This article was originally published on April 20th, 2022. It was republished here after the wallet address for shuel.eth changed.

Terra, relentlessly guided forward by founder Do Kwon, signaled a significant adjustment of its strategic focus beginning in late March 2022. In my previous Terra analysis, I was skeptical of Terra’s long-term viability. With 74% of the total UST supply deposited in Anchor protocol, the majority of UST demand is currently recursive and unsustainable. The Chai payments partnership, which previously created modest legitimate Terra demand, is now dissolved. The Mars and Mirror protocols combined have a TVL of only 4.6% of the total UST supply.

Terra’s ecosystem still does not generate sustainable demand for 3/4 of the circulating UST supply. Anchor’s yield reserve burn rate remains in excess of $100M/month. With no evidence that Terraform Labs would successfully transition its subsidized user base to legitimate use cases before dynamic rates take effect on May 1st, the clock seemed to be running out in mid-March.

https://twitter.com/RossShuel/status/1511861439996198914?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1511861439996198914%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

Since then, the establishment of (1) the diversified strategic reserve, (2) 4Pool, and (3) Avalanche partnership have cumulatively extended Terra’s available runway to build sustainable user demand for UST. With the first strategic reserve announcement, Do Kwon revealed a shift in Terraform Labs’ strategic priority from building individual user demand to integrating Terra to cross-chain ecosystems and assets. The initial reserve announcement of $1.5B BTC was quickly raised to a $10B BTC goal. On April 1st, Do Kwon introduced the 4pool. Within a week, Terra announced a strategic partnership between the Avalanche and Terra ecosystems that will see $100M AVAX added to the strategic reserve, a Terra gaming subnet, expansion of Terra’s grants program to Avalanche protocols natively incorporating UST, and a UST-AVAX swap mechanism that will deflate the AVAX supply during periods of Terra growth. The strategic shift to cross-chain ecosystem integrations and a diversified reserve will create economic interdependence and increased user confidence that can be expected to provide volatility robustness during periods of severe economic contraction that may have previously been fatal to the protocol. Let’s examine each of the above three developments in turn:

Central banks historically start from conservative positions of maximum collateralization (e.g. MakerDAO) and then evolve towards an optimal fractionalized reserve ratio that balances tail risk protection against capital efficiency. Terra’s monetary policy started at the opposite end of the spectrum. It began with zero exogenous backing and is converging towards modern monetary policy.

Modern central banks do not offer note holders 1:1 redemptions for underlying collateral. Instead, a number of financial instruments and reserve assets are employed in market making operations to ensure outstanding notes trade at an arbitrarily designated peg. In this sense, as Terra has communicated during the establishment of its strategic reserve, reserve assets are not equivalent to immediately redeemable collateral.

The Luna Foundation Guard currently holds $1.71B BTC, $398.6M USDC, $181M Luna, and $151.3M USDT in the strategic reserve for a total USD value of $2.44B. LFG continues to conduct BTC purchases and will soon add the recently announced $100M AVAX (more on this further below).

The establishment of a diversified reserve increases volatility robustness through two mechanisms:

1. Increased user confidence: As exogenous assets are added to the reserve, user confidence in UST increases disproportionality to the relatively small percentage (currently 14.1%) of the UST supply that could be redeemed for reserve assets during a peg deviation. The impact of increased user confidence on peg stability is substantial because seigniorage shares-based stablecoins are fundamentally belief-based to the extent they lack exogenous backing,.

2. Reduced economic risk: A reserve composed of centralized and decentralized assets maximizes the probability that it will preserve liquidity and thus market making capacity during future tail risk events. The strategic reserve is designed to exclusively conduct market making operations during periods of severe economic contraction that cause UST to deviate from its peg. While the strategic reserve is currently centralized in the hands of LFG’s seven directors, there is an intent to transition to decentralized, on-chain protocol custody. Market making with BTC (and eventually other assets in the reserve) is proposed to work as such:

The 4pool is a new Curve Finance pool standard that aims to bridge decentralized stablecoins with centralized stablecoins possessing off-chain liquidity. The pool will consist of UST, FRAX, USDC, and USDT. If you need a refresher on the intricacies of Curve Finance, Convex Finance, and the Curve Wars, a reader friendly introduction is available here (part 1) and here (part 2).

