What is Terra (LUNA)?

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robertstevens

Robert has reported for a variety of international publications including the Associated Press, The Guardian, Vice, and Decrypt. Current areas of interest include the political economy of technology, cryptocurrencies, and privacy. Robert has a Bachelor of Science from UCL, and a Master's degree from the University of Oxford's Internet Institute.

Terra is a blockchain platform that powers a network of decentralized stablecoins. Its currency, also known as LUNA operates as a kind of decentralised reserve.

The creation of entrepreneurs Daniel Shin and Do Kwon, Terra was started in 2018. Its governance and staking coin, LUNA, launched in 2019. Since then, LUNA has shot up in value—as of October 2021, it’s the 11th most popular cryptocurrency with a market cap of $18 billion.

Shin and Kwon wanted to create cryptocurrencies that are stable against the world’s major currencies. It started with the Terra Alliance, a consortium of 15 large Asian e-commerce companies that have about 45 million users among them, according to crypto metrics site Messari.

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Terra’s main product is its algorithmic stablecoin, TerraUSD, a cryptocurrency that uses complicated mathematics to maintain its peg to the US dollar. It innovates on other so-called stablecoins like USDC and Tether, which are backed by reserves of cash, the whereabouts of which are frequently called into question by regulators.

Understanding the stablecoin economy

To understand why Terra is innovative, it is helpful to have a cursory understanding of the stablecoin market. Stablecoins are very useful for crypto traders who want to invest in cryptocurrencies but peg the value of their investments to fiat currencies, such as the US dollar, a historically stable currency controlled by the Federal Reserve.

Stablecoins make it possible to hold a store of value in the crypto economy that is generally unrelated to the rest of the crypto market’s whiplash ups and downs. If Bitcoin crashes, a US dollar stablecoin should, in theory, always be worth $1. They are also useful when investing in long-term crypto funds, like liquidity pools that pay out annual percentage yields. It’s a lot easier to work out how much money you will earn when you are paid out in coins equal to $1.

Broadly speaking, there are two types of stablecoins. The first is a reserve-backed stablecoin company. There are lots of these, but the two most popular are Tether (USDT), which has a market cap of $69 billion, and USD Coin (USDC), which has a market cap of $32 billion. Whenever someone gives Tether or Centre, the consortium that maintains USDC, a dollar, the companies will store that money and issue them a crypto dollar in return. Other cryptocurrencies peg the value of a cryptocurrency to another cryptocurrency. Wrapped Bitcoin, a coin that tracks the price of Bitcoin and is backed by reserves of Bitcoin, has a market cap of $9.7 billion.

There are several issues with this approach. Regulators may decide that these companies should be subject to extensive regulation (as Federal Reserve Chair Jerome Powell advised in September 2021) or ban them outright; the companies may lie about their reserves (a charge the New York Attorney lobbed at Tether; Tether neither admitted nor denied the NYAG’s findings when it settled in early 2021), and the companies may reinvest funds in risky products without telling consumers. Tether in particular has been criticised for withholding details about the commercial paper in which it invests some of its reserves.

The second kind is a decentralized, or algorithmic stablecoin. This is what TerraUSD is. Algorithmic stablecoins use, as the name implies, algorithmic mechanisms to maintain their pegs rather than a centralized body. There are many flavours of algorithmic stablecoins. Some are overcollateralized with reserves of other cryptocurrencies, some are partially collateralized with centralized stablecoins, and some are not collateralized whatsoever.

Uncollateralized cryptocurrencies use different techniques to maintain a peg to another currency. Some burn or mint coins in users’ wallets to alter the value of each individual coin (this is known as a rebase), others reward users who have staked money in the protocol. Other examples of algorithmic stablecoins include Frax, Ampleforth, DAI, and sUSD.

These algorithmic coins also have their own difficulties. The most obvious is that some algorithmic stablecoins simply do not work. Empty Set Dollar is worth $0.02 at the time of writing, and Basis is worth $0.05—far from their desired price of $1.

The other problem is that some algorithmic stablecoins are not entirely decentralized, and still rely on collateralization from centralized stablecoins, such as USDC, which means they are subject to the problems mentioned above. DAI became partially backed by USDC after a ‘Black Swan’ event in March 2020, around the time that the coronavirus pandemic sent global markets tumbling. As of this writing, Frax is about 80% backed by reserve-backed stablecoins, down from 100% when it launched in December 2020.

