The following article was written before the complete meltdown of the Terra ecosystem in May, 2022. CoinDesk is maintaining the content for historical purposes but please note that both LUNA (now known as LUNA Classic or LUNC) and UST, the former stablecoin linked to LUNA, have collapsed and do not function as described below.
–Toby Bochan, Managing Editor, Learn
Luna (LUNC) and TerraUSD (UST) are two native tokens of the Terra network, a blockchain-based project developed by Terra Labs in South Korea.
The Terra blockchain is built on Cosmos SDK; a framework that allows developers to create custom blockchains and build their own decentralized applications on top of Terra for various use cases.
The Terra ecosystem contains some natively built projects. These include non-fungible token (NFT) collections, decentralized finance (DeFi) platforms and Web3 applications.
Founded by Do Kwon, a former Stanford University computer science grad who appeared on CoinDesk’s Most influential 2021 list, the Terra ecosystem has experienced tremendous growth recently. The market capitalization of UST grew from $180 million at the start of 2021 to almost $15 billion in March 2022, while LUNA’s price soared by 138-fold.
In addition, the Washington Nationals baseball team announced a five-year sponsorship deal with Terra’s decentralized autonomous organization (DAO) in February, a deal worth $40 million. It was said the team plans to accept UST as a payment option in the future.
What is LUNA?
According to Terra’s white paper, the founders’ goal was to fulfill what Bitcoin originally set out to be: a peer-to-peer electronic cash system. To achieve that, Terra deploys a system of stablecoins – cryptocurrencies whose value is pegged to different assets such as commodities or fiat currencies.
UST is by far the most popular among them and tracks the price of US dollars whereby one UST token hovers closely around the $1 mark. It achieves its peg to the dollar through the use of the ecosystem’s other token, LUNA.
LUNA plays a vital role in maintaining the price of the Terra stablecoins and reduces market volatility so they remain stable (see below).
Read more: What Is a Stablecoin?
The price of the LUNA token has experienced an astronomical rise in price over the last year. In 2021, LUNA traded at $0.66 and closed the year at $89. Subsequently, it hit its all-time high of $104.58 on March 9, 2022, at a time when most other cryptocurrencies were falling in tandem with global capital markets catalyzed by the Ukrainian invasion crisis.
From relative obscurity, UST has emerged to become the fourth-largest stablecoin behind tether (USDT), USD coin (USDC) and Binance USD (BUSD), surpassing $15 billion in market capitalization.
What is UST and how does it work?
Stablecoins are a specific type of cryptocurrency whose price is pegged, usually to a state-issued fiat currency such as the U.S. dollar. What makes stablecoins in the Terra blockchain different is the method they use to keep the price stable.
Instead of relying on a reserve of assets to maintain their peg, as USDC and USDT do, UST is an algorithmically stabilized coin. This involves using a smart contract-based algorithm to keep the price of TerraUSD (UST) anchored to $1 by burning (permanently destroying) LUNA tokens in order to mint (create) new UST tokens.
So, how does it actually work?
It all has to do with arbitrage. This usually refers to the process of making small profits by finding discrepancies between asset prices on different exchanges. However, in the case of LUNA and UST, it works slightly differently.
In the Terra ecosystem, users can always swap the LUNA token for UST, and vice versa, at a guaranteed price of $1 – regardless of the market price of either token at the time. This is important to note because it means if demand for UST rises and its price rises above $1, LUNA holders can bank a risk-free profit by swapping $1 of LUNA to create one UST token (which due to a rise in demand in this example, is worth more than $1).
During the swapping process, a percentage of LUNA is burned (permanently removed from circulation) and the remainder is deposited into a community treasury. Funds in the treasury are then used to invest in applications and services that expand the utility of the Terra ecosystem.
Burning a percentage of LUNA tokens reduces the number of overall tokens left in circulation, making them more scarce and, therefore, more valuable. By minting more UST tokens, it has the effect of diluting the existing tokens in circulation and bringing the overall price back down to its $1 level.
Similarly, if demand is low for UST and the price falls below $1, UST holders can exchange their UST tokens at a ratio of 1:1 for LUNA – which is worth more because of their scarcity and so the user can bank another risk-free profit.
Read more: Crypto Arbitrage Trading: How to Make Low-Risk Gains
While UST remains the most used stablecoin in the ecosystem, there is a range of other stablecoins available pegged to various fiat currencies such as:
TerraCNY (Chinese yuan)
TerraBGP (British pound)
TerraJPY (Japanese yen)
TerraKWR (South Korean kwon)
TerraSDR (the International Monetary Fund)
The International Monetary Fund’s SDR is an outlier among them because the everyday user does not have access to use or purchase anything with it. It’s a special unit of account used as an international reserve asset, calculated by a basket of various fiat currencies belonging to the world’s largest economies.
Terra uses TerraSDR to denominate all of its transaction fees, rewards and stimulus grants on the blockchain to minimize price volatility among the different state-issued currencies. After all, a basket of currencies diversifies risk and so is less prone to wild swings than a single currency – something that’s useful when it comes to determining stable fee rates and rewards.