https://twitter.com/stablekwon/status/1510021707377287170?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1510021707377287170%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

With a massive $21.38B TVL, Curve plays a fundamental role in stablecoin stability for those that possess the requisite influence over CRV emissions needed to attract deep liquidity. To eventually establish the 4pool across all EVM chains, Terra has entered into a 3-way partnership with FRAX and Redacted Cartel. Previously, FRAX and Terra competed against one another for CRV and CVX emissions through votium incentives and vlCVX votes as the two largest DAO holders of CVX. Terra added 605,222 CVX to its holdings in the past week, passing up FRAX to become the top DAO holder of CVX with total holdings of 2,270,406 CVX. FRAX comes in just behind Terra, currently holding 2,229,603 CVX. Redacted Cartel holds 1,502,995 CVX. Combined, the partnership currently owns 10.4% of the circulating CVX supply. While not hegemonic, the partnership’s CVX supply ownership is sufficiently adequate to build deep 4pool liquidity and is still growing with weekly increases in their collective holdings. With the above in mind, the 4pool will improve UST’s peg resilience through several mechanisms:

1. Deep Curve pool liquidity = stability: Until now, UST has primarily resided in the UST+3Crv pool, which has $1.3B of liquidity. This pales in comparison to 3pool’s $3.6B of liquidity. Do Kwon has clearly signaled he intends to kill 3pool and replace it with 4pool, stealing away DAI’s Curve liquidity. With 10.4% of CVX under the Terra-FRAX-RC partnership’s control, this is a realistic possibility pending MakerDAO’s response. Assuming that the 4pool achieves the liquidity depth of the 3pool, a minimum of a 270% increase in trade volume will be required to deviate UST’s peg on Curve compared to the current UST+3Crv pool. Notably, I have only listed Ethereum’s Curve liquidity. Terra intends to expand the 4pool to every EVM chain that Curve is currently on.

2. Integration of UST into FRAX AMOs: FRAX v2 employs Algorithmic Market Operations Controllers (AMOs), which are contracts that carry out arbitrary monetary policy. So long as they submit to FRAX’s base mechanism rules and do not cause peg deviation, any AMO design can be approved. An example of what an AMO might look like can be found here. FRAX governance votes on AMO proposals for implementation, allowing nearly unlimited flexibility for the market operations FRAX can perform. The current Curve AMO’s structure opens the pathway for UST to become FRAX collateral, intertwining the two protocols and, as a result, improving the peg resilience of both FRAX and UST. Terra stated during its 4pool announcement, “stablecoin pegs are stronger together than competing against one another.” The 4pool partnership will lead to brand new AMO strategies that take advantage of Terra’s size and continued growth.

3. Composability: As the 4pool grows in size, the inherent composability of Curve will lead to new DeFi primitives and strategies that integrate UST (via its yield bearing 4pool token) into other layer 1s and protocols. As other protocols become dependent upon the 4pool’s LP token, they will provide another vector for stabilization via demand during future periods of economic contraction. This will simultaneously reinforce the relationship between the 4pool’s underlying assets.

https://twitter.com/stablekwon/status/1512291560171311108?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1512291560171311108%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

On April 7th, Avalanche and Terra announced a three-pronged partnership to integrate each ecosystem’s native assets in a multi-layered approach, explained below.

1. AVAX reserves: Terra will add $100M of AVAX to its strategic reserve. Users will be able to swap UST<>AVAX through a mechanism similar to the BTC redemption diagram shown earlier. Users wanting UST will be able to swap $1 of AVAX for 1 UST, and users wanting AVAX can swap in 1 UST for $0.99 of AVAX. This pricing asymmetry ensures the reserve only conducts market making during periods of peg deviation. This reserve creates a mint/redemption mechanism for UST native to the Avalanche blockchain. Additionally, the quantity of AVAX held by the reserve will increase as UST demand increases on Avalanche. The continual removal of AVAX from the circulating supply will have a deflationary effect, so long as UST growth > contraction on the Avalanche blockchain.

