diff --git a/migrations/add_referral_system.sql b/migrations/add_referral_system.sql
index 9f67d3c..9dec6aa 100644
--- a/migrations/add_referral_system.sql
+++ b/migrations/add_referral_system.sql
@@ -1,9 +1,9 @@
 -- Migration: Referral system (Issue #2)
--- Idempotent
+-- Idempotent: safe to re-run
 
 CREATE TABLE IF NOT EXISTS referral_codes (
   id UUID PRIMARY KEY DEFAULT gen_random_uuid(),
-  code TEXT UNIQUE NOT NULL DEFAULT substring(gen_random_uuid()::text, 1, 8),
+  code TEXT UNIQUE NOT NULL DEFAULT upper(substring(replace(gen_random_uuid()::text, '-', ''), 1, 8)),
   owner_id TEXT NOT NULL,
   uses INT DEFAULT 0,
   credits_awarded INT DEFAULT 0,
@@ -18,30 +18,101 @@ CREATE TABLE IF NOT EXISTS referral_conversions (
   UNIQUE(referral_code, new_user_id)
 );
 
+CREATE TABLE IF NOT EXISTS user_credit_balances (
+  user_id TEXT PRIMARY KEY,
+  free_credits INT NOT NULL DEFAULT 0,
+  updated_at TIMESTAMPTZ DEFAULT NOW()
+);
+
+CREATE TABLE IF NOT EXISTS user_notifications (
+  id UUID PRIMARY KEY DEFAULT gen_random_uuid(),
+  user_id TEXT NOT NULL,
+  message TEXT NOT NULL,
+  created_at TIMESTAMPTZ DEFAULT NOW()
+);
+
+CREATE TABLE IF NOT EXISTS system_events (
+  id UUID PRIMARY KEY DEFAULT gen_random_uuid(),
+  event_type TEXT NOT NULL,
+  payload JSONB NOT NULL DEFAULT '{}'::jsonb,
+  created_at TIMESTAMPTZ DEFAULT NOW()
+);
+
+CREATE INDEX IF NOT EXISTS idx_referral_codes_owner
+  ON referral_codes (owner_id);
+
+CREATE INDEX IF NOT EXISTS idx_referral_conversions_user
+  ON referral_conversions (new_user_id);
+
 CREATE OR REPLACE FUNCTION process_referral(p_code TEXT, p_new_user_id TEXT)
 RETURNS JSONB AS $$
 DECLARE
   v_owner_id TEXT;
   v_credits INT := 5;
+  v_norm TEXT;
 BEGIN
+  IF p_code IS NULL OR btrim(p_code) = '' OR p_new_user_id IS NULL OR btrim(p_new_user_id) = '' THEN
+    RETURN jsonb_build_object('status', 'invalid_input');
+  END IF;
+
+  v_norm := upper(btrim(p_code));
+
   -- Idempotency check
-  IF EXISTS (SELECT 1 FROM referral_conversions WHERE referral_code = p_code AND new_user_id = p_new_user_id) THEN
+  IF EXISTS (
+    SELECT 1 FROM referral_conversions
+    WHERE referral_code = v_norm AND new_user_id = p_new_user_id
+  ) THEN
     RETURN jsonb_build_object('status', 'already_processed');
   END IF;
 
-  SELECT owner_id INTO v_owner_id FROM referral_codes WHERE code = p_code;
-  IF NOT FOUND THEN RETURN jsonb_build_object('status', 'invalid_code'); END IF;
+  SELECT owner_id INTO v_owner_id FROM referral_codes WHERE code = v_norm;
+  IF NOT FOUND THEN
+    RETURN jsonb_build_object('status', 'invalid_code');
+  END IF;
+
+  IF v_owner_id = p_new_user_id THEN
+    RETURN jsonb_build_object('status', 'self_referral');
+  END IF;
 
   -- Log conversion
-  INSERT INTO referral_conversions (referral_code, new_user_id) VALUES (p_code, p_new_user_id);
+  INSERT INTO referral_conversions (referral_code, new_user_id)
+  VALUES (v_norm, p_new_user_id);
 
-  -- Award credits
-  UPDATE referral_codes SET uses = uses + 1, credits_awarded = credits_awarded + v_credits WHERE code = p_code;
+  -- Award credits on code + owner balance
+  UPDATE referral_codes
+  SET uses = uses + 1,
+      credits_awarded = credits_awarded + v_credits
+  WHERE code = v_norm;
+
+  INSERT INTO user_credit_balances (user_id, free_credits, updated_at)
+  VALUES (v_owner_id, v_credits, NOW())
+  ON CONFLICT (user_id) DO UPDATE
+    SET free_credits = user_credit_balances.free_credits + EXCLUDED.free_credits,
+        updated_at = NOW();
 
