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Terra (LUNA) Explained: The Algorithmic Stablecoin Protocol Seeking to Conquer DeFi

Terra (LUNA) Explained: The Algorithmic Stablecoin Protocol Seeking to Conquer DeFi

Explainers DeFi

11 May 2022

Since its launch in 2019, Terra Protocol has experienced astonishing growth.

While its native LUNA cryptocurrency claimed the ninth spot among the top digital assets by market capitalization, the algorithmic stablecoin UST once nabbed the third spot on the crypto market from Binance's BUSD.

At the same time, Terra's ecosystem continued to expand rapidly.

Despite the relatively small number of projects on top of its blockchain, Terra Protocol has become the sixth-largest DeFi chain, featuring a total value locked of $4.1 billion. Despite Ethereum's domination over the NFT sector, Terra is also among its top contenders there.

Last November, LUNA nearly doubled in value while most digital assets experienced a downtrend. This came as a surprise to many investors, since LUNA managed to accumulate significant gains while the whole crypto market underwent a significant correction.

However, it has been caught in a downward spiral recently, shedding more than 50% of its initial value. LUNA is trading at $5 at the time of writing, plummeting by more than 85% in the last 24 hours. One of the reasons explaining LUNA’s fall from its all-time high of $119 in April is attributed to its role of providing stability to UST stablecoin.

Let's explore the essentials about Terra and what the project's most important updates are in the last few months to see how that could have impacted the cryptocurrency's value.

Terra: a Protocol Designed to Boost LUNA's Price With Stablecoin Adoption

With its network officially launching in early 2019, Terra Protocol is a blockchain-powered algorithmic stablecoin ecosystem.

At first, the project found initial success in South Korea's e-commerce industry, where thousands of merchants adopted the Terra-powered Chai mobile payments app to offer discounts to their customers via the UST stablecoin.

Later on, an increasing number of projects launched on top of Terra. As a result, the stablecoin protocol also became popular within the cryptocurrency space, especially after entering sectors like decentralized finance, non-fungible tokens, and Play-to-Earn blockchain gaming.

Terra was founded by Do Kwon and Daniel Shin back in 2018. While the stablecoin's ecosystem is governed by its community in a decentralized manner, the duo has been managing and promoting Terra's development through the Seoul-based company Terraform Labs.

Terra has put the main focus on scalability, which helped the network achieve a maximum capacity of 10,000 transactions per second (TPS) as well as a block time of only six seconds. In exchange, like in the case of most high-throughput Ethereum competitor chains, the project has sacrificed a degree of decentralization (and a likely a bit of security) to feature inexpensive and near-instant transfers as well as avoid future network congestions.

As a result, the network utilizes the Delegated Proof-of-Stake (DPoS) consensus mechanism. It has only 130 validators who are responsible for processing transactions, generating new blocks, and securing the ecosystem. In contrast, there are over 300,000 validators on Ethereum's staking-based Proof-of-Stake (PoS) Beacon Chain, which will soon merge with the mining-based Proof-of-Work (PoW) main blockchain as part of the ETH 2.0 upgrade.

As a side note, it's important to add that Terra was built with the Cosmos software development kit (SDK). It utilizes the Tendermint Byzantine Fault Tolerant (BFT) consensus engine via an ecosystem of application-specific blockchains. For that reason, the project can interconnect with other chains within this framework, which we will discuss more in detail later.

Furthermore, the genesis distribution of LUNA, Terra's native coin, has been increasingly centralized, with a significant percentage of the cryptocurrency going to Terraform Labs, its partners, as well as its employees and contributors:

  • 10% – Terraform Labs
  • 20% – Employees and contributors
  • 20% – Terra Alliance
  • 20% – Stability reserves
  • 4% – Genesis liquidity
  • 26% – Investors (three rounds of seed and private sales)

Interestingly, Terra Alliance is a joint initiative between 15 large e-commerce companies in Asia with over 45 million customers that seek to utilize the Terra blockchain to enhance payments, increase user engagement, and provide an overall better service. At the same time, the alliance aims to facilitate the adoption of the stablecoin project.