2. Terra grants program: During a recent fireside chat with Emin Gün Sirer of Ava Labs, Do Kwon announced Avalanche’s eligibility for Terra’s grants program. Any project building on Avalanche that natively integrates UST is eligible for grant funding to off-set audit costs, initial bootstrapping costs, etc. Neutralization of set-up costs will enable more community-owned launches, rather than forcing protocols to raise funding. As more protocols integrate UST in order to claim grant funds, demand for UST on Avalanche will increase, and more AVAX will be removed from the circulating supply. Economic incentives are well aligned in this partnership, so long as UST’s overall growth > contraction. Should UST face a significant de-peg scenario, economic incentives will become net negative as Avalanche users rush to redeem their UST for $0.99 of AVAX.

3. Gaming subnet: Terra will launch a gaming subnet on the Avalanche blockchain in the near future. I expect to see UST deeply integrated within this subnet, likely used as gas for transactions. This subnet, if successful, will further increase (1) AVAX demand as each subnet validator must own 2,000 AVAX in order to also validate the main network and (2) Avalanche-native UST demand as the subnet increases in popularity.

*The term Avalanche “native” UST only means that there is a swap mechanism for AVAX<>UST directly on the Avalanche blockchain for which the liquidity is owned by the Terra protocol. Per the Terra blockchain’s design, Terra (UST) can only be minted by burning LUNA on the Terra blockchain via the LUNA<>UST mint/burn seigniorage mechanism. All swap mechanisms with the strategic reserve are nothing more than specialized virtual AMMs. Thus, UST is only truly native to the Terra blockchain; it must be bridged to all other blockchains (via Wormhole v2 currently). This somewhat misleading language is used by Do Kwon and Terra, so I have decided to continue to use it within this article for continuity.

Seignorage-shares based stablecoins are fundamentally belief-based systems to the extent they lack exogenous collateral or backing. If all economic incentives are related to rewards endogenous to the system itself, it is at risk of collapse should severe and protracted economic conditions shake users’ belief in the peg. With this in mind, sustainable monetary policy for an algorithmic stablecoin requires two primary considerations:

1. Appropriate design mechanisms and economic incentives to stabilize the currency’s peg.

2. Sustainable economic demand for the currency within its respective economy, external to consideration #1.

Terra has previously focused on the second consideration, seeking to develop a thriving ecosystem around UST that drives sustainable demand and, therefore, provides stability. It has failed to do so thus far. Terra has now heavily shifted its strategic focus to point #1, actively creating more runway to build sustainable economic demand before a tail risk event occurs.

At the current pace and in alignment with Do Kwon’s vision to make Terra the decentralized money of all blockchains, I expect Terra to announce similar major partnerships with other layer 1s by the end of Q2. In addition to all of the above mechanisms stabilizing the peg, venture capitalists invested in the protocol have significant economic incentive to ensure the peg’s resilience. I believe most Terra skeptics severely underestimate the exposure firms such as Jump have to LUNA. As a result, they severely underestimate the willingness of those firms to step in as market makers of last resort to ensure any peg deviation is recovered. Due to VC economic incentives, the recently established strategic reserve, and the various ecosystem integrations described above, I fully expect Terra to rapidly recover any peg deviation that occurs in the short-to-medium term, with the exception of a tail risk event.

Over the long-term, I remain deeply skeptical of the Terra protocol’s viability. Terra, per its original design, has no reserve backing or exogenous collateral. The addition of a strategic reserve as an afterthought requires human estimation of the appropriate reserve ratio required to sustain peg confidence through tail risk volatility. Changes to the reserve ratio and market making design mechanisms are slow and cumbersome, requiring decentralized proposal, approval, and implementation. In Terra’s afterthought reserve design, the principles of decentralization and immutability work against the protocol rather than for it. This is juxtaposed against designs such as the FRAX protocol, which allows real-time market forces to continuously determine and re-adjust the appropriate collateral ratio required to maintain peg confidence amidst dynamic economic conditions.

Scenario 1: Envision a sudden, severe economic contraction occurs that causes the BTC<>UST mechanism to conduct market making in order to recover the peg. Community members realize the daily cap on BTC<>UST swaps* is insufficient to rapidly recover the peg. A proposal to increase the daily swap cap is proposed and voted on. While the on-chain vote period persists, BTC swaps are unavailable. During that 24-hour period, Terra becomes highly reflexive as capital seeks to flee the ecosystem via off-chain UST swaps. UST drops below $0.50 and LUNA’s market capitalization rapidly drops towards zero.