   -- Log event
   INSERT INTO system_events (event_type, payload, created_at)
-  VALUES ('referral_conversion', jsonb_build_object('code', p_code, 'new_user', p_new_user_id, 'credits', v_credits), NOW());
+  VALUES (
+    'referral_conversion',
+    jsonb_build_object(
+      'code', v_norm,
+      'new_user', p_new_user_id,
+      'owner_id', v_owner_id,
+      'credits', v_credits
+    ),
+    NOW()
+  );
+
+  -- Notify both users
+  INSERT INTO user_notifications (user_id, message)
+  VALUES
+    (v_owner_id, format('Referral success: +%s free credits (code %s).', v_credits, v_norm)),
+    (p_new_user_id, format('Welcome — you joined via referral %s.', v_norm));
 
-  RETURN jsonb_build_object('status', 'ok', 'credits_awarded', v_credits, 'owner_id', v_owner_id);
+  RETURN jsonb_build_object(
+    'status', 'ok',
+    'credits_awarded', v_credits,
+    'owner_id', v_owner_id
+  );
 END;
 $$ LANGUAGE plpgsql;
diff --git a/src/growth/referral.ts b/src/growth/referral.ts
new file mode 100644
index 0000000..4750d52
--- /dev/null
+++ b/src/growth/referral.ts
@@ -0,0 +1,177 @@
+/**
+ * Referral reward loop — Issue #2
+ * When user B signs up with A's code and makes their first paid call,
+ * A receives 5 free credits once (idempotent per code+new_user).
+ */
+
+export const REFERRAL_CREDITS = 5;
+export const EVENT_TYPE = 'referral_conversion';
+
+export interface ReferralCode {
+  code: string;
+  ownerId: string;
+  uses: number;
+  creditsAwarded: number;
+  createdAt: string;
+}
+
+export interface ReferralConversion {
+  referralCode: string;
+  newUserId: string;
+  convertedAt: string;
+}
+
+export interface SystemEvent {
+  eventType: string;
+  payload: Record<string, unknown>;
+  createdAt: string;
+}
+
+export interface Notification {
+  userId: string;
+  message: string;
+  createdAt: string;
+}
+
+export type ProcessStatus =
+  | 'ok'
+  | 'already_processed'
+  | 'invalid_code'
+  | 'self_referral'
+  | 'invalid_input';
+
+export interface ProcessReferralResult {
+  status: ProcessStatus;
+  creditsAwarded?: number;
+  ownerId?: string;
+  event?: SystemEvent;
+  notifications?: Notification[];
+}
+
+function nowIso(): string {
+  return new Date().toISOString();
+}
+
+function normalizeCode(code: string): string {
+  return code.trim().toUpperCase();
+}
+
+/** In-memory mirror of referral_codes + referral_conversions + system_events. */
+export class ReferralStore {
+  codes = new Map<string, ReferralCode>();
+  /** key = `${code}::${newUserId}` */
+  conversions = new Map<string, ReferralConversion>();
+  /** owner_id → free credit balance */
+  balances = new Map<string, number>();
+  events: SystemEvent[] = [];
+  notifications: Notification[] = [];
+
+  createCode(ownerId: string, code?: string): ReferralCode {
+    if (!ownerId?.trim()) throw new Error('ownerId required');
+    const raw = code?.trim() || crypto.randomUUID().replace(/-/g, '').slice(0, 8);
+    const normalized = normalizeCode(raw);
+    if (this.codes.has(normalized)) throw new Error('code already exists');
+    const row: ReferralCode = {
+      code: normalized,
+      ownerId: ownerId.trim(),
+      uses: 0,
+      creditsAwarded: 0,
+      createdAt: nowIso(),
+    };
+    this.codes.set(normalized, row);
+    if (!this.balances.has(row.ownerId)) this.balances.set(row.ownerId, 0);
+    return row;
+  }
+
+  getCode(code: string): ReferralCode | undefined {
+    return this.codes.get(normalizeCode(code));
+  }
+
+  getBalance(userId: string): number {
+    return this.balances.get(userId) ?? 0;
+  }
+
+  clear(): void {
+    this.codes.clear();
+    this.conversions.clear();
+    this.balances.clear();
+    this.events = [];
+    this.notifications = [];
+  }
+}
+
+const defaultStore = new ReferralStore();
+
+/**
+ * process_referral(referral_code, new_user_id)
+ * Awards REFERRAL_CREDITS to the code owner on first paid conversion.
+ * Idempotent: same (code, new_user) pair cannot convert twice.
+ */
+export function processReferral(
+  referralCode: string,
+  newUserId: string,
+  store: ReferralStore = defaultStore,
+): ProcessReferralResult {
+  if (!referralCode?.trim() || !newUserId?.trim()) {
+    return { status: 'invalid_input' };
+  }
+
+  const code = normalizeCode(referralCode);
+  const userId = newUserId.trim();
+  const row = store.codes.get(code);
+  if (!row) return { status: 'invalid_code' };
+