Overall, while remaining permissionless, Terra sacrificed a certain level of decentralization to create a highly scalable stablecoin protocol that is very active in the crypto space and other industries as well, such as Asia's e-commerce market.

Stablecoin Focus

When we first wrote about Terra on AAX Academy approximately a year ago, we described the project as a "highly scalable, payment-focused blockchain platform that operates as an open financial infrastructure via programmable stablecoins."

Indeed, stablecoins have been at the center of focus on Terra Protocol. In fact, they are such crucial elements within the ecosystem that one could argue that the project wouldn't have achieved much success without them.

Most stablecoins on the market – especially when the project launched in April 2019 – are backed by fiat currencies that are meant to be held in the form of physical reserves. Due to the latter, stable assets like USDT, USDC, and BUSD operate on a centralized basis. Corporate players like Tether, Circle, and Binance are responsible for their issuance and protocol management.

While not everything has to be fully decentralized in the crypto world, the centralized governance of stablecoins increases counterparty risks and raises questions about how the issuer maintains the value peg to fiat currencies.

Regarding the latter, Tether was fined for miscommunicating about its fiat holdings backing USDT, which later forced the company to reveal that cash represented less than 3% of its reserves.

As an alternative, multiple stablecoin projects utilize cryptocurrency collateral (e.g., ETH, WBTC, and other ERC-20 tokens) that is transparently locked in smart contracts to issue decentralized fiat-pegged digital assets. While DAI is an excellent example of the success of this strategy, major changes in the price of deposited crypto assets can lead to undercollateralization, which could put the whole system at risk.

Probably the most exciting form of stablecoins is algorithmic stable assets that Terra utilizes to power its protocol. Unlike the other two and their hybrid variants, algorithmic stablecoins don't need any collateral to maintain their pegs to fiat currencies and other (more stable) instruments.

Instead, an algorithm is responsible for achieving that, utilizing smart contracts and various mechanisms to autonomously adjust the coin's supply and demand based on the strength of its peg in regard to the underlying asset.

However, before Terra, the predominant majority of algorithmic stablecoins either featured unsustainable business models or struggled to maintain their pegs to fiat currencies in the long run. As price stability is the most important feature of any stablecoin, failing to succeed in this field can easily render the project unusable.

Considering all this, Terra's success shouldn't come as a surprise. Unlike most algorithmic projects, stablecoins like UST and TerraKRW (KRT) on Terra Protocol feature an extensive history of price stability that is very similar to USDT, USDC, and any other stable assets that utilize real-world reserves to maintain their fiat pegs.

At the same time, Terra's business model is not just profitable, but it has also managed to provide generous incentives for the project's end-users and enterprise clients as part of LUNA's allocation to the Terra Alliance. We will talk about these along with the actual mechanism that is utilized for UST's price stability a bit later in this article.

As of today, UST has a nearly $19 billion market capitalization, with a $650 million volume in the last 24 hours. At the same time, TerraKRW is the largest stable asset pegged to South Korea's national currency that features a nearly $30 million market cap.

With a near tenfold supply growth in the last 365 days, demand for UST has been surging steadily. And since LUNA's value is practically tied to stablecoin demand on the protocol, this is probably why the cryptocurrency has managed to outperform the market since November.

LUNA and Terra's Dual-Token Model

Terra utilizes a dual-token model for maintaining the peg of stablecoins issued on top of the protocol to their underlying assets. This model has two components: the native LUNA token and stable assets like the UST.

LUNA is the native governance token of the platform. In addition to utilizing it to vote on issues and proposals concerning the protocol's future, the cryptocurrency also has staking functionality. But most importantly, it plays a crucial role in ensuring the price stability of Terra's stable assets.