*The particular details of daily redemption caps, proposal vote details, etc. are not yet set, but I expect a daily redemption cap of some kind per Jump’s design proposal.

Scenario 2: Envision a sudden, severe economic contraction occurs that causes the BTC<>UST mechanism to conduct market making in order to recover the peg. Community members realize the daily cap on BTC<>UST swaps is insufficient to rapidly recover the peg. A proposal to increase the daily swap cap is put forth and voted on. The vote fails due to some unforeseen reason. UST develops an exponential price trend from $1.00 down to $0.89 during the 7-day period that strategic reserves are still available. On the 8th day, the last strategic reserves are depleted and UST races to zero as investors and speculators swiftly exit their positions via off-chain swaps.*

*LUNA/UST on-chain swaps would also occur to the swap rate-determined maximum during scenarios such as these, infinitely diluting LUNA and driving its price down. AVAX and any other strategic reserve assets available for swaps above market rate would also be swapped to the daily maximum cap in these scenarios.

In both of these scenarios, flawed human assessments that lag behind dynamic market conditions are inadequate to maintain peg confidence. Terra, by design, is unable to modify its reserve ratio at the same pace that tail risks emerge. On a long-enough timeframe, the probability that Terra eventually underestimates the reserve ratio required to ensure UST peg confidence is 100%. When the protocol’s reserve ratio is insufficient to maintain peg confidence amidst a tail risk event - when severe, protracted, global risk-off conditions crush all of crypto - Terra’s reflexive design will pose an existential risk. At that point, all of Terra’s cross-chain ecosystem integrations will cease to bolster the peg and transition to liabilities on Terra’s respective partners, unwinding the health of the entire crypto ecosystem.

This article was originally published on April 20th, 2022. It was republished here after the wallet address for shuel.eth changed.

Terra, relentlessly guided forward by founder Do Kwon, signaled a significant adjustment of its strategic focus beginning in late March 2022. In my previous Terra analysis, I was skeptical of Terra’s long-term viability. With 74% of the total UST supply deposited in Anchor protocol, the majority of UST demand is currently recursive and unsustainable. The Chai payments partnership, which previously created modest legitimate Terra demand, is now dissolved. The Mars and Mirror protocols combined have a TVL of only 4.6% of the total UST supply.

Terra’s ecosystem still does not generate sustainable demand for 3/4 of the circulating UST supply. Anchor’s yield reserve burn rate remains in excess of $100M/month. With no evidence that Terraform Labs would successfully transition its subsidized user base to legitimate use cases before dynamic rates take effect on May 1st, the clock seemed to be running out in mid-March.

https://twitter.com/RossShuel/status/1511861439996198914?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1511861439996198914%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

Since then, the establishment of (1) the diversified strategic reserve, (2) 4Pool, and (3) Avalanche partnership have cumulatively extended Terra’s available runway to build sustainable user demand for UST. With the first strategic reserve announcement, Do Kwon revealed a shift in Terraform Labs’ strategic priority from building individual user demand to integrating Terra to cross-chain ecosystems and assets. The initial reserve announcement of $1.5B BTC was quickly raised to a $10B BTC goal. On April 1st, Do Kwon introduced the 4pool. Within a week, Terra announced a strategic partnership between the Avalanche and Terra ecosystems that will see $100M AVAX added to the strategic reserve, a Terra gaming subnet, expansion of Terra’s grants program to Avalanche protocols natively incorporating UST, and a UST-AVAX swap mechanism that will deflate the AVAX supply during periods of Terra growth. The strategic shift to cross-chain ecosystem integrations and a diversified reserve will create economic interdependence and increased user confidence that can be expected to provide volatility robustness during periods of severe economic contraction that may have previously been fatal to the protocol. Let’s examine each of the above three developments in turn:

Central banks historically start from conservative positions of maximum collateralization (e.g. MakerDAO) and then evolve towards an optimal fractionalized reserve ratio that balances tail risk protection against capital efficiency. Terra’s monetary policy started at the opposite end of the spectrum. It began with zero exogenous backing and is converging towards modern monetary policy.

