bounce off of.”
When the crisis passes, the reserve pool drains its UST holding by letting traders purchase UST at the $1 peg with BTC.
“Can $2 billion in reserves really protect $17 billion of stablecoin from collapsing? Of course not. But it is a psychological backstop to comfort people that this in fact is not a house of cards,” said Hartmann.
The proposal is still in the feedback process on Agora, the research forum of Terraform Labs where users can discuss governance and development initiatives.
“The proposal process on Agora is for eliciting feedback and calibrating the design before moving forward with the specs for the BTC Reserve. Currently, bridging solutions are being explored for adding BTC to the Reserve, and a timeline for the launch of the Reserve is still TBD [to be decided],” Terraform Labs spokesperson told CoinDesk in a statement.
“As of now, the proposal is being built out – not by Jump, but by other partners of Terra – before being presented again to the community,” Nihar Shah, a researcher at Jump Crypto, Jump Trading's filial said in an email.
LFG didn’t return requests for comment.
Perpetual need for demand
All of this would just be another in-the-weeds explanation of the rules of a complex blockchain protocol – a dime a dozen in crypto – if it weren't for the fact that so much money was at stake.
Terra’s UST toppled Binance USD as the third-largest stablecoin behind Tether’s USDT and Circle’s USDC because its circulating supply has grown nearly tenfold over the past year to a whopping $17 billion. The price of LUNA, UST’s sister token that absorbs the stablecoin’s price swings, exploded to $95 from $13 a year ago.
The fast growth has raised concerns that a collapse of the UST peg might trigger systemic failures in crypto markets. LUNA's market capitalization is just over $70 billion. Bitcoin's is $770 billion.
“A late implosion of LUNA would be catastrophic for the space,” bringing down the industry into a “cold, bitter, long winter,” Galois Capital argued in a tweet.
The steady rise is mainly fueled by Anchor, a decentralized finance (DeFi) protocol built on top of the Terra blockchain, which currently holds more than half of the total supply of UST, some $9.5 billion – locked up on the platform, thanks to a tempting 19.5% annual yield that savers can reap on their UST deposits.
Yield-hungry depositors flocked to Anchor, fueling the demand for UST, but the platform’s revenue can’t keep up with yield payout and it already needed a $450 million bailout in February.
'Step back' risk – LFG or GTFO?
As long as UST grows via demand-creating schemes such as Anchor’s subsidized yields, the algorithmic peg seems to hold fine. But what happens if the “only-up” market ends and demand dwindles?
Jump Trading’s proposal assumes robust private markets and liquidity for UST, while one of the main criticisms of algorithmic stablecoins is their constant need to generate demand; otherwise, they break the peg and collapse.
In a research paper, Ryan Clements, chair in business law and regulation at the University of Calgary, argued that algorithmic stablecoins must generate a perpetual demand in the underlying ecosystem and the arbitrage mechanism to remain stable. Translation: The $1 pegging mechanism for UST might not hold if traders who help to maintain the system were to lose confidence, and back away altogether.
“Perpetual demand, and reliance on arbitrage, is not certain because of 'step-back' risk,” Clements told CoinDesk in email. Step-back risk refers to an event when trust in an algorithmic stablecoin evaporates and investors lose interest in executing the arbitrage to stabilize the price, so the stablecoin drifts into a death spiral.
There is no shortage of examples for that. Beanstalk Farms, an Ethereum-based stablecoin protocol, was exploited for $182 million in a hack on April 17, and its BEAN token collapsed to $0.03 from the $1 peg after the attack. In July 2021, Iron Finance’s stablecoin, which was partially asset-backed and also pegged algorithmically, imploded when investors panic-sold its sister token, TITAN.
Clements cited various potential threats to the stability of UST. For example, Anchor may not be able to sustain its current high yield and depositors flee, a sell-off in bitcoin might transmit volatility to UST, or trading activity may not be sufficient to replenish the reserves.
LUNA has already had a close encounter with losing its peg. When the crypto market crashed in May 2021, UST briefly dropped to $0.87 and LUNA collapsed to $4 from $20.
If only LUNA can absorb the price deviation of UST, selling LUNA for UST makes the situation worse. So, having billions of dollars worth of bitcoin in reserve can counteract the downward spiral in price.
“It should materially reduce the risk of a catastrophic failure. Not to zero, of course,” Dragonfly Capital Managing Partner Haseeb Qureshi said.
Then is UST still decentralized?
The reserve was not part of the Terra blockchain protocol’s original design, nor are there any mentions in the white paper that Terra would need any other assets – apart from the UST and LUNA used in the algorithm – to maintain the peg.
“LFG's backstop of BTC reserves turns UST into something closer to Celo's model, which is a mix of seigniorage shares with crypto collateral,” Qureshi said. Celo’s stablecoins are partially backed by assets and an algorithm adjusting its supply.
Can UST claim to be decentralized? Analysts are split.
“The fact that [Terraform Labs] needs a centralized entity (LFG) to inject capital, purchase reserves and continually take actions to strengthen the underlying Terra ecosystem (and create more and more use cases for UST) seriously calls into question the 'decentralized' assertion of Terra,” said Clements.
By contrast, Messari’s Teander said UST would remain decentralized through the whole process.
“The BTC only practically comes into the equation once the Jump proposal is implemented, and when it does, it will be controlled in a decentralized protocol, not the centralized LFG organization,” he said.
Jordi Alexander of Selini Capital said that it takes many steps for a crypto project to get to decentralization.
“I see it like a parent having a child,” Alexander said. “You first give birth to them and have to guide them through childhood and education years by supporting and making decisions, until eventually when they are adults and ready to leave the house. If you have done a good job they will manage to be successfully independent without you.”
UPDATE (19:45 UTC): This update includes statement about the status and prospective launch of the proposal from Terraform Labs spokesperson.
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