+  if (row.ownerId === userId) {
+    return { status: 'self_referral' };
+  }
+
+  const convKey = `${code}::${userId}`;
+  if (store.conversions.has(convKey)) {
+    return { status: 'already_processed', ownerId: row.ownerId };
+  }
+
+  const convertedAt = nowIso();
+  store.conversions.set(convKey, {
+    referralCode: code,
+    newUserId: userId,
+    convertedAt,
+  });
+
+  row.uses += 1;
+  row.creditsAwarded += REFERRAL_CREDITS;
+  store.balances.set(row.ownerId, store.getBalance(row.ownerId) + REFERRAL_CREDITS);
+
+  const event: SystemEvent = {
+    eventType: EVENT_TYPE,
+    payload: {
+      code,
+      new_user: userId,
+      owner_id: row.ownerId,
+      credits: REFERRAL_CREDITS,
+    },
+    createdAt: convertedAt,
+  };
+  store.events.push(event);
+
+  const notifications: Notification[] = [
+    {
+      userId: row.ownerId,
+      message: `Referral success: +${REFERRAL_CREDITS} free credits (code ${code}).`,
+      createdAt: convertedAt,
+    },
+    {
+      userId,
+      message: `Welcome — you joined via referral ${code}.`,
+      createdAt: convertedAt,
+    },
+  ];
+  store.notifications.push(...notifications);
+
+  return {
+    status: 'ok',
+    creditsAwarded: REFERRAL_CREDITS,
+    ownerId: row.ownerId,
+    event,
+    notifications,
+  };
+}
diff --git a/tests/referral.test.ts b/tests/referral.test.ts
new file mode 100644
index 0000000..67d070f
--- /dev/null
+++ b/tests/referral.test.ts
@@ -0,0 +1,74 @@
+import { assertEquals, assertExists } from 'https://deno.land/std@0.224.0/assert/mod.ts';
+import {
+  REFERRAL_CREDITS,
+  EVENT_TYPE,
+  ReferralStore,
+  processReferral,
+} from '../src/growth/referral.ts';
+
+Deno.test('happy path awards 5 credits and logs event + notifications', () => {
+  const store = new ReferralStore();
+  store.createCode('alice', 'ALICE01');
+  const r = processReferral('alice01', 'bob', store);
+  assertEquals(r.status, 'ok');
+  assertEquals(r.creditsAwarded, REFERRAL_CREDITS);
+  assertEquals(r.ownerId, 'alice');
+  assertEquals(store.getBalance('alice'), 5);
+  assertEquals(store.getCode('ALICE01')?.uses, 1);
+  assertEquals(store.getCode('ALICE01')?.creditsAwarded, 5);
+  assertEquals(store.events.length, 1);
+  assertEquals(store.events[0].eventType, EVENT_TYPE);
+  assertEquals(store.notifications.length, 2);
+});
+
+Deno.test('idempotent: duplicate conversion for same user is rejected', () => {
+  const store = new ReferralStore();
+  store.createCode('alice', 'ALICE02');
+  const first = processReferral('ALICE02', 'bob', store);
+  assertEquals(first.status, 'ok');
+  const second = processReferral('ALICE02', 'bob', store);
+  assertEquals(second.status, 'already_processed');
+  assertEquals(store.getBalance('alice'), 5);
+  assertEquals(store.getCode('ALICE02')?.uses, 1);
+  assertEquals(store.events.length, 1);
+});
+
+Deno.test('same code can convert different users', () => {
+  const store = new ReferralStore();
+  store.createCode('alice', 'SHARE01');
+  assertEquals(processReferral('SHARE01', 'bob', store).status, 'ok');
+  assertEquals(processReferral('SHARE01', 'carol', store).status, 'ok');
+  assertEquals(store.getBalance('alice'), 10);
+  assertEquals(store.getCode('SHARE01')?.uses, 2);
+});
+
+Deno.test('invalid code returns invalid_code', () => {
+  const store = new ReferralStore();
+  const r = processReferral('NOPE', 'bob', store);
+  assertEquals(r.status, 'invalid_code');
+});
+
+Deno.test('self-referral is blocked', () => {
+  const store = new ReferralStore();
+  store.createCode('alice', 'SELF01');
+  const r = processReferral('SELF01', 'alice', store);
+  assertEquals(r.status, 'self_referral');
+  assertEquals(store.getBalance('alice'), 0);
+});
+
+Deno.test('invalid inputs are safe no-ops', () => {
+  const store = new ReferralStore();
+  assertEquals(processReferral('', 'bob', store).status, 'invalid_input');
+  assertEquals(processReferral('X', '', store).status, 'invalid_input');
+});
+
+Deno.test('event payload includes code, new_user, credits', () => {
+  const store = new ReferralStore();
+  store.createCode('owner', 'EVT001');
+  const r = processReferral('EVT001', 'newbie', store);
+  assertEquals(r.status, 'ok');
+  assertExists(r.event);
+  assertEquals(r.event!.payload.code, 'EVT001');
+  assertEquals(r.event!.payload.new_user, 'newbie');
+  assertEquals(r.event!.payload.credits, 5);
+});