How bnUSD uses rebalancing to maintain its peg

A comparison between two algorithmic stablecoins: Balanced Dollars and TerraUSD (UST).

How bnUSD uses rebalancing to maintain its peg

Many people have questions about how Balanced Dollars maintains its peg, and how the rebalancing mechanism works. The best way to understand something new is to compare it to something people are already familiar with. The relationship between ICX and bnUSD is most similar to the relationship between LUNA and UST, so that’s what I’ll focus on here.


LUNA and UST

UST is an algorithmic stablecoin that’s meant to maintain a peg against USD. It can be minted by burning LUNA, or redeemed for its USD value in LUNA, minus a fee. To analyze how this works in practice, the best place to look is the TerraSwap liquidity pool for LUNA/UST. For simplicity, I’ll ignore the fees in all examples.

If a trader has UST and is looking to purchase LUNA, they have 2 options:

  1. Sell UST for LUNA using the TerraSwap liquidity pool.
  2. Burn UST and mint LUNA using the Terra core blockchain functionality, which is based on the actual market price of LUNA.

At any given time, one of these two options will offer a better price to the trader and an arbitrage opportunity may exist. Let’s walk through a specific example of how this could work in practice, and how arbitrage opportunities would align the pricing between option 1 and option 2. (If you don’t have a firm understanding of liquidity pools, watch How do liquidity pools work? first.)

Scenario:

  • TerraSwap: 1 LUNA = 75 UST
  • Market price on exchanges: 1 LUNA = 75 USD

Now, imagine the market price of LUNA drops to 50 USD. The new situation is:

  • TerraSwap: 1 LUNA = 75 UST
  • Market price on exchanges: 1 LUNA = 50 USD

There's now a clear price difference between the market price and the price offered by TerraSwap. Alice, an arbitrage trader holding 100 UST, would like to take advantage of it. Here’s the flow of funds for Alice to realize a profit:

  1. Burn 100 UST to mint 2 LUNA.
  2. Sell 2 LUNA on TerraSwap for 150 UST.
  3. Continue to do this over and over again until the TerraSwap price comes back down to the market price.

The end result of this scenario is that all LUNA holders are diluted in order to help maintain the peg of UST, and Alice earns a profit through arbitrage. This increases the circulating supply of LUNA and decreases the circulating supply of UST.


ICX and bnUSD

bnUSD is an algorithmic stablecoin that’s meant to maintain a peg against USD. Unlike UST, bnUSD is initially minted through leverage, where users lock ICX as collateral to borrow/mint bnUSD.

Balanced also has a rebalancing mechanism (discussed later) which automatically mints/burns bnUSD to stay within a certain range of the $1 peg. To analyze how this works in practice, the best place to look is the Balanced liquidity pool for sICX/bnUSD. For simplicity, I’ll assume that the rebalancing range and all fees are 0%.

The bnUSD system operates a bit differently from the LUNA/UST model: the benefits of mispricing are realized by everyone who minted bnUSD, not just Alice. If a trader has bnUSD and is looking to purchase ICX, the trader only has one option: sell bnUSD for ICX using the Balanced liquidity pool. However, Balanced has an automated mechanism, rebalancing, to correct the price of the liquidity pool without the use of outside arbitrage.

Scenario:

  • Balanced: 1 ICX = 4 bnUSD
  • Market price on exchanges: 1 ICX = 4 USD

Now, imagine the market price of ICX drops to 2 USD. The new situation is:

  • Balanced: 1 ICX = 4 bnUSD
  • Market price on exchanges: 1 ICX = 2 USD

There's now a clear price difference between the market price of ICX and the price offered by Balanced. This is where things change, in a technical sense, from UST.

Instead of Alice coming in with arbitrage trades, Balanced has an automated system in place known as rebalancing. (Caveat: arbitrage traders can take advantage of this knowing the price will change, but I won’t focus on that here.)

Rebalancing will sell some ICX collateral from borrowers in exchange for bnUSD from the Balanced DEX, essentially allowing a redemption mechanism for bnUSD. The bnUSD is then used to repay the debt of the borrowers at a favorable price (versus the market price of ICX) and burned. Here’s an example of the flow of funds for rebalancing:

  1. 5M ICX is removed from the collateral pool, taken pro-rata based on total bnUSD debt.
  2. 5M ICX is sold on Balanced for 20M bnUSD.
  3. 20M bnUSD is used to pay off borrower debt (pro-rata based on total bnUSD debt) and burned.
  4. This continues until the price of ICX on Balanced equals the market price.

The end result of this trade is that all Balanced borrowers have some of their ICX collateral sold at a favorable price (versus market value) to help maintain the peg of bnUSD. This increases the circulating supply of ICX and decreases the circulating supply of bnUSD.


Conclusion

From a high-level, bnUSD isn’t as complicated as it may seem. Increased demand for bnUSD locks up more ICX, just as increased demand for UST burns more LUNA (see appendix). Even though the ICX is not technically burned, it’s taken out of circulation until the bnUSD is burned, just as the LUNA is taken out of circulation until the UST is burned. The difference between the stability mechanisms of UST and bnUSD is much more technical than economical.

After reading this post, my goal is for Balanced users and supporters to better understand the inner workings of the product, see through the smoke and mirrors of industry jargon so they can focus on the economics, recognize how it can benefit them, and give them more confidence when using the product and explaining it to others.


Appendix

I’ve provided the reverse of the examples above to illustrate the locking of ICX and the burning of LUNA to mint bnUSD and UST, respectively.

LUNA burning and UST minting

Scenario:

  • TerraSwap: 1 LUNA = 50 UST
  • Market price on exchanges: 1 LUNA = 50 USD

Now, imagine the market price of LUNA increases. The new situation is:

  • TerraSwap: 1 LUNA = 50 UST
  • Market price on exchanges: 1 LUNA = 100 USD

There’s now a clear price difference between the market price and the price offered by TerraSwap. Alice, an arbitrage trader holding 2 LUNA, would like to take advantage of it. Here’s the flow of funds for Alice to realize a profit:

  1. Burn 2 LUNA to mint 200 UST.
  2. Sell 200 UST on TerraSwap for 4 LUNA.
  3. Continue to do this over and over again until the TerraSwap price comes back up to the market price.

ICX locking and bnUSD minting

Scenario:

  • Balanced: 1 ICX = 2 bnUSD
  • Market price on exchanges: 1 ICX = 2 USD

Now, imagine the market price of ICX increases to 4 USD. The new situation is:

  • Balanced: 1 ICX = 2 bnUSD
  • Market price on exchanges: 1 ICX = 4 USD

There’s now a clear price difference between the market price of ICX and the price offered by Balanced. Let’s see how rebalancing works in this example scenario:

  1. 20M bnUSD is auto-minted on behalf of Balanced borrowers, pro-rata based on debt.
  2. 20M bnUSD is sold on Balanced at a favorable price, for 10M ICX.
  3. 10M ICX is added to borrowers’ collateral, pro-rata based on total bnUSD debt.
  4. This continues until the price of ICX on Balanced equals the market price.