Deep dive into the Terra blockchain and $LUNA token
Executive Summary
$LUNA is the token of the Terra blockchain, the protocol’s main offering is its fiat pegged algorithmic stablecoins that are offered in a number of different local currencies. The $LUNA token is used to stabilise the price of the these stablecoins while also acting as a governance token that allows holders to submit and vote for proposals on key decisions.
Problem Solved
Terra aims to build a global payment system that challenges a number of different offerings within the current financial system. The use cases include reducing settlement time for merchants from days to seconds, near instant foreign exchange delivery and intermediary-free remittance
Utilising blockchain technology Terra aims to combine the benefits of peer-to-peer value transfer offered by cryptocurrencies with the price stability of fiat currencies. Ultimately this goal ends with users using cryptocurrencies without even knowing they have.
Terminology
Terra is the blockchain protocol that issues a number of different fiat tracked stablecoins.
US Terra ($UST) is the most used stablecoin issued by Terra which aims to peg itself 1:1 against the United States Dollar.
$LUNA is the reserve and governance token used to keep $UST and other stablecoins in the Terra ecosystem to their pegs.
Terraform Labs is the Singapore based entity behind Terra.
Luna Foundation Guard (LFG) was founded in January 2022 as a non-profit organization based in Singapore to help grow the Terra Ecosystem.
Funding
The project has attracted considerable funding in varying forms from some of the most prominent and active investors within the crypto industry.
From a successful $25M round led by Mike Novogratz’s Galaxy Digital into Terraform Labs, commitments from Pantera Capital and Arrington XRP to invest $150M into products tied to the Terra ecosystem, a successful private token sale of $LUNA (ICO) and most recently a $1B raise completed by a consortium led by Three Arrows Capital for the non-profit arm Luna Foundation Guard.
Understanding the Tech
The Terra blockchain is built using the popular backbone that is Cosmos SDK which operates a delegated Proof-of-Stake consensus algorithm. Where miners (known as validators) are required to stake their $LUNA to secure the network and are rewarded from each block executed. In practice the more $LUNA a validator has staked the higher the probability it will generate the next block and rewards for doing so.
By using the Cosmos SDK there is a capability for Terra to perform up to 10,000 transactions per second and communicate easily with other blockchains built using Cosmos.
With the formalities out of the way let’s dig into it a little bit more and see what that all means.
Table of Contents
- Introduction
- Overview: The role of stablecoins
- Relationship between Terra and $LUNA
- Price drivers for $LUNA
- Risks and Threats
- Founding Team
- Investors and Funding rounds
- Tokenomics
- Timeline
- Links and Resources
- The Terra Ecosystem
Introduction
For us to get a better understanding of the $LUNA token it’s worth zooming out a little bit and away from some of the current noise if only to remind ourselves of the core purpose that cryptocurrencies set out to achieve: provide secure digital payments without the need for third parties.
However, if we were judging the impact cryptocurrencies have had on the world by using just this metric we would deem the whole experiment a failure. While “currency” is in the name, cryptocurrencies themselves aren’t being used in the way currency has traditionally been used — exchanged for goods and services.
This boils down to a couple of reasons with the most important being that holders of cryptocurrencies think the value is going to go up and naysayers think it’s going to zero. This lack of agreement means a merchant hasn’t wanted to exchange their goods for cryptocurrencies to assume the risk of a 50% decrease against their local currency by the time rent is due and on the flip side, a Bitcoin holder doesn’t want to end up paying $470,000,000 for a couple of pizzas (again).
This price volatility has led to a demand for a safe-haven within the cryptosphere. Something with the familiar attributes of being cheap to move, censorship-resistant, intermediary free, fast and trustless but also price reliable; stable if you would.
Enter Terra and its family of stablecoins where all the boxes above are checked and where one Terra issued UST will equal one US Dollar, one Terra issued EUT will equal one Euro, and so on across several different currencies.
But to harness the benefits of cryptocurrencies with the reliability of fiat is no simple feat and Terra wasn’t the first.
In 2014 Realcoin (now Tether Limited) was founded and became the first issuer of a stablecoin on the promise that every one dollar you gave them will be locked away somewhere in reserve, in return they will issue you with the cryptocurrency $USDT which will equal one US dollar. It was the safe-haven from volatility everyone was hoping for and not long after launching had a multi-billion dollar market cap.