Modern central banks do not offer note holders 1:1 redemptions for underlying collateral. Instead, a number of financial instruments and reserve assets are employed in market making operations to ensure outstanding notes trade at an arbitrarily designated peg. In this sense, as Terra has communicated during the establishment of its strategic reserve, reserve assets are not equivalent to immediately redeemable collateral.

The Luna Foundation Guard currently holds $1.71B BTC, $398.6M USDC, $181M Luna, and $151.3M USDT in the strategic reserve for a total USD value of $2.44B. LFG continues to conduct BTC purchases and will soon add the recently announced $100M AVAX (more on this further below).

The establishment of a diversified reserve increases volatility robustness through two mechanisms:

1. Increased user confidence: As exogenous assets are added to the reserve, user confidence in UST increases disproportionality to the relatively small percentage (currently 14.1%) of the UST supply that could be redeemed for reserve assets during a peg deviation. The impact of increased user confidence on peg stability is substantial because seigniorage shares-based stablecoins are fundamentally belief-based to the extent they lack exogenous backing,.

2. Reduced economic risk: A reserve composed of centralized and decentralized assets maximizes the probability that it will preserve liquidity and thus market making capacity during future tail risk events. The strategic reserve is designed to exclusively conduct market making operations during periods of severe economic contraction that cause UST to deviate from its peg. While the strategic reserve is currently centralized in the hands of LFG’s seven directors, there is an intent to transition to decentralized, on-chain protocol custody. Market making with BTC (and eventually other assets in the reserve) is proposed to work as such:

The 4pool is a new Curve Finance pool standard that aims to bridge decentralized stablecoins with centralized stablecoins possessing off-chain liquidity. The pool will consist of UST, FRAX, USDC, and USDT. If you need a refresher on the intricacies of Curve Finance, Convex Finance, and the Curve Wars, a reader friendly introduction is available here (part 1) and here (part 2).

https://twitter.com/stablekwon/status/1510021707377287170?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1510021707377287170%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

With a massive $21.38B TVL, Curve plays a fundamental role in stablecoin stability for those that possess the requisite influence over CRV emissions needed to attract deep liquidity. To eventually establish the 4pool across all EVM chains, Terra has entered into a 3-way partnership with FRAX and Redacted Cartel. Previously, FRAX and Terra competed against one another for CRV and CVX emissions through votium incentives and vlCVX votes as the two largest DAO holders of CVX. Terra added 605,222 CVX to its holdings in the past week, passing up FRAX to become the top DAO holder of CVX with total holdings of 2,270,406 CVX. FRAX comes in just behind Terra, currently holding 2,229,603 CVX. Redacted Cartel holds 1,502,995 CVX. Combined, the partnership currently owns 10.4% of the circulating CVX supply. While not hegemonic, the partnership’s CVX supply ownership is sufficiently adequate to build deep 4pool liquidity and is still growing with weekly increases in their collective holdings. With the above in mind, the 4pool will improve UST’s peg resilience through several mechanisms:

1. Deep Curve pool liquidity = stability: Until now, UST has primarily resided in the UST+3Crv pool, which has $1.3B of liquidity. This pales in comparison to 3pool’s $3.6B of liquidity. Do Kwon has clearly signaled he intends to kill 3pool and replace it with 4pool, stealing away DAI’s Curve liquidity. With 10.4% of CVX under the Terra-FRAX-RC partnership’s control, this is a realistic possibility pending MakerDAO’s response. Assuming that the 4pool achieves the liquidity depth of the 3pool, a minimum of a 270% increase in trade volume will be required to deviate UST’s peg on Curve compared to the current UST+3Crv pool. Notably, I have only listed Ethereum’s Curve liquidity. Terra intends to expand the 4pool to every EVM chain that Curve is currently on.

