In this dashboard, we talk about why UST is not collateralized by LUNA. We also explain how UST is governed by a set of game-theoretic incentives which allow it to maintain its peg.

Why LUNA is not collateral for UST

A common misconception about Terra is that UST is collateralized by LUNA. The same thinking is true for all other stablecoins on Terra. To understand why this is not true, let's first understand what collateralisation means:

<aside> 💡 Collateralization is the use of a valuable asset to secure a loan. If the borrower defaults on the loan, the lender may seize the asset and sell it to offset the loss.

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So now that we know what collateralisation means, doesn't UST seem to be collateralized by LUNA? In fact, you burn $1 of LUNA to mint $1 of UST and you burn $1 of UST to burn $1 of LUNA, right? Looks a lot like collateral doesn't it?

There's actually some meaningful differences between the creation of UST and debt in the typical sense here. Let's imagine a scenario where you lock up 100 bLUNA to take a $100 loan from the Anchor Money Market. Here you've posted 100 bLUNA as collateral and get $100 in return. When you return the $100 with interest you will get back the 100 bLUNA that you had deposited. This is a typical debt example, where you post a valuable asset as collateral.

But now, what happens when you burn $1 of LUNA to get 1 UST. Let's assume the price of LUNA was $500 at this point, so you burned 1/500th of a LUNA to get 1 UST. In a couple of months, you are done using your UST, so you want to burn it and get back the 1/5th LUNA you deposited. But, the price of LUNA is now $10 which means you'll only get back 1/10th of a LUNA for burning your UST. You don't actually have to get back the same amount of LUNA you burned to mint UST! This makes the minting/burning process of LUNA/UST very interesting (and reflexive). It's not collateral because to mint one asset the other is being burned and there is no guarantee you'll get back the same amount of the initial asset back when you reverse your first transaction.

Now that we understand that the UST minting/burning process is different from a simple collateralized debt position. Let's try to think about what it truly is. I believe the mechanism that allows UST to maintain its peg is purely game-theoretic in nature. People believe that UST and other Terra stablecoins have value and their value is pegged to the fiat currency they represent. They believe this because they believe there will be a demand for these stablecoins at their peg, due to products like Anchor, Mirror and Chai.

Why do I say so? For something like USDC, its value comes from the USD in Circle's bank account. Why? Because if USDC dips below $1 then an arbitrageur can profit by buying the USDC in an open market and then redeeming it with Circle for $1.

Why would anyone buy UST when it dips below its peg? If UST falls below its peg, then the arbitrageur can mint $1 of LUNA for 1 UST. So then the question becomes, why would people want LUNA? Because there is inherent perceived value in LUNA, LUNA can be staked to generate cash flow from the activities on the Terra blockchain. So, as long as LUNA has value arbitrageurs will continue to burn UST for LUNA. This can have extreme side effects to the price of LUNA and in the case of severe de-pegging can lead to LUNA asymptotically heading to 0.

On the other hand, if UST goes above its peg (unlikely), an arbitrageur can just mint a ton of UST for $1 of LUNA each and sell it on the open market. UST going above its peg is a signal of demand so the closing of the difference in case the peg breaks to the upside is fairly simple.

So our conclusion is that UST is backed by a set of game-theoretic incentives around the usage of the Terra blockchain. Users will bring UST back to its peg by burning it to get more LUNA which in turn can be used to generate cashflow by staking the LUNA. Thus, all in all, the best way to express this is that UST is backed by the ability of LUNA to generate cashflow, which in turn is backed by the activities on the Terra blockchain which in turn is backed somewhat by the economic value of UST (this cyclicality is what brings in most of the risk)

This relationship does seem a bit cyclical and is largely dangerous when a stablecoin is in its fledgeling stages but if the team creating the stablecoin is able to generate enough demand for the stablecoin (what is enough is to be determined as we wait for an algo stablecoin to succeed) then the risk of a bank run get lower as the use of the blockchain and the stablecoin increase.

Let's now take a look at some tweets/discussions that have guided my understanding of this