Terra and Luna, The Dynamic Duo
By Nayan Bandaru | Crescent City Capital Market Analyst Intern
History
The Terra ecosystem was initially created in 2018 to incentivize mass adoption of cryptocurrencies globally with a price-stable digital asset. Founders Daniel Shin and Do Kwon had the idea of using Terra as a payment processing method compared to credit cards with much fewer fees than merchants. Terra had the support of the Terra Alliance (15 massive e-commerce companies in Asia). They supported Terra and its vision of the project bringing adoption and engagement of a large payment network. In turn, allowing a bootstrapped blockchain payment network to scale to the size it deserves and create products and various use cases within its infrastructure. The real gold of the ecosystem lies in its algorithmic stable coins (UST, SDT, KRT) and the native token Luna.
What are Terra and Luna
In the Terra Ecosystem lies a dynamic duo of Terra (I will only be talking about UST) and Luna. UST is the algorithmic stablecoin that stays pegged to USD 1:1 using an incentivized arbitrage system. Luna is the native token of the platform and users need to own Luna to transact and essentially do anything in the Terra Ecosystem.
Stablecoins are cryptocurrency assets that track the price of a currency; in the case of UST, that underlying currency would be the US dollar. These stablecoins are meant to be used exactly like a traditional fiat currency, except they come with the added benefits of blockchain technology. UST can stay at a 1:1 ratio to USD because Terra uses the basics of supply and demand to keep the price stable.
How the stablecoin (UST) is able to stay pegged to USD
When the demand for Terra is high but the supply is lower than the demand, the price of UST increases compared to USD. The vice versa is true if UST demand is low with a large supply, the value of UST drops. The protocol actually balances the supply and demand of Terra to allow the price to stay stable.
This happens because the protocol incentives the users of the ecosystem to burn their Luna and in turn mint Terra when the price of UST is higher than USD. 1 USD of Luna is worth 1 Terra (This is a very important aspect of the system that will be explained later). What this does is that by increasing the supply of Terra in circulation it begins to match the demand levels and the price decreases to its optimal 1:1 ratio. This works in reverse when the price of Terra is low compared to USD. Users are incentivized by the protocol to burn Terra and mint Luna, thereby decreasing the supply of Terra and increasing the price. These two processes are called expansion and contraction.
For example: imagine that UST is trading at 1.01 and USD is worth $1. People can use the Terra marketswap feature to exchange 1 USD of Luna for 1 UST. Users then can sell their UST for 1.01 making a profit by mint Terra by burning their luna. This arbitrage continues until the price falls back to $1 and stabilizes. That same process works in reverse for contraction.
Proof of Stake
Terra uses a proof of stake (POS) consensus mechanism. POS works as users stake a cryptocurrency they become validators. Then validators are chosen at random to validate or mine the next block on the blockchain.
Terra uses Tendermint consensus to validate blocks. A validator also known as a proposer is chosen to essentially add the next set of blocks to the blockchain. There are 2 rounds for a validatory to vote on whether to accept or reject the block and if the block is rejected a new prosper is chosen to start the process again. The validators have a copy of all the transactions made on the network, which they use to compare against the proposed new block of transactions to check validity.
Terra only allows the top 130 validators to participate in consensus, and their rank is determined by the amount of luna that is bonded to them. Validators may bond luna to themselves, but also can get luna bonded to them by delegators (users that stake luna). Delegators are people who want rewards from consensus without having to run a full node. As a delegator, you can stake your luna to a validator adding to their weight and thereby receive a portion of transaction fees as staking rewards.
Rewards are distributed in 2 ways. The first is through transaction or gas fees. Validators are allowed to set their own minimum gas fees. The protocol usually estimates higher gas fees than the minimum to ensure transactions are completed, however unused gas fees are not returned. Transactions on Terra are not queued by their gas amounts rather in sequential order of when they were received. Currently, users are able to earn around 19% APY when staking their luna.
Tokenomics
Circulating supply: 363,213,183
Total Supply: 995,414,805
Total Stake: $32 billion
Luna by nature is deflationary as the tokens used to validate transactions are burned. This creates a diminishing supply of luna in the long run. What is interesting is as the Terra ecosystem continues to grow the value of luna also grows with it, as the token is needed for any interactions. As UST and other stable coins garner more demand the price of luna continues to rise. That fact combined with its deflationary nature means luna has lots of potential upside even after its already massive growth. Luna is currently trading at $99 at the time of writing.
Conclusion
The Terra ecosystem is a revolutionary protocol that keeps its stablecoins values pegged to their respective fiat currency through an arbitrage incentivization system. The total staked value of Luna exceeds that of ETH, and the token by nature is deflationary. I personally believe that Terra will continue to grow and capture portions of the market cap of USDT or Tether. We do not know what actually backs USDT and any form of crisis for USDT can further push the adoption of UST and in turn luna. I would love to see how the ecosystem and users continue to grow as the vision of becoming a mass payment processing method comes to life for the protocol.
References
https://docs.terra.money/docs/learn/protocol.html
https://messari.io/asset/terra/chart/sply-circ
https://messari.io/asset/terra/profile