Is Bitcoin Becoming an Anchor of Value?

Introduction

Why Terra is Making Multi-Billion Dollar Bitcoin Purchases

The biggest publicly known buyer of bitcoin in recent weeks isn't who you'd historically expect it to be. It isn't a corporation, pension fund, endowment or even a large traditional financial institution. Rather, a different digital asset protocol, who has not been shy in making public statements, is currently the biggest known buyer of bitcoin. The Terra ecosystem has purchased more than $1.5 billion of bitcoin and has plans to buy more in both the short and long-term, as of the time of this writing. We'll give a brief overview of stablecoins, how bitcoin is being used to potentially increase the level of trust in Terra's stablecoin, and what other ecosystem's utilizing bitcoin could mean for the future of bitcoin and the digital asset ecosystem as a whole.

A Brief Overview of Stablecoins

Stablecoins are one of the most important technologies to emerge in the digital asset space in recent years. Stablecoins' objective is to provide a token with a value that is constant, stable, and pegged to some third-party asset such as a fiat currency, a commodity, or even a price index. The most popular type of stablecoin aims to maintain price stability with the U.S. dollar.

Stablecoins fulfill a variety of financial use cases including trading, borrowing, lending and spending. Stablecoins are a critical piece of infrastructure for the decentralized finance (DeFi) ecosystem. This has resulted in questions surrounding their level of decentralization in recent years. The history of stablecoins is rather extensive and more complicated than it may seem. We'll briefly give an overview of the three major categories of stablecoins and explain why algorithmic stablecoins, important to today's discussion, are growing in popularity. The three main categories of stablecoins are explained below:

• Centralized, Fiat-backed Stablecoins Centralized: stablecoins are the simplest of this category to understand and are the largest in size. These stablecoins hold reserves in real world assets such as U.S. treasuries or other investible securities and the level of transparency and regulatory oversight of these assets ranges broadly. For example, every $1 in a centralized stablecoin is trusted to be backed by a reserve of $1 in other real-world assets. The biggest issue with centralized stablecoins is that they are centralized, lack censorship resistance, and require trust in third parties – all of which are directly at odds with much of the ethos of cryptocurrencies. As a result, alternatives have emerged to allow users to choose stablecoins which are arguably more decentralized, thereby trading trust in central intermediaries holding their underlying assets in exchange for trust in code and digitally native assets.
• Collateralized Stablecoins: The next evolution of stablecoins took a logical step towards decentralization by stabilizing themselves using digitally native assets rather than real world assets that require a centralized custodian. MakerDAO was responsible for the first digitally collateralized stablecoin, known as the Dai stablecoin, and remains the most popular in this category to date. Dai is an Ethereum-based stablecoin that is collateralized by crypto and uses smart contracts and economic incentives to maintain its $1 stable peg. However, in order to ensure that the $1 peg can be maintained at all times, these vaults need to be heavily overcollateralized. This leads to an inefficiency of capital, and though a slow and conservative approach to stablecoin issuance could make sense, it also slows the issuance rate of the token and the enthusiasm of potential users.
• Algorithmic Stablecoins: The last category, and most important to explain bitcoin's recent role in stablecoin stability, are algorithmic stablecoins. Over time, some stablecoin entrepreneurs and observers have realized that the most important aspect of a successful stablecoin is simply its ability to maintain its pegged price at all times, particularly during times of large redemptions. The Terra ecosystem embraced this concept by building a platform whose native token is primarily used in the creation and redemption of their stablecoin, UST (terraUSD, abbreviated as UST, not to be confused with the popular centralized stablecoin from Tether, abbreviated as USDT). The native platform token used to create UST is known as Luna. Users can burn (destroy) $1 worth of Luna to create $1 worth of UST. They can also do the opposite, redeem their UST for $1 worth of Luna whenever they wish. Luna is not stable in price, and much of its price movement is a result of the issuance and destruction of the UST stablecoin. The stablecoin doesn't aim to be backed by assets, but rather it maintains a constant bid at its "peg" to maintain its $1 stability. A rough analogy would be a country's central bank that uses its reserve to maintain a peg for its domestic currency. For example, it might use its reserve of U.S. dollars to maintain the value of its domestic currency, buying and selling as needed. In this case, Luna is the reserve asset, and the algorithm is the central bank. For Terra, the most important mission is the ability for the ecosystem to support this $1 peg at all times. If trust is lost in this peg, the project would likely fail.

Why is UST so Popular?