This reserve method to create a cryptocurrency without price volatility seemed beautifully simple up until some important questions began to be asked around the reserve. The idea of billions of dollars just sitting in a bank account somewhere is an inefficient use of capital and also creates a counterparty risk — what if the bank failed (again).
Using the funds to purchase something liquid and low-risk like government bonds would make sense and generate a small yield for Tether. Perhaps some AAA-rated corporate debt could be considered to gain a slightly higher yield but the mystery remained because as a private company no legal obligations exist to produce audited public accounts.
With this knowledge a bigger conversation began around transparency and what risk management was in place — what if in their search for higher returns they were assuming more risk? The elephant in the room then began to reveal itself; a private company acting as custodian goes against the principles of self-custody that cryptocurrency is based upon and billions “under management” posed a systemic risk to the whole crypto economy if poorly managed.
A new method was needed.
2. Overview: The role of stablecoins
It is difficult to imagine the cryptocurrency industry would have grown to the trillion dollar market cap we have today without what Tether’s $USDT started. Stablecoins underpin the foundation for the rest of the innovation to grow upon and without the ability to shelter from price volatility would almost certainly trigger those to seek off-ramps to fiat via centralized exchanges. A percentage of those taking profit never to return. Stablecoins keep money in the system.
Being a stablecoin issuer using the reserve method is lucrative (take in one billion dollars, get 3% from some AAA corporate bonds, return the one billion and keep $30 million for yourself) and simple enough, so simple in fact that Tether has a market cap of $80+ billion with only 13 employees. Not hard then to understand why dozens of new players began to emerge with their own reserve method stablecoin; Binance launched $BUSD, Circle partnered with Coinbase to produce $USDC, Gemini’s $GUSD and the list goes on.
With a clear demand for stablecoins the task of creating a decentralized version began and at the end of 2017 after three years in development MakerDAO launched theirs. Built on Ethereum and using smart contracts the $DAI stablecoin became available. This new method didn’t take your dollars and put them in the bank, instead MakerDAO locked your crypto, say $ETH, into a smart-contract and issued you $DAI in the form of an over-collateralized loan.
Let’s say the value of your $ETH is worth $100,000 and you don’t want to sell it because you think it’s going to increase in value over time but you also want to invest in another red hot crypto project. Lock your $ETH up with MakerDAO and you’ll receive $66,000 worth of $DAI in return (66% LTV) which you can now go and put to good use (this process is called “minting”, remember this term). Want your $ETH back? Sell your red hot crypto project for profit and pay back your 66,000 $DAI then pat yourself on the back (this process is called “burning”, remember this term). Open source smart contracts and the collateral reserve available for the public to see.
Mission Decentralized Stablecoin: Complete.
$ETH price go down tho? Liquidations. The value of your $ETH drops from $100k to $71,000 the smart contracts in MakerDAO will sell your $ETH, take a 5% liquidation fee then pay back your $DAI on your behalf thus relinquishing you of your debt obligation and also your $ETH position. A different set of risks, but at least these are risks you are responsible for managing.
There’s other risks of course but we’ll skip over hacks and smart contract vulnerabilities for the moment. The problem with $DAI as it later emerged is that over 50% of the collateral being deposited was $USDC. Yes, the centralized stablecoin issued by Circle and Coinbase and therefore assuming the same risks. Full circle if you would. Problem not solved. Mission Decentralized Stablecoin: Not Complete.
Monkey see monkey do. MakerDAO set the trend for the crypto-asset-over-collaterized-smart-contract-combo and inspired a whole host of other projects, all with slightly different collateral to be allowed. A protocol called Spell became a quick hit by allowing users to deposit not just other cryptocurrencies but income generating liquidity provider (LP) tokens* and receive a loan in their beautifully named stablecoin Magic Internet Money ($MIM). Another project called JPEG’d now allows you to put up your NFT as collateral and receive a $PUSd stablecoin.
You can see where this is going.
The next step in stablecoin innovation was to go fully algorithmic but the short life of the $TITAN/$IRON project exploded costing investors a cool $1.75B in June 2021. Up next was a combination of these ideas called FRAX.
(* More on this another time but to sum it up quickly. AMMs or decentralized spot exchanges don’t run an order book, instead markets are created when two assets are put in a balancing pool. When you deposit the two assets you receive rewards that are generated when other users buy or sell one of the assets in your pool and pay fees to do so. As proof of your two asset deposit you receive an LP token that serves as your receipt. This receipt used to be illiquid, Spell allows you to get a loan against it for $MIM).