2. Integration of UST into FRAX AMOs: FRAX v2 employs Algorithmic Market Operations Controllers (AMOs), which are contracts that carry out arbitrary monetary policy. So long as they submit to FRAX’s base mechanism rules and do not cause peg deviation, any AMO design can be approved. An example of what an AMO might look like can be found here. FRAX governance votes on AMO proposals for implementation, allowing nearly unlimited flexibility for the market operations FRAX can perform. The current Curve AMO’s structure opens the pathway for UST to become FRAX collateral, intertwining the two protocols and, as a result, improving the peg resilience of both FRAX and UST. Terra stated during its 4pool announcement, “stablecoin pegs are stronger together than competing against one another.” The 4pool partnership will lead to brand new AMO strategies that take advantage of Terra’s size and continued growth.

3. Composability: As the 4pool grows in size, the inherent composability of Curve will lead to new DeFi primitives and strategies that integrate UST (via its yield bearing 4pool token) into other layer 1s and protocols. As other protocols become dependent upon the 4pool’s LP token, they will provide another vector for stabilization via demand during future periods of economic contraction. This will simultaneously reinforce the relationship between the 4pool’s underlying assets.

https://twitter.com/stablekwon/status/1512291560171311108?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1512291560171311108%7Ctwgr%5Ec8b80843117f0dccb246cf6aa13515f8734b9202%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fmirror.xyz%2F0x8C208E4D9a7Ed8205392a4DFc5516e68518fF4A2%2FL4g1j5I9ZFgT0cSIDVYAXg7sqmtriHvX6JylOBlyENM

On April 7th, Avalanche and Terra announced a three-pronged partnership to integrate each ecosystem’s native assets in a multi-layered approach, explained below.

1. AVAX reserves: Terra will add $100M of AVAX to its strategic reserve. Users will be able to swap UST<>AVAX through a mechanism similar to the BTC redemption diagram shown earlier. Users wanting UST will be able to swap $1 of AVAX for 1 UST, and users wanting AVAX can swap in 1 UST for $0.99 of AVAX. This pricing asymmetry ensures the reserve only conducts market making during periods of peg deviation. This reserve creates a mint/redemption mechanism for UST native to the Avalanche blockchain. Additionally, the quantity of AVAX held by the reserve will increase as UST demand increases on Avalanche. The continual removal of AVAX from the circulating supply will have a deflationary effect, so long as UST growth > contraction on the Avalanche blockchain.

2. Terra grants program: During a recent fireside chat with Emin Gün Sirer of Ava Labs, Do Kwon announced Avalanche’s eligibility for Terra’s grants program. Any project building on Avalanche that natively integrates UST is eligible for grant funding to off-set audit costs, initial bootstrapping costs, etc. Neutralization of set-up costs will enable more community-owned launches, rather than forcing protocols to raise funding. As more protocols integrate UST in order to claim grant funds, demand for UST on Avalanche will increase, and more AVAX will be removed from the circulating supply. Economic incentives are well aligned in this partnership, so long as UST’s overall growth > contraction. Should UST face a significant de-peg scenario, economic incentives will become net negative as Avalanche users rush to redeem their UST for $0.99 of AVAX.

3. Gaming subnet: Terra will launch a gaming subnet on the Avalanche blockchain in the near future. I expect to see UST deeply integrated within this subnet, likely used as gas for transactions. This subnet, if successful, will further increase (1) AVAX demand as each subnet validator must own 2,000 AVAX in order to also validate the main network and (2) Avalanche-native UST demand as the subnet increases in popularity.

*The term Avalanche “native” UST only means that there is a swap mechanism for AVAX<>UST directly on the Avalanche blockchain for which the liquidity is owned by the Terra protocol. Per the Terra blockchain’s design, Terra (UST) can only be minted by burning LUNA on the Terra blockchain via the LUNA<>UST mint/burn seigniorage mechanism. All swap mechanisms with the strategic reserve are nothing more than specialized virtual AMMs. Thus, UST is only truly native to the Terra blockchain; it must be bridged to all other blockchains (via Wormhole v2 currently). This somewhat misleading language is used by Do Kwon and Terra, so I have decided to continue to use it within this article for continuity.