The UST stablecoin has gained traction for a variety of reasons, but among the most important are its prioritization around decentralization and innovation. The minting and burning of the UST stablecoin does not rely on real world assets that can be censored or seized, and therefore creates a token that embodies decentralization relative to the most popular stablecoins of today that require large amounts of trust like Tether and USD Coin. Terra has also created partnerships and products that its users want to interact with such as payment platforms to make their stablecoin usable in traditional commerce as well as the platforms most popular feature, a savings account known as Anchor. Anchor has offered users an attractive fixed-rate savings account paying a consistent rate of roughly 20%. The high rate is partially due to an unsustainable subsidy being paid to attract new users. Although this rate is likely to be reformed and brought to a more sustainable level, the product is still likely to remain attractive relative to similar offerings.

For these reasons, UST has had the highest growth rate amongst stablecoins in recent months. The market capitalization of UST was under $3 billion in early November and has ballooned to over $16 billion today, that's an average of over $2 billion of stablecoin creation per month according to CoinGecko. This has led some to become concerned that the stablecoin could become unpegged if a large number of users decide to redeem their UST for $1 of Luna at the same time. A "run on the bank" scenario is the most commonly discussed risk associated with the Terra ecosystem. If many users redeemed at once, a large amount of Luna would be minted causing token dilution that could lead to market disruptions and possibly lead to UST becoming unpegged. This brings us to recent weeks where Terra and bitcoin have come to cross paths.

Two Worlds Collide - Terra and Bitcoin

Terraform Labs, the company responsible for much of the innovation within the Terra ecosystem, announced the launch of a new initiative known as the Luna Foundation Guard in January of 2022. In short, the Luna Foundation Guard's mission is to ensure price stability of the UST stablecoin to further instill trust that $1 of UST can always be redeemed for $1 of assets. The group released their initial plans in the weeks following which detailed an ambitious roadmap to acquire assets outside of their own ecosystem that would provide ongoing support for the stablecoins $1 peg.¹ Their first order of business has become purchasing a stockpile of bitcoin, with an initial outlay of $3 billion and a goal to reach $10 billion over time.²

At the time of this writing, Terra has purchased more than $1.5 billion in bitcoin year-to-date (35,700 BTC)³. They've done so with an initial purchase of nearly 10,000 bitcoin at the end of January, followed by a purchase plan of roughly $125 million in daily buying from March 22nd through March 30th. Based on the initial raise and goal of making roughly $3 billion in purchases to begin, we expect the group to continue purchasing additional bitcoin throughout the near future.

This stockpile of bitcoin will be used as a safety mechanism for the UST stablecoin. UST users will then be able to rely on a large quantity of bitcoin, in addition to the Luna minting mechanism that already exists. It is likely, based off current proposals, that the Luna Foundation Guard will agree on some form of action where this bitcoin will provide a constant bid for UST at 98 or 99 cents, whereby the bitcoin would only be purchased by rational actors if the stablecoin were to begin to become unpegged from its $1 promise.⁴ Knowing that there is now a large amount of bitcoin supporting this stablecoin will likely lead to an increased level of trust that users have when interacting with UST. It's a great example of other ecosystem’s being able to lean on bitcoin for the tradeoffs it makes that emphasize stability and trustworthiness.

Going Forward

The purchases of bitcoin by Terra align very well with some of the thinking that we’ve mentioned in the past regarding a multichain future. In our piece titled Bitcoin First, we discussed the possibility of success for multiple different ecosystems that make various tradeoffs, each aiming to achieve a wide array of use cases and gradually becoming more interconnected and interoperable through time. We also mentioned how we view bitcoin as unique and likely to be a central part of this digital asset ecosystem regardless of how the landscape evolves.

We suspect that these types of actions could become increasingly frequent as discussions of bridging bitcoin collateral to other ecosystems continue to grow.⁵ Dai has already done something similar to what Terra is making headlines for. In fact, Dai holds over $2.3 billion in wrapped bitcoin tokens throughout its multi-collateral vaults today.⁶ So, while what Terra is doing is exciting and aligns with the potential vision of a multichain world where bitcoin's stability and tradeoffs can be leaned on by other ecosystems, it is not the first time that this has been done to the tune of billions of dollars.

While Bitcoin's design is simple and boring, it is also, for this exact reason, trustworthy and elegant. It is very likely, in our view, that bitcoin continues to exist as a form of "pristine collateral" for both the traditional investment world to use for purposes that include diversification and hedging against traditional currencies, and also for alternative blockchain ecosystems that live on the cutting-edge of technological advancement that can rely on it to bring stability to their world of constant change and innovation.