The point is not all stablecoins are created equal. Different methodologies mean different conditions will cause different risks when trying to keep their namesake and avoid depegging.
3. The relationship between Terra and $LUNA
This is from Terra’s website:
“When the demand for Terra is high and the supply is limited, the price of Terra increases. When the demand for Terra is low and the supply is too large, the price of Terra decreases. The protocol ensures the supply and demand of Terra is always balanced, leading to a stable price.”
Users can mint new Terra-based stablecoins — of which UST is the largest — by burning LUNA tokens, and similarly, they can burn UST to mint LUNA. They are incentivized by the protocol to burn and mint in a way that ensures $1 worth of LUNA can always be traded for 1 UST, and vice versa.”
What he said. Terra = Earth, Luna = Moon. They need each other — got it.
There’s a couple of things we need to get our head around here and some terminology that comes in handy; minting, burning and arbitrage. Emissions and seigniorage we’ll cover another time.
First to recap that the goal of a stablecoin is to stay exactly the same price of the chosen asset, in UST’s case it is the US dollar. We also need to understand that market forces can cause a price discrepancy between the two, this is called a depegging. The method in which $LUNA is used to incentivise market players to quickly close this price discrepancy is what is novel.
Think of this method as a system of fixed rules and within this system the most important rule is the fixed redemption value.
Let’s paint it with an example.
On an exchange you notice that the price of UST drops below the supposed peg of $1USD and can be bought on the open market for $0.90USD. You, as a savvy market player knows a place that guarantees it will always buy 1UST from you at $1USD. On the exchange you swap your $0.90 for 1UST. You choose to instantly sell your 1UST to the Terra ecosystem who keeps their promise and buys it for $1.00USD, netting you a profit of $0.10. The 1UST you have just exchanged is then burned (meaning destroyed forever) by Terra. The market sees this happen and becomes aware that there is less UST available (or to look at it another way has increased in rarity) and as per economics 101 of supply and demand the price of 1UST increases to $0.93USD. The process is repeated by others in the market who like what you did and the gap is closed and the peg is restored. Now buying 1UST costs you 1.00USD. Because the promise is kept by Terra, market participants now trust Terra and are therefore incentivised by the potential $0.10 profit to keep monitoring the open market.
The other way around would be if 1UST is trading above the peg, say $1.10, on the open market. After discovering that someone on an exchange wants to buy 1UST for $1.10USD and knowing the Terra systems promise you exchange your $1.00USD for exactly 1UST (to whip out the terminology textbook this is called “minting”) and instantly sell it for $1.10 to make yourself $0.10 profit again. Your actions increase the amount (supply) of UST in the open market and with more supply available then lowers the price back to peg.
To make sense of $LUNA’s role you’ll need to replace “USD” in the examples above with “the USD price of $LUNA on the open market” meaning $0.90 worth of $LUNA or $1.10 worth of $LUNA.
Don’t worry. Read it again and you’ll get it. And congratulations, you are now officially an arbitrageur profiting from arbitrage opportunities. Now scale to a few hundred thousand UST then automate the process with a bot you’ve designed that buys and sells automatically when these parameters are met.
So to sum it up in steps:
When the price dips below the peg:
1. Users have 1UST and it’s worth $0.90USD
2. They give it to Terra.
3. Terra gives them $1.00 USD worth of $LUNA.
5. Terra burns the UST which reduces its available supply and therefore increases the price of the stablecoin.
When the price of the UST stablecoin rises above the peg:
1. $LUNA holders see the price of UST is $1.10 on the open market. They swap $1.00USD worth of their $LUNA with Terra and receive 1UST.
2. They sell the 1UST on the market for $1.10USD worth of $LUNA
3. They receive $1.10USD worth of $LUNA for which they only paid $1.00 worth of $LUNA.
3. The UST circulating supply increases and therefore the price of the UST stablecoin decreases closer to the peg.
With $LUNA having a fluctuating market price and Terra having a promise to always deliver UST at a fixed price the system is essentially saying “Give me your UST that is unfortunately worth $0.90 but don’t worry I will give you $1.00USD worth of $LUNA which you can go and sell on the open market to make you whole again.”
