Terra (LUNA): The "decentralized bank" in focus

Terra is a decentralized financial network that focuses on stable cryptocurrencies (so-called stablecoins). The various stablecoins (e.g. TerraUSD, TerraEUT) are algorithmically backed by the LUNA token. The LUNA token can also be staked and used for voting on protocol changes. An overview of the “decentralized bank” Terra.

Who invented Terra (LUNA)?

Terra is backed by South Korean startup Terraform Labs. Terraform Labs was founded in 2018 by Do Kwon and Daniel Shin. Terraform Labs’ investors include VCs Pantera Capital and Coinbase Ventures.

How does Terra work.

Supply and demand determine the price – this principle is enforced by algorithms in Terra. Stablecoins on the Terra network have a dynamic supply that is based on demand. If the demand for a certain stablecoin – for example UST – increases, the amount in circulation is increased to restore the target value (1 USD). If demand decreases, the UST supply is reduced. The lower supply raises the UST price back to 1 USD.

The LUNA Token as “Collateral”: An Example

In both processes – the expansion as well as the contraction of the Terra supply – the LUNA token comes into play. For example, suppose an app decides to introduce UST as a payment option. This would have the effect of increasing the demand for UST and thus the number of UST transactions. According to the law of the (secondary) market, the UST rate also increases because the UST supply has not yet been adjusted to meet demand – for example, to USD 1.1.

Now we have a problem: as a USD stablecoin, UST aims for an exchange rate of 1 USD. Admittedly, the new UST units can’t become nothing to increase supply and bring the exchange rate back to the target value – USTs have to be backed by something, after all. This is where LUNA comes in.

LUNA holders have the option to exchange 1 USD worth of LUNA for one (newly created) UST. Recall that the UST rate is at 1.1 USD in the example due to high demand. This allows LUNA holders to sell the exchanged UST at an instant profit of 10 percent. The whole thing also works in reverse: if the UST rate falls below 1 USD, UST Holders can exchange 1 UST for LUNA equivalent to one USD.

Each time LUNA is exchanged for new Terra stablecoins, a percentage of the LUNA is destroyed. The rest goes back into the system, or more precisely, a community pool that funds the expansion of the ecosystem. The project refers to this process as “seigniorage” – in reference to the money creation profit of central banks.

Saynora, Seigniorage: Columbus-5 turns up the LUNA furnace.

On September 9, 2021, Terra will undergo a major update with Columbus-5. Among the key innovations is that in Columbus-5, for the time being, all seigniorage will be destroyed instead of going into the community pool flow. The background for this step was what initially sounds like a luxury problem: The community treasury was simply overflowing. Terra founder Kwon noted this in March 2020. On Agora, Terra’s governance platform, Kwon wrote:

Due to the rapid generation of Seigniorage, too much Seigniorage is flowing into the Community Pool and Oracle Reward Pool, resulting in overfunding […] and this trend is likely to continue unless something is done about it.

Columbus-5 is therefore expected to bring the following changes to Terra’s token economy:

  • The Luna economy will be simplified in that all fees will be used to deploy Luna, and $1 worth of Luna will be burned upon minting 1 UST.
  • The Community Pool is intended to remain well-funded, as new distributions will be made when proposals are in the ballot stage, while preventing it from becoming overfunded.
  • Staking Rewards will be attractive, but not exorbitant.

What is the maximum LUNA Supply?

Luna – unlike, say, the “digital gold” Bitcoin – does not have a supply cap. Such a cap would be impractical given the dynamic expansion and contraction of the monetary base on the Terra network. After all, new LUNA tokens must be “printed” as needed to compensate for a contracting stablecoin demand. However, this is not to say that LUNA is experiencing runaway inflation. In particular, Columbus-5’s “burn all seigniorage” policy will unleash deflationary pressure on LUNA supply – assuming the LUNA ecosystem continues to grow.

LUNA staking: delegation trumps validation (for most)

Transactions in Terra are validated by so-called validators. These are operators of special network nodes that have deposited (staked) a large amount of LUNA in the network. They write new blocks to the blockchain and receive a staking reward in return, which (until Columbus-5) is generated from seigniorage and transaction fees. They also participate in treasury management by voting on management proposals. In addition, they serve as an in-network Oracle in which they register and propagate exchange rates within the Terra ecosystem to the network. Running Validator Nodes requires a high level of technical expertise and hardware requirements, making them not for crypto laymen.

Basically, the higher the LUNA reserve of a Validator Node, the greater its influence. At the time of writing, there are 130 validators in Terra/Luna. The number should be raised to 300 in perspective. In the process, anyone with the know-how and the wherewithal can apply to become a Validator by completing a special transaction. The network automatically selects the 130 richest addresses as validators.

Smaller wallets can also participate in the staking process by delegating their LUNA to a validator. As a rule, however, the latter charge a commission of between 0 and 20 percent of the staking revenue..

Use Cases: What apps and dApps rely on Terra (LUNA)?

Chai: 2 million users are already using Terra – whether they know it or not.

Terra wants nothing less than to build a global payments network around programmable money. It aims to do that via growing commercial adoption of its stablecoins, most notably its flagship UST. Terra has already scored a major coup in this regard with South Korean payment app Chai. Chai has 2 million users – and uses Terra on the backend.

Anchor: The better savings book?

With the Anchor protocol launched in March, the Terra ecosystem has a kind of savings account that gives a return on stablecoin reserves. At the time of writing, for example, investors are receiving a whopping 20 percent (annualized) on UST they deposit in the Anchor-dApp.

Mirror Protocol: synthetic assets on Terra.

Terra can also do DeFi: you can see this not only in Anchor, but also in Mirror Protocol. This is a platform for synthetic assets. These are tokens that represent real assets (such as an inverted oil price or a stock). These so-called mAssets must be over-collateralized before they are created. For example, to create a mAsset that represents a $10 stock, Terra stablecoins (optionally other mAssets) must be deposited with an equivalent value of $15.