How do Terra traders arbitrage between LUNA and bLUNA?

Author: ELAINE HU

Compiled by: Katie Gu, Odaily

Terra Market Analysis

Typically, the end of the year is a time for rest and preparation for the holidays, but in the last few weeks of 2021, the crypto market showed no signs of "rest."

One of the most notable pieces of news is that Terra reached an all-time high in TVL (Total Value Locked), surpassing BSC to become the DeFi chain second only to Ethereum. According to data from Defi Llama, after hitting the $20 billion mark on December 24, Terra's TVL has dropped to around $19.3 billion at the time of writing (not a bearish signal).

Top five public chains by locked value. Source: Defi Llama

Currently, Terra has only 14 protocols built on-chain, while BSC has 257 protocols and Ethereum has 377 protocols. Terra's protocols have successfully attracted liquidity, and the recent launch of the Astroport protocol coincided with a rapid rebound of Terra's native governance token LUNA on December 26, 2021, setting a new all-time high.

In USD terms, the TVL has experienced exponential growth since September 2021, while LUNA has remained relatively stable during the same period. It is not difficult to see that the recent increase in TVL in USD is primarily due to the rise in the price of LUNA itself.

Total locked value of Terra in USD compared to LUNA. Source: Defi Llama

While the rise in the price of governance tokens usually indicates investor confidence in the public chain and protocols, it also seems to be due to the emergence of more favorable arbitrage opportunities.

Let's explore some strategies for arbitraging between LUNA and its collateral asset bLUNA.

LUNA price vs LUNA/bLUNA premium ratio. Source: Flipside Crypto

Why is this happening in the Terra market?

LUNA is the governance and staking token of the Terra public chain, while bLUNA is the token representing staked LUNA and its corresponding block rewards. Since bLUNA is fungible and tradable like LUNA, it is also traded on Terra's decentralized exchanges.

Like other currency or token trading pairs on exchanges, the LUNA/bLUNA trading pair traded on different decentralized exchanges (DEX) may have different prices due to price inefficiencies across platforms. Arbitrageurs profit by buying at a lower price on one protocol and selling at a higher price on another, helping to resolve price inefficiencies across platforms and ultimately achieving a fair price across all exchanges.

In addition to the common reason of price inefficiency, there are other factors related to the nature of bLUNA that cause the price of LUNA/bLUNA to differ between protocols.

• The price of bLUNA is higher than LUNA on the Anchor protocol. This is because once bLUNA is used as collateral and minted on Anchor, it can only be burned and traded for LUNA after 21 days (plus 3 days of processing time), unless it is burned immediately.

• Since bLUNA not only represents the value of the held LUNA but also the block rewards of the LUNA held during the 21-day lock-up period, its value is always higher than that of LUNA. As shown in the figure below, on Anchor, the price of bLUNA is slightly below 1 most of the time, with three different outliers showing that bLUNA is more valuable at a ratio of 0.97 (bLUNA/LUNA).

• The price of LUNA on exchanges is usually higher than that of bLUNA, which may be due to:

1. More selling of bLUNA than buying bLUNA on DEX (thus lowering the value of bLUNA), because burning bLUNA on the Anchor protocol takes 21 days unless it is burned immediately. Therefore, if users want to get LUNA immediately, they need to sell bLUNA on DEX. For bLUNA that is burned instantly on the Anchor protocol, the rate is the same as that on TerraSwap.

2. Unless users need to use them as collateral on the Anchor protocol, they do not expect to receive other LUNA series assets like they do with bLUNA. Currently, Anchor provides a binding function to trade between LUNA and bLUNA at a rate very close to but slightly below 1. That is, investors receive slightly less than 1 bLUNA for 1 LUNA. Although the exchange rate on DEX is better, as traders can receive more than 1 bLUNA for 1 LUNA on DEX, users tend to seek the most convenient way, which is to use Anchor bonds to obtain their bLUNA without having to switch between different protocols.

How to take advantage of arbitrage opportunities on Terra

Based on the price difference explanations provided earlier, there are mainly two ways to arbitrage LUNA and bLUNA.

TerraSwap, Loop Markets, and Astroport all offer trading of LUNA/bLUNA. There are usually small price differences between these exchanges, creating arbitrage opportunities for traders who can buy this trading pair at a lower rate on one exchange and sell it at a higher rate on another.

Price comparison of LUNA/bLUNA on DEXs. Source: Flipside Crypto

The following figure shows the average daily trading prices of LUNA/bLUNA on different platforms during December 2021. The ratio is the total number of bLUNA actually received (after deducting fees) divided by the total number of LUNA provided for trading. As explained in the previous paragraph, due to the increased demand for LUNA on DEX, one LUNA can be traded for multiple bLUNA on DEX.

The following figure calculates the daily arbitrage return rates between any two exchanges among the three exchanges. The best opportunity appeared between TerraSwap and Loop on December 15, with an annualized return (APY) close to 600%.

Arbitraging the LUNA/bLUNA trading pair between different DEXs. Source: Flipside Crypto

Arbitrage between DEX and Anchor protocol

Investors can trade LUNA to one of the DEXs that offers the highest bLUNA per LUNA, burn bLUNA on the Anchor protocol, and wait for 21 days (plus 3 days) to receive more LUNA. Note that the burn on the Anchor protocol must be a normal "slow" burn. Since the trading rate is the same as that on TerraSwap, "instant burn" will not work.

Based on the annualized return over 24 days (21 days for Anchor burn + 3 days processing), the following figure shows the annualized return rates (APY) for arbitrage between different DEXs and Anchor.

Arbitrage between DEX and Anchor annual returns vs. LUNA staking annual returns. Source: Flipside Crypto

The 8% annual average return obtained from LUNA liquid staking by Lido is also added as a risk-free benchmark return comparison. In December, the highest annual average return reached 80% on December 27, after which it significantly declined, falling below the risk-free return in the new year.

This may be due to more users adopting Terra and participating in different Terra protocols, helping to rationalize prices across platforms, reducing price inefficiencies and arbitrage opportunities, thus creating a fairer price.

Savvy investors are always on the lookout for the next opportunity

From the trading data observed in December 2021, there are arbitrage opportunities for the LUNA/bLUNA trading pair between different protocols on Terra. Traders can choose riskier methods to arbitrage between different DEX platforms (such as between TerraSwap, Astroport, and Loop Markets), or they can choose safer methods to arbitrage between these DEX platforms and the Anchor protocol, provided they are willing to hold bLUNA for 24 days.

In December 2021, the annualized returns from DEX and Anchor protocol arbitrage strategies consistently outperformed the risk-free Lido liquid staking. Until recently, this return nearly evaporated on January 1, 2022.

This may be due to more user participation and price rationalization within the Terra protocols. Due to fluctuations in trading volume and participation rates, or the launch of new DEX protocols, arbitrage opportunities may arise again in the future.

The views expressed in this article are solely those of the author. Every investment and trade carries risks; do your own research before making decisions.