Theoretically, to mint $1 UST for example, the protocol's algorithm has to burn $1 worth of LUNA. And in another scenario of this hypothetical situation, $1 UST (or any other stablecoin) has to be burned to mint $1 of LUNA. So, basically, while no real collaterals are used for stable asset minting on Terra, LUNA is the instrument that backs them.

In practice, as the supply and demand dynamics are continuously changing on the market, we have to take the price stability mechanism into account. That changes how the protocol mints and burns LUNA and other stablecoins.

Say the demand for UST increases significantly, which drives the stablecoin's price above $1. In that case, the protocol burns LUNA to stabilize the supply and get UST's price back to $1 by minting new coins. For investors, this is an optimal scenario, as moving a part of the LUNA supply out of circulation will come with an increase in the asset's price (if demand stays the same or grows).

In the opposite scenario, when the demand for UST takes a hit and the price goes below $1, the algorithm burns UST and mints more LUNA to decrease the supply and get the stablecoin's value back to $1. In this case, LUNA investors might see their portfolio's value fall due to significant growth in LUNA's supply.

During both scenarios, Terra incentivizes users either to buy UST with LUNA or burn UST in exchange for LUNA by offering them prices above the market rate. For example, users can swap $1 LUNA for $1.10 worth of UST to increase the stablecoin supply or to burn $0.9 UST for $1 LUNA to move stable assets out of circulation.

As a result, LUNA's price is based on the demand for Terra's stablecoins.

And as stablecoin demand grows when more people utilize them for payments as a store of value or for various crypto-related activities via different services (e.g., DeFi, NFT) within the ecosystem, LUNA's value is essentially tied to the actual usage of the Terra Protocol.

A Thriving Ecosystem

In the last few sections, we have explored how Terra successfully maintains its algorithmic stablecoins' price stability and how LUNA is directly tied to the demand for stable assets on the protocol.

Due to the latter, one of the best ways to ensure a long-term price appreciation for LUNA is to incentivize activity and development within the project's ecosystem. And Terra has been considering this a top priority since its launch.

Terra utilizes a discount model to facilitate increased adoption of stablecoins for payments. Here, a solution like the payment-focused app Chai cuts fees to offer price-based promotions and other incentives for merchants and their customers. Interestingly, this initiative helped Chai attract over 2.5 million users to its Terra-powered solution by the end of 2020.

At the same time, Terra's official entry to the DeFi space has quickly made the project the second-largest blockchain for decentralized finance applications. Throughout various activities – such as yield farming, lending, and staking –, users have been increasingly utilizing algorithmic stablecoins like the UST across multiple protocols, such as:

  • Lido Protocol: Normally, if you stake a digital asset, you won't be able to move your coins for several days, weeks, or even months. You can't even interact with them in any other ways, for example by trading or using them as collateral for loans. Lido seeks to solve this issue by distributing the equivalent amount of bonded assets (bAssets) as the user is staking via the protocol. bAssets' value is tied to the ones you are staking, and you are free to utilize them in any way you'd like to on other protocols (e.g., Anchor) to maximize your yield or access extra capital.
  • Anchor Protocol: Anchor is a lending protocol that offers low-risk yields for investors via stablecoin deposits or bonded assets. At the same time, borrowers can access extra capital by using their bAssets as collateral, with the option to generate rewards during the process.
  • Mirror Protocol: As its name suggests, Mirror Protocol "mirrors" the price dynamics of real-world stocks like APPL and TSLA via synthetic assets called mAssets. Users can trade these instruments for UST to gain exposure to general market instruments without the hassle of opening an account at a broker or relying on other traditional finance services.

In addition, Terra has been active lately in the NFT and blockchain gaming spaces as well. While the project's market share is still very small in these sectors, non-fungible tokens have become an integral part of the ecosystem, with further growth to be expected in this field.