Seignorage-shares based stablecoins are fundamentally belief-based systems to the extent they lack exogenous collateral or backing. If all economic incentives are related to rewards endogenous to the system itself, it is at risk of collapse should severe and protracted economic conditions shake users’ belief in the peg. With this in mind, sustainable monetary policy for an algorithmic stablecoin requires two primary considerations:

1. Appropriate design mechanisms and economic incentives to stabilize the currency’s peg.

2. Sustainable economic demand for the currency within its respective economy, external to consideration #1.

Terra has previously focused on the second consideration, seeking to develop a thriving ecosystem around UST that drives sustainable demand and, therefore, provides stability. It has failed to do so thus far. Terra has now heavily shifted its strategic focus to point #1, actively creating more runway to build sustainable economic demand before a tail risk event occurs.

At the current pace and in alignment with Do Kwon’s vision to make Terra the decentralized money of all blockchains, I expect Terra to announce similar major partnerships with other layer 1s by the end of Q2. In addition to all of the above mechanisms stabilizing the peg, venture capitalists invested in the protocol have significant economic incentive to ensure the peg’s resilience. I believe most Terra skeptics severely underestimate the exposure firms such as Jump have to LUNA. As a result, they severely underestimate the willingness of those firms to step in as market makers of last resort to ensure any peg deviation is recovered. Due to VC economic incentives, the recently established strategic reserve, and the various ecosystem integrations described above, I fully expect Terra to rapidly recover any peg deviation that occurs in the short-to-medium term, with the exception of a tail risk event.

Over the long-term, I remain deeply skeptical of the Terra protocol’s viability. Terra, per its original design, has no reserve backing or exogenous collateral. The addition of a strategic reserve as an afterthought requires human estimation of the appropriate reserve ratio required to sustain peg confidence through tail risk volatility. Changes to the reserve ratio and market making design mechanisms are slow and cumbersome, requiring decentralized proposal, approval, and implementation. In Terra’s afterthought reserve design, the principles of decentralization and immutability work against the protocol rather than for it. This is juxtaposed against designs such as the FRAX protocol, which allows real-time market forces to continuously determine and re-adjust the appropriate collateral ratio required to maintain peg confidence amidst dynamic economic conditions.

Scenario 1: Envision a sudden, severe economic contraction occurs that causes the BTC<>UST mechanism to conduct market making in order to recover the peg. Community members realize the daily cap on BTC<>UST swaps* is insufficient to rapidly recover the peg. A proposal to increase the daily swap cap is proposed and voted on. While the on-chain vote period persists, BTC swaps are unavailable. During that 24-hour period, Terra becomes highly reflexive as capital seeks to flee the ecosystem via off-chain UST swaps. UST drops below $0.50 and LUNA’s market capitalization rapidly drops towards zero.

*The particular details of daily redemption caps, proposal vote details, etc. are not yet set, but I expect a daily redemption cap of some kind per Jump’s design proposal.

Scenario 2: Envision a sudden, severe economic contraction occurs that causes the BTC<>UST mechanism to conduct market making in order to recover the peg. Community members realize the daily cap on BTC<>UST swaps is insufficient to rapidly recover the peg. A proposal to increase the daily swap cap is put forth and voted on. The vote fails due to some unforeseen reason. UST develops an exponential price trend from $1.00 down to $0.89 during the 7-day period that strategic reserves are still available. On the 8th day, the last strategic reserves are depleted and UST races to zero as investors and speculators swiftly exit their positions via off-chain swaps.*

*LUNA/UST on-chain swaps would also occur to the swap rate-determined maximum during scenarios such as these, infinitely diluting LUNA and driving its price down. AVAX and any other strategic reserve assets available for swaps above market rate would also be swapped to the daily maximum cap in these scenarios.

In both of these scenarios, flawed human assessments that lag behind dynamic market conditions are inadequate to maintain peg confidence. Terra, by design, is unable to modify its reserve ratio at the same pace that tail risks emerge. On a long-enough timeframe, the probability that Terra eventually underestimates the reserve ratio required to ensure UST peg confidence is 100%. When the protocol’s reserve ratio is insufficient to maintain peg confidence amidst a tail risk event - when severe, protracted, global risk-off conditions crush all of crypto - Terra’s reflexive design will pose an existential risk. At that point, all of Terra’s cross-chain ecosystem integrations will cease to bolster the peg and transition to liabilities on Terra’s respective partners, unwinding the health of the entire crypto ecosystem.