An Overview of the Terra/Luna Ecosystem
If you are reading this post, then like me, I am sure you have also been a witness to the recent meteoric rise in Luna's price. While I wish I was among the investors who had the conviction early on to hold Luna and realize those massive gains, I sadly knew nothing about the project and how it functions. Hoping to change the status of an unknowing pleb, I ventured out to try and learn everything I could about the Terra/Luna ecosystem, and with posting it here, for you all to read as well, I hope I can do the same for you.
What is Terra?
Terra is a delegated Proof-of-Stake (PoS) blockchain that supports stable programmable payments and open financial infrastructure development. Terra is an algorithmically backed stable coin that is supported by a basket of fiat pegged, seigniorage share style stable coins which are algorithmically stabilized by its native crypto asset, Luna.
Terra’s vision is facilitating the mass adoption of cryptocurrencies with payments and commerce by creating digitally native assets that are price stable against traditional fiat currencies.
Terra stable coins are pegged to the USD, EUR, CNY, JPY, BGP, KRW and the IMF SDR
What is Luna?
Luna is the native staking token of the Terra protocol. Luna serves as the foundational asset for the entire Terra network and ecosystem. Its primary function is to protect the integrity of Terra mechanisms through staking. Staking rewards are provided to incentivize and align long-term interest in Luna ownership. Luna is also used for:
- Staking to validate blocks and to provide accurate price feeds
- Keeping Terra currencies at their peg
- Governance
Luna also plays a critical role in pegging the value of Terra stable coins to fiat currencies as it acts as the collateral.
Luna can exist in 3 states:
1) Unbonded: Luna that can be freely traded
2) Bonded: Luna that is staked. Staked luna is locked into the ecosystem until it becomes unbonded but accrues staking rewards for the delegator and validator it is bonded to
3) Unbonding: Luna that is instructed to be undelegated from a delegator transition into an “unbonding” state during which neither rewards accrue or can the Luna be freely traded
How it works?
The Terra blockchain was built using the Cosmos SDK and uses a PoS BFT consensus mechanism based on Tendermint, which relies on a set of the top 100 validators that are responsible for committing new blocks in the blockchain. These validators participate in the consensus protocol by broadcasting votes which contain cryptographic signatures signed by each validator’s private key. Validator candidates can bond their own Luna and have Luna ‘delegated’, or staked to them by token holders. The top 100 validators are determined by who has the most Luna delegated to them.
In order to secure the network, validators are subject to slashing risks should they behave in a malicious manner that goes against the best interests of the network. Major slashing conditions are:
1) Double Signing: a validator signed two different blocks with the same chain ID at the same height
2) Downtime: a validator was non-responsive
3) Too many missed oracle votes: a validator failed to report a threshold amount of votes that lie within the weighted median in the exchange rate oracle
Validators and their delegators earn the following fees:
1) Compute Fees: essentially just gas fees for each transaction
2) Stability Fees: To stabilize the value of Luna, the protocol charges a transaction fee ranging from 0.1–1% which is disbursed pro-rata to validators
3) Seigniorage Rewards: Validators that participate in the Luna Exchange Rate Oracle get a portion of seigniorage if they faithfully report and win the ballot
How does Terra maintain Price Stability?
Terra stable coins function as an elastic supply currency, meaning that circulating supply algorithmically increases/decreases as a function of dollar demand. To mint a Terra stable coin, a user needs to burn the equivalent dollar amount of Luna. A user can also burn the Terra stable coin and redeem it for the equivalent value of Luna. Variable-rate transaction fees are also utilized to promote stabilization, with fees rising when Terra’s price falls below the peg, and falling when Terra is above the peg.
When demand for stables rises, prices as a result also rise. To combat this effect, more stable tokens are needed to compensate for an increase in dollar demand and to help drive the price back down (Dollar expansion). The inverse is also true for when the stables trade below their peg, with dollars needing to be removed from circulation to drive prices up (Dollar contraction).
Ex: If 1 Luna costs $10 and the price of UST is $1.50 (ie: above its peg), Luna holders can burn their Luna to mint UST and make a 50% risk-free profit. Arbitrageurs engage in this trade by burning Luna to receive an equivalent $ amount of UST (ie: $1 worth of Luna for $1 UST) which can then be sold into the market at a premium, capturing the difference which also leads to more UST in circulation and diluting its value back to the $1 peg.
Conversely, if UST is trading below its peg, say $0.5, a UST holder can elect to burn their UST and receive an equivalent dollar value in Luna. A user holding 10 UST can burn and mint themselves a whole Luna, instantly capturing a 100% profit in this scenario as Luna and UST are redeemable at a 1:1 dollar ratio. This mechanism incentivizes supply contraction for UST which helps drive its price back up towards its $1 peg.
When Luna is swapped for UST, a certain % of that Luna is burned while the rest piles up in a community pool. This process is called seigniorage. Seigniorage is the recaptured value achieved through minting Terra in a Luna:Terra swap. A portion of this value is distributed back to validators that participate in the Luna Exchange Rate Oracle and any remaining community funds are reinvested back into the ecosystem to aid in development of new apps that use UST.
· Market shocks will be handled with the liquid fiat/crypto reserve including the Luna token reserve (the value of which is always maintained to be above the circulating Terra supply) is used to buy back Terra and burn it. The reserve is resupplied during oversupply when it collects higher tax rates.
· Extreme undersupply will be solved by minting new Terra and selling it to exchanges, where received funds will be used to reinforce the reserve, and the surplus distributed through a method so-called Decentralized Fiscal Spending.
A protocol-level market-maker for Terra/Luna swaps provides an elastic monetary policy that is both sensitive to deviations in price and swift to react to apply balancing forces through arbitrageurs who profit on the difference. So long as there is a threshold level of demand within the Terra ecosystem, be it manifested in Luna price or Terra transaction volume, the balancing act of exchanging value back and forth across currency and collateral to maintain the peg provides a robust defense against tumultuous volatility. However, it’s impossible to design a perfectly stable asset under all conditions, and the Terra protocol does have vulnerabilities.
Terra Applications
Terra hosts a number of applications within its ecosystem that target payments, earnings and investments and all make use of its stable coins. Terra applications include:
Chai
A payment product used by 5% of the population in South Korea. It uses Terra’s stable coins to settle transactions faster and cheaper than legacy counterparts and has generated over $2b in annualized transaction volume.
Mirror
A DeFi protocol that enables the creation of synthetic assets to provide real world exposure to all types of asset classes such as equities, commodities, ETF’s, etc. Minting synthetic mAssets requires users to deposit Terra’s UST as collateral at a 150% collateralization ratio. Mirror has accumulated more than $2.3b in TVL.
Anchor
A high yield savings protocol offering low-volatile yields on Terra stable coin deposits. The protocol aims to be the DeFi reference rate for savings and has accumulated more than $1b in TVL.
BuzLink
A viral marketing product to scale social referrals.
MemePay
A payments product used by 3% of the population in Mongolia.
Conclusion
After diving into what is the Terra/Luna ecosystem, I have become a big proponent of Do Kwon (project creator) and am quite bullish on the ecosystem as a whole. Luna essentially acts as the lifeline of the whole Terra ecosystem and as more and more applications are developed and integrated into Terra, the more dollar demand (UST) will be required to utilize these projects which in turn leads to a very bullishly reflexive Luna asset price to the upside. Cosmos’s Inter-Blockchain Communication Protocol (IBC) will also allow cross-chain collaboration and flow of assets, helping to potentially get more dollars (UST) into other Layer 1’s.