The Most Crucial Terra Updates and Developments

Now let's explore the most critical updates of the project that could have accelerated this trend. Terra has gone through quite some developments in this field since our last article.

The Luna Foundation Guard and Bitcoin Reserves

In 2022, it seems Terra has been following the footsteps of Michael Saylor's MicroStrategy, El Salvador's government, Elon Musk's Tesla, and others that have been acquiring massive amounts of Bitcoin.

In January, the project announced the formation of the Luna Foundation Guard (LFG), a Singapore-based non-profit dedicated to facilitating the growth of Terra's ecosystem, the advancement of open-source technology, and enhancing sustainability and stability of Terra-based algorithmic stablecoins.

While the non-profit kept its methods for achieving these objectives a secret at first, one of them was revealed after a high-profile action. And this is utilizing UST to accumulate huge amounts of BTC to hold as reserves to improve the price stability of the stablecoin.

The LFG started acquiring the cryptocurrency in February – along with $100 million worth of AVAX in April –, with its last purchases growing the project's BTC reserves to the size of $3.5 billion as of May 5. As a result, the Luna Foundation Guard's UST Forex Reserve has become one of the top 10 Bitcoin holders in the world.

According to Terraform Labs co-founder Do Kwon, Terra plans to become the "largest single holder of Bitcoin in the world" besides Satoshi Nakamoto by acquiring a total of $10 billion BTC via the LFG.

We know so far that Terra's plans to allocate huge amounts of Bitcoin reserves are very ambitious, which can likely mean two things.

First, as algorithmic stablecoins are more prone to significant price deviations than those backed by real-world fiat or crypto reserves, it seems like the project is acquiring BTC to provide an additional layer of security in case the protocol's algorithm fails. This way, Terra could utilize its Bitcoin reserves to stabilize UST's price before a death spiral occurs.

Taking place during bear markets in most cases, a death spiral is an event in which the native token - in this case, LUNA - falls significantly in price, leading to many users panic-selling. In the case of LUNA, many have panic sold it in exchange for the stablecoin UST, which increases the latter instrument's value. As the protocol seeks to stabilize the stable asset's price, it mints more native coins, further reducing its value and creating hyperinflation.

This is what happened to TitanDAO's native IRON Titanium Token last year, after a huge crypto bank run led to the native coin losing nearly all its value after a massive fall from June 16's $64 to $0.00000105 by June 17.

In addition to avoiding such an unfortunate situation, it seems like Terra also has plans to establish a Bitcoin Standard or a similar system for UST that leverages BTC's scarcity and deflationary halvening mechanism to retain the stablecoin's purchasing power – even compared to the USD. However, apart from a tweet by Do Kwon depicts the company’s intention to “open a new era of the Bitcoin standard” with a Bitcoin reserve, we don't know more details about such plans.

Overall, accumulating substantial amounts of Bitcoin to serve as some kind of reserve of last resort while letting the algo do its work in stabilizing stablecoin prices across Terra increases the safety of users and creates new opportunities for the project to capitalize on.

Essentially, the LFG's crypto stash transforms UST from an algorithmic stable asset into a hybrid stablecoin that maintains its peg to the USD via a combination of algorithms and BTC reserves.

Columbus-5 Launch and Cross-Chain Compatibility

In addition to the LFG's Bitcoin reserves, Terra had another crucial event in the past few months that could positively impact LUNA's price.

This was the Columbus-5 upgrade, which the project called "Terra's boldest and most significant mainnet upgrade" since the protocol's launch. Taking place in late September 2021, Col-5 focused on capturing more value via the project's ecosystem, interconnecting Terra-based stablecoins and other digital assets with other blockchains, and setting the foundation of a fast-growing DeFi economy.

To achieve these goals, the Columbus-5 upgrade has introduced numerous new changes.

