Summary
Cap Luna inflation rate algorithmically in order to ensure the stability of the system and the alignment of economic incentives between the major holders of Luna and the rest of the network. Restart the chain. Allow UST to slowly return to the peg as the Luna markets recover some of the lost liquidity, ideally (but not crucially for the survival of the network) with additional injection of capital from the LFG.
Motivation
The recent events have been a real shock to all of us, but they don’t necessarily mean that Terra is dead, the infrastructure and whole ecosystem is still here and is immensely valuable, the Luna and UST tokens still have more than zero capitalization in the open market which reflects that some confidence still remains that we will be able to find a path out of this setback. Terra can survive if we want it to survive.
Proposal
The greatest existential threat of the Terra network IMO is not the depegging of UST in itself, which would have proven to be temporary and would have resolved itself algorithmically if the Luna markets had had enough liquidity to absorb the surge in Luna supply [Also: If a large portion of the market hadn’t engaged in the speculative shorting/dumping of Luna attempting to front-run the UST supply contraction].
The real existential threat to Terra is the recent hyperinflationary spiral of Luna, which makes it prohibitively expensive to hold Luna in order to become a validator, to participate in governance, or to otherwise support the Terra ecosystem with liquidity. As long as the Terra stability mechanism keeps increasing the supply of Luna exponentially, the fair value of one Luna token will be close to zero today to any rational investor, since its expected sale value is an infinitesimal fraction of its present value. In order to restore confidence in the value of Luna the rate of inflation needs to be limited algorithmically before the chain is restarted. Note that this is the exact opposite of what is being suggested here and here, both of those proposals would have greatly exacerbated the hyperinflationary spiral of Luna, further contracted the capitalization of Luna and with it reduced the amount of liquidity that can be provided to users seeking to redeem their UST.
The opposite needs to be achieved in order to save the Terra ecosystem: Minting of Luna needs to be limited to a level of inflation manageable to the present holders of Luna, which requires greatly increasing the spread of on-chain UST/Luna swaps to reduce the demand for UST->Luna exits and reduce the amount of Luna that needs to be released to the market for each one of such swaps, in order to ensure that the rate of UST contraction matches the liquidity available in the Luna markets. The easiest (though somewhat inaccurate) way to achieve that would be to scale down BasePool by more than 2 orders of magnitude (roughly the scale of the contraction of the Luna market capitalization – More exact calculations of the adjustment required to contain inflation TBD if this proposal is well received).
This will, yes, severely slow down withdrawals, and ensure an extended period of UST de-peg, until enough confidence is restored in the stability of this network and enough liquidity returns to the Luna markets that the on-chain swap spreads can be reduced progressively without creating an existential risk to the whole network. Luna/UST liquidity injections from the LFG and any major stakeholders would allow this process to be speeded up, and would be profitable to such stakeholders in the long run, as long as we prevent the network from falling further into a death spiral.
The extended depegging period might sound alarming to some, but there is simply no way we can guarantee the immediate $1 peg for 11B UST tokens from the seigniorage of the <300M market cap Luna token, we need to face the sad reality that the recent spiral of hyperinflation and evaporation of speculative capital from the Luna markets have left us in a position where we need to momentarily reduce the performance of the network and the accuracy of the peg IF we want to survive. An extended period of underperformance is better than the complete destruction of the ecosystem. If the extended period of depeg is unacceptable to some individuals and they are encouraged to exit, well, that’s actually great for the rest of us (as long as we have measures in place to maintain the inflation of Luna within limits), since it reduces the supply of UST bringing its value closer to the target.