• What Exactly Is Terra? Explanation of the Blockchain for Stablecoins

    • Terra is a Layer 1 blockchain and financial ecosystem focused on payments, powered by scalable algorithmic stablecoins.
    • With a market capitalization of $15.6 billion, its native token, LUNA, is the world’s 11th largest cryptocurrency.
    • In less than a year, its UST stablecoin has risen to become the fifth largest stablecoin on the market.

    Terra is a smart contract blockchain that aims to provide a decentralized ecosystem for algorithmically governed, seigniorage-based, fiat-pegged stablecoins.

    Unpacking Terra

    Terra is a blockchain protocol and financial ecosystem focused on payments, powered by algorithmic and scalable stablecoins pegged to real-world fiat currencies.

    Terraform Labs created the protocol in January 2018. Daniel Shin and Do Kwon, serial entrepreneurs, founded Terraform Labs, a Korean blockchain company. Terra’s stablecoins, known as “Terra currencies,” and its governance and utility token, LUNA, are the two most important components of its ecosystem. The balance of these two components is intended to be analogous to how the Earth (Terra in Latin) and the Moon (Luna in Latin) rely on one another for gravitational stability and rotation.

    While the Terra ecosystem currently supports multiple Terra currencies, including those pegged to the South Korean Won, Mongolian Tugrik, and the IMF’s SDR basket of currencies, Terra’s flagship product is TerraUSD, its native USD-pegged stablecoin (UST). UST, the fifth largest stablecoin on the market, is one of the industry’s fastest-growing assets, having reached a market capitalization of $2.5 billion within a year of its launch.

    What Are Terra Stablecoins and How Do They Work?

    Unlike other decentralized algorithmic stablecoins such as MakerDAO’s DAI, Fei Protocol’s FEI, and Ampleforth’s AMPL, which rely on over-collateralization, fractional reserves, or rebasing to keep their pegs, Terra’s stablecoins rely on an elastic monetary policy to ensure price stability and growth.

    Because of the elastic monetary policy, Terra stablecoins achieve price stability by adjusting their supply in response to real-time fluctuations in demand. Seigniorage is crucial in this regard. Seigniorage is the difference between the nominal value of money and the cost of producing it in monetary terms.

    Terra’s protocol, for example, employs a dual token mechanism to capture value and stabilize the price of its stablecoins. If UST deviates from its peg, the system uses LUNA to stabilize its price by agreeing to counter-party anyone looking to swap UST and LUNA at the UST’s target exchange rate of one US dollar.

    Users must burn an equivalent dollar amount of LUNA tokens in order to mint UST. To mint 1,000 UST, for example, with the current market price of LUNA at $38.87, they would have to burn 25.72 LUNA tokens. To create $1,000 worth of LUNA, the user would have to burn 1,000 UST.

    Terra stablecoins, in essence, maintain price stability by leveraging market forces. When the value of one UST falls below the value of one dollar, users and arbitrageurs can burn one UST to obtain one dollar’s worth of LUNA. When the value of one UST exceeds $1, they can burn $1 of LUNA to obtain one UST, collecting the “seigniorage” in the process.

    The LUNA token acts as a volatility absorber while also capturing rewards from seigniorage and transaction fees. When demand for Terra currencies rises, the system mints them, earns LUNA in exchange, and then burns a portion of the LUNA earned, making supply scarcer. Furthermore, because LUNA is used for Terra transaction validation via staking, LUNA stakers earn transaction fees charged by the protocol.

    Terra stablecoins maintain their peg without being over-collateralized thanks to this mechanism, making them significantly more capital-efficient and scalable than other algorithmic stablecoins on the market.

    How Does the Protocol Function?

    Terra is based on the Cosmos SDK and makes use of the Tendermint Delegated-Proof-of-Stake (DPoS) consensus mechanism.

    While the protocol currently relies on a set of 130 validators determined by who has been delegated the most stake, the network is expected to expand to 300 validators in the future. Terra validators’ primary function is to verify, settle transactions, and secure the network by running full nodes to commit blocks to the chain. In a nutshell, validators in Proof-of-Stake blockchains are similar to miners in Proof-of-Work blockchains in that they secure the network and help it maintain consensus.

    To become a miner or validator in Terra, users must either bond (lock their LUNA tokens for a minimum of 21 days) or have other users delegate their LUNA stakes. Stakeholders of LUNA can delegate their tokens to validators in order to become delegators.

    Validators and delegators serve the same purpose and have the same benefits and responsibilities. This means that, while delegators earn a portion of the fees earned by validators, they also risk losing their funds if the validator to whom they’ve delegated their stake misbehaves. Validators (and, by extension, validators) risk having their staked tokens depleted if they attempt a double-spend attack or remain inactive for an extended period of time.

    Terra’s DPoS consensus model, like other consensus mechanisms, employs a “carrot and stick” incentive structure. Validators and delegated earn the reward or “carrot” in Terra’s case through transaction fees and seigniorage. At the same time, the “stick” is the threat of being “slashed” or losing the staked LUNA if misconduct occurs.

    Governance, Decentralization, and the Future

    Terra is not the most decentralized blockchain, with only a few hundred validators. Terra, like other DPoS-based blockchains such as Cardano, EOS, and TRON, optimizes for performance, scalability, and interoperability while making decentralization sacrifices.

    Terra is still developed and maintained primarily by Terraform Labs, but LUNA token holders can participate in governance through staking. Terra validators can submit protocol improvement proposals and vote on them with their staked LUNA.

    Certain protocol changes, such as blockchain parameters, rewards distribution, transaction fees, and spending from Terra’s treasury, can be applied automatically, whereas other more complex proposals are manually implemented by Terraform Labs’ core development team after they are voted in by the community.

    While most other Layer 1 protocols today cater to crypto natives, Terra’s moat is that its adoption and growth strategy looks outwards rather than inwards. Terra is well-positioned to expand beyond the cryptosphere and create a stable and intuitive environment that drives real-world adoption with interoperable and scalable stablecoins like UST, simple savings protocols like Anchor, and the synthetic stocks trading platform Mirror.

    So far, this strategy has proven to be effective. Terra is currently the world’s 11th largest cryptocurrency, with a market capitalization of $15.6 billion and a total value locked across protocols on the network of $8.6 billion. Terra is well positioned to continue growing in popularity with the impending release of the long-awaited Columbus 5 upgrade, which will introduce a deflationary mechanism for LUNA similar to Ethereum’s EIP-1559 update.

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