Among them, maybe the most important for investors is eliminating the seigniorage mechanism, which traditionally points to the profit made by the government via money issuance. Seignoriage is best understood as the difference between the face value of money and how much it cost to produce it. If the seigniorage is positive, then the government makes a profit. However, in the case that the seignorage is negative, an economic loss then arises. In Terra's case, before the update, the protocol would burn only a portion of the LUNA utilized to mint more UST, distributing the rest of the coins to fund community projects.

However, due to the increased adoption of the project and its stablecoins, the protocol collected so much LUNA as seigniorage that its community pool became overfunded. At the time of the proposal, around $3.5 billion of the cryptocurrency were held in the stash dedicated for ecosystem development.

As part of the Columbus-5 upgrade, developers have decided to eliminate future seigniorage, modifying the price stability algorithm to burn 100% of the LUNA utilized to mint UST and other stablecoins. As a result, more LUNA will be moved out of circulation if more people use Terra-based stable assets. Thus, if demand stays the same or grows, this will make the cryptocurrency a deflationary instrument that will likely increase in value over time due to the long-term decrease of its supply.

At the same time, the project also decided to burn $1 billion out of the total $3.5 billion LUNA in the community pool to mint roughly the equivalent in UST, which is utilized to fund the algorithmic, claims-based insurance Terra protocol Ozone.

Such a significant change in the project's supply, as well as its LUNA-burning mechanism, likely had an influence on the cryptocurrency's recent bull run.

Since Terra cut the community pool's funding to introduce deflationary properties for LUNA, developers decided to rely on community initiatives like the LFG and Terraform Labs' $150 million ecosystem fund to provide the necessary capital for facilitating the development of Terra-based projects. At the same time, the protocol also started compensating oracles for the loss of seigniorage revenue by redirecting swap fees in the form of dividends to validators and delegators with the goal of incentivizing accurate oracle voting.

In addition to these mostly economic changes, the Col-5 update also put a focus on enhancing Terra's capabilities to interact with other blockchains via the Cosmos SDK. After Columbus-5, developers have enabled Inter-Blockchain Communication (IBC) functionality for Terra, a standardized communication protocol for IBC-compatible chains (mainly within the Cosmos ecosystem).

With the IBC enabled, Terra can transfer assets and data as well as seamlessly connect its dApps with other IBC-enabled chains, such as ThorChain, Akash, Cosmos Hub, and Secret Network. Since LUNA's price is greatly influenced by the adoption of Terra-based stablecoins, this interoperability is crucial for the project in opening up new markets for UST and other stable assets, especially in the field of decentralized finance.

Terra: A Decentralized Stablecoin Protocol That Just Got Upgraded

Since its mainnet's launch in April 2019, Terra has achieved quite some success in the crypto space.

As part of a promising stablecoin protocol, the project leveraged algorithmic stable assets to enhance e-commerce, challenge Ethereum's lead in the DeFi space, and also gain a foothold in the blockchain gaming and NFT sectors.

While algorithmic stablecoins provide a permissionless alternative to centralized, fiat-pegged assets without facing the bottleneck of overcollateralization, they usually involve more risk due to a potential flaw in their algos or business models.

Yet, UST and other Terra-based stable instruments have managed to feature excellent track records of price stability without any major issues in this field. Despite that, the project started to accumulate $10 billion of Bitcoin reserves to provide additional safeguards for stablecoin users, especially against a scenario like a death spiral.

At the same time, Terra developers modified the seigniorage mechanism to burn 100% of the LUNA utilized to mint UST, which seeks to add deflationary properties to the native cryptocurrency. In addition to burning $1 billion LUNA to fund Ozone with UST, the recent Columbus-5 upgrade introduced new markets for Terra-based stablecoins via cross-chain interoperability.

Considering all the above as well as the Terra ecosystem's rapid growth, it shouldn't come as a surprise that LUNA has managed to outperform the crypto market in the past few months.

But with its recent dramatic downfall, will it manage to thrive in the future?

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