How Terra works
The Terra smart contract platform was built on the Cosmos SDK, which is known for its interoperability between chains to communicate with each other. Terra also has bridges to other blockchains such Ethereum, Binance Smart Chain, Harmony and Osmosis – allowing for the seamless transfer of data and tokens between non-native ecosystems.
Terra uses the Delegated Proof-of-Stake (DPoS) consensus protocol known as “Tendermint,” where token holders can delegate their funds to certified validators – individuals or groups of people responsible for proposing new blocks – to secure and add new transactions to the blockchain.
It works in a similar way to a House of Representatives or Parliament in politics. LUNA token holders (like citizens) can delegate their coins to validators (the representatives), whereby the more coins that are delegated to them (votes in an election), the more power they have to propose new blocks of transactions, vote on their validity to earn rewards and also play a part in the governance of the blockchain.
Validators are responsible for running the Terra network with a program called full node, which validates the transactions and blocks of the blockchain. The software they use for it is Terra Core, and full node validators must run the latest version of it without any lags or downtime. They also stabilize the price of Terra stablecoins by arbitraging any deviation from the peg and vote for proposals to develop the network.
A validator’s voting power is weighted according to the total number of coins delegated to them to stake, including their own coins, meaning those who have the biggest stake pool have a higher chance of adding a new block to the chain in exchange for staking rewards from transaction fees.
LUNA coins can exist in three different status:
Bonded: Coins are staked or delegated to a stake pool. These are locked up to earn rewards and cannot be traded freely.
Unbonded: Coins that are traded freely and not committed to a stake pool.
Unbonding: Coins that have been withdrawn from staking or delegating. It takes 21 day to complete and it cannot be canceled during the waiting period.
Read more: How Do Ethereum Smart Contracts Work?
What you can do with Terra
Terra was created to be a global, user-friendly platform for electronic cash. It first gained traction among South Korean e-commerce platforms because it offered cheaper transaction fees than most credit card companies and payment processors.
Transactions incur a computational fee that’s usually below 1% of the transferred value and goes to the validators as rewards. Users can pay with Terra stablecoins seamlessly and merchants can accept it as a payment method to lower their costs. More recently, people can use Terra for a myriad of additional things beyond payments, including;
Here are a few examples of some of the leading applications built on top of the Terra blockchain.
Anchor is a decentralized money market built on the Terra blockchain. It gained fame for its industry-leading 20% annual percentage yield that UST holders can earn if they deposit their tokens on the platform. It works like a regular bank account. Users can take out loans and deposit savings to earn a yield. Yields earned from the borrower’s interest payments and the staking rewards of the collateral they deposit to borrow are distributed to stakers.
Chai is a payment rail of the Terra network that lets users and merchants send and receive UST.
Chai uses the Terra blockchain to cut out the middlemen and offers lower transaction fees to merchants than mainstream payment processors and credit card companies. It also offers a debit card (Chai Card) that allows buyers to accumulate points and can redeem them for outsized rewards with specific merchants. The payment app was launched in June 2019 in South Korea and has millions of users.
The Mirror Protocol is a decentralized finance (DeFi) platform that allows users to create and trade “mirrored assets,” or mAssets, that “mirror” the price of stocks – including major stocks traded on U.S. exchanges. They work like derivatives that let you track an asset’s value without actually buying the underlying asset.
Other notable applications built on Terra include:
Read more: What Is a Dapp? Decentralized Apps Explained
Risks associated with LUNA and UST tokens
Algorithmic stablecoins are a relatively new way of pegging cryptocurrencies to any fiat currency. Thus, they have not stood the test of time yet because we have not seen how they work during major market stress or shocks. A research paper published by the University of Calgary found that algorithmic stablecoins “are inherently fragile” and “are not stable at all but exist in a state of perpetual vulnerability. The Federal Reserve Bank’s research about the stablecoin market pointed out that design flaws might lead to de-pegging, as exemplified by the rocky launch of Fei – an algorithmic stablecoin that temporarily collapsed after its launch in April 2021.
Stablecoins have drawn a lot of scrutiny over whether the issuers have enough collateral to back the price and what assets ensure the value of the coins. Algorithmic stablecoins do not have any collateral by design – the collateral is its governance token that can be minted or burned to stabilize the price. If the design turns out to be broken, the value of the coin can drop without a backstop.
Singapore-based Luna Foundation Guard (LFG), a non-profit organization dedicated to developing the Terra ecosystem, addressed the worries by adding $1 billion in bitcoin as a reserve asset behind the stablecoins.
It is worth flagging that stablecoins, along with decentralized finance, are still mostly unregulated around the world. How nation-states decide to regulate this part of the crypto market and what rules issuers have to comply with also pose risk to the future value of your money invested in LUNA or UST. The U.S. Securities and Exchange Commission, for instance, subpoenaed Terra CEO Do Kwon related to the Mirror Protocol for offering derivatives of stocks such as Apple (AAPL) or Tesla (TSLA). Do Kwon and Terraform Labs are challenging the SEC in court.
Read more: DeFi Lending: 3 Major Risks to Know