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Terra is a smart contract blockchain that aims to provide an ecosystem for algorithmically governed, seigniorage-based, fiat-pegged stablecoins in a decentralized manner.
Terra Unpacked
Terra is a blockchain protocol and a payments-focused financial ecosystem powered by algorithmic and scalable stablecoins pegged to real-world fiat currencies.
The protocol was developed by Terraform Labs in January 2018. Terraform Labs is a Korean blockchain enterprise founded by serial entrepreneurs Daniel Shin and Do Kwon. Terra’s two key ecosystem components are its stablecoins, known as “Terra currencies,” and its governance and utility token, LUNA. The balance of these two components is meant to be analogous to the way the Earth (Terra in Latin) and the Moon (Luna in Latin) rely on each other for gravitational stability and rotation.
While the 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 its native USD-pegged stablecoin, TerraUSD (UST). Currently the fifth largest stablecoin on the market, UST is one of the fastest-growing assets in the industry, reaching a market capitalization of $2.5 billion within a year of its launch.
How Do Terra Stablecoins Work?
Unlike other decentralized algorithmic stablecoins like MakerDAO’s DAI, Fei Protocol’s FEI, and Ampleforth’s AMPL, which respectively rely on over-collateralization, fractional reserves, or rebasing to maintain their peg, Terra’s stablecoins leverage an elastic monetary policy to ensure price stability and growth.
The elastic monetary policy means that Terra stablecoins achieve price stability by adjusting their supply according to real-time fluctuations in demand. Seigniorage plays a vital role in this. In monetary terms, seigniorage refers to the difference between the nominal value of money and the cost of producing it.
In Terra’s case, the protocol utilizes 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 the price of UST by agreeing to counter-party anyone looking to swap UST and LUNA at UST’s target exchange rate of one U.S. dollar.
To mint UST, users must burn an equivalent dollar amount of LUNA tokens. For example, to mint 1,000 UST, with LUNA’s current market price at $38.87, they would have to burn 25.72 LUNA tokens. On the other hand, to mint $1,000 worth of LUNA, the user would have to burn 1,000 UST.
In essence, Terra stablecoins maintain price stability by leveraging market forces. When the value of one UST is below that of $1, users and arbitrageurs can burn one UST to get $1 worth of LUNA. When the value of one UST is above $1 dollar, they can burn $1 worth of LUNA to get one UST, collecting the “seigniorage” in the process.
The LUNA token serves as a volatility absorption tool that also captures rewards through seigniorage and transaction fees. When demand for Terra currencies increases, the system mints Terra currencies, earns LUNA in return, and then burns a portion of the earned LUNA, making the supply scarcer. Furthermore, as LUNA is used for validating Terra transactions through staking, LUNA stakers also earn transaction fees charged by the protocol.
With this mechanism at work, Terra stablecoins maintain their peg without being over-collateralized, making them significantly more capital-efficient and scalable compared to other algorithmic stablecoins on the market.
How Does the Protocol Work?
Terra is built on the Cosmos SDK and uses the Tendermint Delegated-Proof-of-Stake (DPoS) consensus mechanism.
While the protocol currently relies on a set of 130 validators, determined by who has the biggest stake delegated, the network is due to see an increase to 300 validators in the future. The primary role of Terra validators is to verify, settle transactions, and secure the network by running full nodes to commit blocks to the chain. In simpler terms, validators in Proof-of-Stake-based blockchains play a similar role to miners in Proof-of-Work-based blockchains—they secure the network and help it maintain consensus.
To become a miner or a validator in Terra, users must either bond (lock for a minimum of 21 days) their own LUNA tokens or have other users delegate their LUNA stakes. LUNA stakers can delegate their tokens to validators to become delegators.
Delegators and validators have the same function and share the same benefits and responsibilities. This means that while delegators get to earn a portion of the fees accrued by the validators, they also face the threat of losing their funds if the validator to whom they’ve delegated their stake misbehaves. Validators (and by extension validators) face having their staked tokens slashed if they try to execute a double-spend attack or remain inactive for a prolonged period.
Like other consensus mechanisms, Terra’s DPoS consensus model employs the “carrot and the stick” incentive structure. In Terra’s case, validators and delegators earn the reward or the “carrot” through transaction fees and seigniorage. At the same time, the “stick” is the threat of getting “slashed” or losing the staked LUNA in the case of misconduct.
Decentralization, Governance and the Future
With only a few hundred validators, Terra isn’t the most decentralized blockchain. Similar to other DPoS-based blockchains like Cardano, EOS, and TRON, Terra optimizes for performance, scalability, and interoperability while making compromises on the side of decentralization.
While Terra is still primarily developed and maintained by Terraform Labs, LUNA token holders can participate in governance through staking. Terra validators can submit protocol improvement proposals and vote on changes using their staked LUNA as voting power.
Certain protocol changes, including blockchain parameters, rewards distribution, transaction fees, and spending from Terra’s treasury can be applied automatically, while other more complex proposals, are manually implemented by the core development team at Terraform Labs once they are voted in by the community.
While most other Layer 1 protocols cater to crypto natives today, Terra’s moat is that it looks outwards instead of inwards in its adoption and growth strategy. With interoperable and scalable stablecoins like UST, simple savings protocols like Anchor, and the synthetic stocks trading platform Mirror, Terra is well-positioned to expand beyond the cryptosphere and create a stable and intuitive environment that drives real-world adoption.
So far, this approach has proven to be a success. Terra is currently the world’s 11th largest cryptocurrency on the market, with a market capitalization of $15.6 billion, and $8.6 billion in total value locked across protocols on the network. With the imminent introduction of the long-awaited Columbus 5 upgrade, which will introduce a deflationary mechanism for LUNA similar to Ethereum’s EIP-1559 update, Terra is well poised to continue growing in popularity.