What is Terra (LUNA)?
Updated: Apr 15, 2021
Terra is the most important project in blockchain that you haven’t heard about. It is the third-largest blockchain (after Bitcoin and Ethereum) in terms of revenues collected, generating $13mn in fees annually. It is backed by top-notch investors including Binance, Polychain, Coinbase, and Pantera.
Terra is a payment system, supported by a basket of fiat-pegged stablecoins, algorithmically stabilized by the native token- LUNA.
=> That was a mouthful. I hope you're brave enough to keep reading.
To understand LUNA one must first understand stablecoins
Stablecoins are cryptocurrencies that are pegged to a fiat currency, say US$. They are an excellent gateway into the crypto world since they allow one to operate in the blockchain ecosystem without having exposure to the volatility of a typical cryptocurrency.
Stablecoins have become the reserve currency of DeFi (Decentralized Finance). If you get paid in bitcoin but do not want exposure to the volatility and do not want to pay the fees charged by centralized institutions to convert your earnings to fiat, then the solution is to convert your earnings to a stablecoin.
There are 3 types of stablecoins
1. The simplest form of stablecoins are Fiat-Backed Stablecoins like USDT(Tether) and USDC. For every 1$ worth of USDT or USDC in circulation, there is a bank account somewhere with an equal amount of actual US$ deposited.
=> The problem with these is that they are centralized i.e. they need central authorities (banks, auditors, regulators) to vouch for the fact that sufficient fiat backing the stablecoin exists. USDT, the fiat-backed stablecoin with the highest market cap, is under investigation for not being sufficiently collateralized. Apparently, Bitfinex (an associated firm) used the US$ deposits to cover $850mn of trading losses)
2. Then there are Crypto-Backed Stablecoins like Dai. Dai is collateralized by crypto assets instead of fiat. Because of the volatility of crypto assets, Dai is over-collateralized i.e if Dai is being backed by ETH then for every $1 of ETH, only $0.75 worth of Dai is issued.
=> Dai does not depend on a central authority but rather runs on code and hence is a decentralized stablecoin. The amount of cryptos backing Dai are available for anyone to see and verify. The problem with Dai however is that there are limits to how much it can scale. Over-collateralization makes it capital inefficient to produce and hence demand often outstrips supply. Limits in the scalability of collateralized stablecoins are limiting the scalability of DeFi.
3. The third type of stablecoin is Algorithmic Stablecoins like Terra (the subject of this article). These do not have any collateral backing them. Instead, they use price stabilization algorithms.
=> Terra is decentralized and the amount of Terra and Luna in circulation can be easily verified. Additionally, algorithmic stablecoins are infinitely and immediately scalable.
TERRA and LUNA
Terra stablecoins are the 1st stablecoins that are decentralized, scalable, yield generating, and inter-chain.
TerraUSD, TerraKRT, TerraMNT are stablecoins built on the Terra blockchain. While TerraUSD is new, TerraKRW has a successful track record in South Korea and TerraMNT in Mongolia.
How does Terra work?
TerraUSD is pegged 1:1 against the US$. The stabilization of TerraUSD is controlled by the native currency of the Terra blockchain, LUNA. Terra’s algorithm brings TerraUSD back every time it deviates from its peg by either minting or burning coins.
If the value of TerraUSD falls to say 0.98, then arbitrageurs will have the option of selling 1TerraUSD (worth $0.98) and receiving $1 worth of LUNA in exchange. On the backend, the protocol will mint new LUNA to pay the arbitrageurs and burn the TerraUSD sold by arbitrageurs which would reduce the total supply of TerraUSD. In other words, the drop in value of TerraUSD will be absorbed by LUNA holders as the total supply of LUNA will increase.
If the value of TerraUSD rises to say $1.02, then arbitrageurs will have the option of buying 1 TerraUSD (worth $1.02) for $1 worth of LUNA. The protocol will mint more TerraUSD increasing the supply. On the backend, the LUNA paid by arbitrageurs will be burnt. In other words, the increase in the value of TerraUSD will accrue to LUNA holders as the total supply of LUNA will fall.
=> Described above is a balancing act involving exchanging value between currency and collateral. This is called the seigniorage model. The difference between the cost and value of 1TerraUSD or 1 LUNA is the seigniorage.
Essentially, the protocol functions as a market maker for Terra/LUNA swaps that is immediately sensitive to price changes and balances supply and demand through arbitrageurs.
Why own LUNA?
LUNA holders are investing in the long-term growth of the network. They absorb short-term volatility in exchange for predictable mining profit and steady growth.
LUNA staking earns holders, validators, and delegator staking rewards which have 3 components:
1. Gas - Fee added to each transaction
2. Taxes or Stability fee - capped at 1TerraSDR is charged to each Terra transaction
3. Voting rewards - Voting within the reward band in the LUNA exchange rate oracle process earns holders rewards from the seigniorage pool
On the other hand, they can suffer slashing if they:
1. Sign 2 different blocks within the same chain at the same height.
2. Are off-line or otherwise non-responsive beyond a certain amount of time
3. Miss too many oracle votes
Terra blockchain is a Proof-of-Stake (POS) blockchain that believes in the importance of keeping miners incentivized to stake LUNA in all market conditions. If staking rewards are too volatile, then there won't be a strong validator community to absorb short-term volatility. Therefore Terra has built miner incentive stabilization that keep mining rewards stable irrespective of Terra's demand and market conditions. The stabilization mechanism involves adjusting unit mining rewards to counteract volatility.
The growth potential of Terra
Terra Blockchain becomes more valuable as more value is transacted on Terra. As more online and offline businesses accept Terra and more use-cases are created (from products like Chai, Anchor and Mirror described below), the trend in transaction fees will be upwards.
Chai is Terra’s e-commerce focussed payment gateway that allows a seamless user experience to customers who themselves have no direct exposure to cryptos (No confusing private/public keys or wallet addresses or overwhelming custody concerns). In the front end, it is like any other credible payment gateway that integrates with the top 15 Korean banks. On the backend, it uses Terra’s blockchain to service merchants who enjoy the benefits of substantially quicker settlement times (6 seconds) and lower costs (0.5-1.3%) than traditional payment systems. Users can be incentivized by unparalleled discounts and promotions funded by the spread or seigniorage instead of through VC money raising.
At the time of writing, Chai has 2.2mn total users, 53k daily active users, 71k daily transactions, and $1.2bn in annual transaction volumes. It is widely integrated with e-commerce merchants in South Korea and expanding aggressively offline through the Chai top-up debit card and offline retail store- CU.
Anchor will be a savings protocol that earns yield by staking in Proof-of-Stake networks. Staking returns are composed of transaction fees and block rewards which are far more stable than the yields offered in DeFi protocols.
Mirrot protocol will offer people around the world exposure to the US stock market through their mTokens that will mirror US equities. Using an oracle system able to check prices every 6 seconds, it’ll provide 24/7 minting, trading, and settlement of US equities.
=> The pioneer in such exchanges is “Synthetix”. Mirror is a more capital efficient alternate as it applies a collateralization ratio of 150% compared to 750% by Synthetix. Lower collateralization is possible given collateral is provided in the stable TerraUSD vs the volatile SNX.
LUNA is an exciting coin with a strong underlying product (capitalizing on the growth in stablecoins), a credible team and investors, and a promising pipeline of growth opportunities.