Explaining Terra

So, where does Terra fit into this? Terra (LUNA) powers a bunch of algorithmic stablecoins, the most popular of which is a US dollar-pegged stablecoin called TerraUSD (UST). If the price of TerraUSD falls below $1, Terra’s algorithm draws from a pool of LUNA to mint more UST and boost the price. Correspondingly, if TerraUSD rises above $1, the pool will burn LUNA—destroy it permanently from circulation—to depress the price of the token.

Like a couple of other algorithmic stablecoin projects (such as Ampleforth), Terra’s model relies on arbitrage. If TerraUSD is low, it is rational for an arbitrageur to buy lots of it, which will increase the demand of UST and hopefully pump up the price to $1. When it’s above $1, arbitrageurs will sell it. Since there’s no joy in buying a dollar-pegged stablecoin for more than a dollar, it should fall in value.

People are incentivized to stake lots of LUNA in the liquidity pool in the hopes that when it is burned, the value of all LUNA tokens increases over time. Terra’s whitepaper says that this strategy is designed to mimic national governments that use expansionary fiscal spending.

“The hope of fiscal spending is that the economic activity instigated by the original spending results in a feedback loop that grows the economy more than the amount of money spent in the initial stimulus,” wrote the authors of Terra’s whitepaper.

While other coins use a token like LUNA to maintain the peg of a single token, LUNA maintains the peg of several different Terra-based stalbecoins, and the supply of LUNA can expand or contract quite dramatically.

UST is dependent on the success of LUNA tokens to maintain its peg, and if everyone decides that LUNA is worthless, it might become difficult to burn LUNA tokens to maintain UST’s peg to $1. This is not unique to Terra. As noted by Bloomberg’s Matt Levine, Tether issues risky loans to Celsius in exchange for Bitcoin, not US dollars. Tether, he argues, is thus tied to Bitcoin.

As CoinGecko writes in its book, How to DeFi, “Many algorithmic stablecoins protocols are also heavily reliant on competent arbitrageurs to maintain the price peg,” as well as a “cooperative community.” If the LUNA or UST market is full of short-term investors who are only interested in “leverag[ing] their capital reserves to control and manipulate the price,” they may struggle to coordinate on emergency events, like keeping funds invested in the pools that maintain UST’s peg if LUNA crashes.

TerraUSD launched in 2020, but others preceded it. These include TerraKRW, a stablecoin pegged to the Korean won, and TerraMNT, a stablecoin pegged to Mongolia’s currency, the tugrik. TUSD is still the largest; TerraKRW has a market cap of $35 million and TerraMNT is not listed on major exchanges. There are also stablecoins pegged to the Chinese yuan, Japanese yen, British pound, and the euro.

What can you do with LUNA and Terra Stablecoins?

LUNA is a fungible token that you can buy and sell on crypto exchanges. You can stake it to support its stablecoin projects, like TerraUSD, and its proof-of-stake validator network. LUNA is also a governance token, meaning you can stake it to determine the parameters of the algorithms that maintain the peg to TerraUSD.

You can buy LUNA from crypto exchanges, such as Coinbase and Gemini. Wealthsimple does not support LUNA as of this writing. However, it supports Maker (MKR), a governance token that also maintains the peg to DAI, another decentralized stablecoin, and Synthetix (SNX), which supports a whole network of cryptocurrency derivatives, among them sUSD, a decentralized stablecoin.

Terra stablecoins also come with low transaction costs and instant settlements, even across borders. That means it’s feasible to use them as a means of payment, an alternative to services like Wise or Western Union. Bespoke Terra apps, like PayWithTerra, CHAI, and MemePay, all support Terra stablecoins.

Terra says that UST is an “inter-chain” stablecoin, meaning that it runs on Ethereum, Solana Binance Smart Chain, and Harmony. This is made possible through Mirror Protocol, a decentralized asset creation app, and the Inter-Blockchain Communication Protocol on which Terra is built. It’s possible to build smart contract projects on Terra using the development framework CosmWasm, which lets you built decentralized applications in languages such as Rust and Go. Other platforms in the Terra ecosystem let you swap tokens, invest in liquidity pools and delegate LUNA to validators.

Last Updated November 1, 2021

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