Terra is a blockchain network built using Cosmos SDK specializing in stablecoin creation. Rather than use fiat or over-collateralized crypto as reserves, each Terra stablecoin is convertible into the network's native token, LUNA.
LUNA allows holders to pay network fees, participate in governance, stake in the Tendermint Delegated Proof of Stake consensus mechanism, and peg stablecoins.
To peg a stablecoin like TerraUSD (UST), a USD value of LUNA is convertible at a 1:1 ratio with UST tokens. If UST's price is, for example, at $0.98, arbitrageurs swap 1 UST for $1 of USD and make 2 cents. This mechanism increases UST demand and also reduces its supply as the UST is burned. The stablecoin then returns to its peg.
When UST is above $1, say at $1.02, arbitrageurs convert $1 of LUNA into 1 UST and make 2 cents. The supply of UST increases, and demand for UST also decreases, bringing the price back to peg.
Apart from reducing stablecoin volatility, validators and delegators stake LUNA for rewards. These two actors play an essential part in keeping the network secure and confirming transactions.
You can purchase LUNA via Binance and then store it, stake it, and participate in governance with Terra Station, the official wallet and dashboard for the Terra blockchain network.
For stablecoin lovers, there are now multiple options to pick from when choosing where to invest. And it's not all fiat-backed stablecoins either. There's a wide variety of methods and networks experimenting with ways of keeping stablecoins pegged. Terra is one such project developing a unique approach to stablecoins and the tools developers can use to create their own pegged tokens.
What does Terra do?
Terra is a blockchain that lets users create stablecoins pegged to fiat currencies. These coins primarily use the network's seigniorage mechanism. The network was founded by Do Kwon and Daniel Shim of Terraform labs in 2018 and uses Tendermint Delegated-Proof-of-Stake (DPoS) as its consensus mechanism. Terra provides smart contract capability for the creation of a wide range of different stablecoin types.
The project has proved popular in the Asian markets for e-commerce and has a large userbase in South Korea, where its headquarters are. For example, taxi users in Mongolia can pay some drivers in the stablecoin Terra MNT pegged to the Mongolian tugrik. Tokens minted on the platform are known as Terra currencies and exist alongside the network's native token for governance and utility LUNA. Terra and LUNA have a complementary relationship.
Terra already has stablecoins pegged to the US Dollar, South Korean Won, and Euro, among others. Within a short time, the project has seen wide popularity with the stablecoins minted on the platform. TerraUSD has, as of writing, already made it to the fifth-largest stablecoin by market cap.
What are Terra stablecoins?
Stablecoins on the Terra network use a different method to collateralize fiat-backed stablecoins and crypto-backed stablecoins. Collateralized stablecoins typically allow the holder to exchange their stablecoin for an equivalent amount of fiat or some amount of crypto. This is the case with BUSD, which maintains audited US dollar reserves. The same is true for DAI, which is backed up with over-collateralized cryptocurrencies.
Terra's stablecoins, however, use algorithmic methods to control their supply. Each stablecoin is, in effect, backed up and exchangeable for the governance and utility token LUNA. Terra acts as a counterparty for anyone looking to swap their stablecoin for LUNA and vice versa, which affects the two tokens' supplies.
How do Terra stablecoins work?
Imagine you want to mint $100 of TerraUSD (UST), which is equal to 100 UST at the peg. To mint the UST, you'll need to convert an equivalent monetary amount of LUNA tokens. Terra will then burn the tokens you supply. So, if the price of LUNA is $50 per coin, the algorithm would require you to burn 2 LUNA to mint 100 UST. Previously, Terra only burned a portion of the tokens provided, but with the introduction of the Columbus-5 update, 100% is burned.
You can also mint LUNA with Terra tokens. Minting $100 of LUNA (2 LUNA) would require burning 100 UST. Even if the market price of UST isn't $1 per token, the conversion rate for minting treats 1 UST as equal to $1. This exchange mechanism is what gives TerraUST its price stability.
Let's look at an example to see exactly how the algorithm works to try and keep the price stable:
1. The price of 1 UST falls to $0.98, 2 cents lower than its intended pegged value. However, for all conversions between Terra stablecoins and LUNA, 1 UST is treated as being worth $1.
2. An arbitrageur sees this price difference and notices an opportunity to make some profits. They proceed to buy 100 UST for $98 and then convert it to $100 of LUNA.
3. The arbitrageur can either keep their $100 of LUNA or convert it to fiat and cash out their profit. While $2 doesn't sound like much, bigger profits can be made on a larger scale. This difference between the price of minting the tokens and their value is known as seigneurage.
But how does this end up stabilizing the price at $1? First, the increased demand for UST by arbitrageurs increases UST's price. Terra burns the UST during the exchange to LUNA, reducing its supply and increasing UST's price. Once 1 UST reaches $1, the arbitrage opportunity closes.
The same process works in reverse when the price of UST is above $1. Let’s see another example.
1. The price of 1 UST rises $1.02, which also provides arbitrageurs a way to make a profit.
2. Arbitrageurs purchase $100 of LUNA and convert it to 1 UST worth $102. Terra burns the LUNA, and there's an increase in the supply of UST.
3. In combination with a decrease in demand for UST due to its high price, UST's price decreases to $1.
The LUNA token is integral to all of this and acts as collateral for all Terra stablecoins. There's no need to over collateralize, and the token absorbs the UST price volatility. In many ways, Terra acts as a central bank with an elastic monetary policy, carefully controlling the supply of its currencies. When compared to over-collateralized projects like MakerDAO, the Terra model is highly scalable and more affordable.
LUNA is Terra's cryptocurrency that plays four different roles on the platform:
1. A method to pay transaction fees in its gas system (utility token).
2. A way to take part in the platform's governance system. By staking your LUNA tokens, you can create and vote on proposals with changes regarding the Terra protocol.
3. A volatility absorber for the price of stablecoins minted on Terra.
4. A token to stake in the DPoS consensus mechanism behind validators processing network transactions.
LUNA has a maximum target supply of one billion tokens. If the network exceeds one billion LUNA, Terra will burn LUNA until its supply returns to the equilibrium level.
In the future, there will be a lot of opportunities for Terra to take advantage of its cross-chain compatibility with other Cosmos SDK blockchains. As the stablecoin topic is important globally regarding regulation and mainstream adoption in payment systems, there's room for Terra to grow and improve its user base outside of Asia.