How To Make Money Out Of The Subtle Relationship Between TERRA and LUNA

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You’ve heard the rumblings. It’s all about the TERRA/ LUNA ecosystem at the moment. The protocol’s main stablecoin, the dollar-pegged UST, had a market capitalization of around $200 million at the beginning of 2021. It’s nearing the $16 billion mark, as of the time of writing. The climb was slow and steady until November 2021, when demand skyrocketed. It’s now the fourth most popular stablecoin; behind Tether, Circle, and Binance’s digital dollars. 

During the same period, LUNA, the protocol’s native governance token, consolidated its status as a Top 10 cryptocurrency and currently has a $32 billion market cap. Using a clever system that we’ll thoroughly explain, the success of LUNA is inextricably linked to the success of the stablecoins that the protocol hosts. And the whole thing is growing. 

According to their website, “Terra is a public blockchain protocol deploying a suite of algorithmic decentralized stablecoins which underpin a thriving ecosystem that brings DeFi to the masses.” For its part, “the Terra Protocol is an open-source stablecoin network controlled by its stakeholders. Besides UST, the ecosystem hosts Terra stablecoins pegged to the IMF’s SDR, the Won, and the Tugrik, among others. 

According to Do Kwon, one of Terra’s creators, decentralized stablecoins are “the most important innovation in crypto.” The other creator is Daniel Shin, and the company, Terraform Labs, launched the Terra mainnet on April 23rd, 2019. In the protocol’s introductory video, Kwon describes the project as, “a permissionless form of money and a permissionless financial system built on top of it.”

Technically speaking, the creators of the Terra blockchain used the Cosmos SDK framework to do it. So, Terra is a part of the Cosmos Ecosystem, a network of compatible blockchains that can talk to each other. That makes it a cross-chain protocol. It uses a Proof-Of-Stake consensus mechanism, mixed with Cosmo’s Tendermint consensus.

Then there’s Terra’s decision to buy $1 billion in bitcoin to use as collateral to back their stablecoins. All is well and good, but the point of algorithmic stablecoins is that they don’t need any collateral. By design. The system contains its own collateral, the LUNA token in this case. Is Terra changing its entire model? What are they planning?

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The Pros And Cons Of Terra’s Algorithmic Stablecoins

How does the TERRA/ LUNA dichotomy maintain the stablecoin’s peg to the dollar? Incentives. And by expanding or contracting the token supply. The system guarantees a 1-to-1 exchange between UST and LUNA. The slight price changes present opportunities. When UST is below $1, investors can burn UST and get $1 worth of LUNA at a discount. When UST is above $1, they can burn LUNA to get UST at a discount. Performing any of those actions, they balance the system and make money at the same time. 

Another way of looking at the process, directly from the protocol’s knowledge base:

“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.”

Algorithmic stablecoins have been heavily criticized.   Many believe they only have worked in healthy markets and are yet to prove themselves in less favorable ones.  Can their pegging survive a real stress test? How will they deal with de-pegging events? In the paper “Built to Fail: The Inherent Fragility of Algorithmic Stablecoins,” Ryan Clements said: 

“Algorithmic stablecoins are inherently fragile. These uncollateralized digital assets, which attempt to peg the price of a reference asset using financial engineering, algorithms, and market incentives, are not stable at all but exist in a state of perpetual vulnerability.”

Answering the critics with actions, the non-profit Singapore organization Luna Foundation Guard (LFG) started buying bitcoin. 

Which begs the question: will Terra stop being an algorithmically controlled stablecoin and become a bitcoin-backed financial product? Is the change even necessary?  By design, Terra is a scalable protocol that could maintain price stability in the ecosystem “regardless of market size, volatility, or demand,” according to the documentation.

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Validators, Delegators, And Staked LUNA

As in all Proof-Of-Stake systems, a set of validators process transactions, add new blocks to the chain and secure the system. In the TERRA/ LUNA ecosystem, in particular, only 130 validators run full nodes. All of the other participants are delegators. 

Delegators sFtake or bond their LUNA stake to a validator and immediately start earning “staking rewards from transaction fees.” The higher the stake, the higher the validator’s rank, the more business it gets.  

It’s worth noting that LUNA is a governance token. That means users get to vote on the protocol’s key issues. However, if you’ve got your LUNA staked to a validator and you fail to vote in any governance decision, said validator gets your vote. 

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The Many Protocols Of The Terra Ecosystem

• For savings, the Anchor Protocol. It gives a 20% APY on your UST holdings.
• For investing, the Mirror Protocol. Similar to Ethereum’s Synthetix and Solana’s Fabric, it lets users invest in synthetic versions of real-world assets called mAssets. Users get exposure, even if they don’t own the real asset itself.
• TerraSwap serves as a decentralized exchange for Mirror assets. And as Automated Market Makers, users can provide mAssets liquidity and earn Mirror tokens. 
• For payments, the Pylon Protocol. The project describes itself as “a suite of savings and payments products.” It “enables sustainable exchanges between long-term value providers and their consumers.” They provide a separate app called Gateway in which users can crowdsource liquidity pools and stake their $MINE token.
• The Spectrum Protocol is a yield optimizer. It can help you “Auto-compound and auto-stake your rewards” on Mirror, Anchor, and more.
• Chai serves as the payment rails of the Terra network. The system lets users and merchants transact in UST with low commissions. It offers users a debit card that lets them spend their stablecoins seamlessly in the real world. All of that while giving them rewards. 

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Before The Billions: A Little Bit Of Terra History

Before the fame, Terraform Labs, a South Korean company, was already making waves. By shortening the final settlement of transactions to mere seconds and reducing fees, Terra became a merchant’s favorite. The funny thing was, not many of their customers were aware that they were using cryptocurrencies to move money around. Transactions worked, and that was enough.

That means the Chai payment app was instrumental in Terra’s success. When Chai reached two million open accounts, Do Kwon told Coindesk: 

"Growth over the last couple months has been largely driven by volume lift from COVID-friendly categories. For example, some of the high performing recent integrations include [Korean food-delivery service] Yogiyo and [online grocer] Hello Nature, both of which have seen tremendous growth in the recent months."

It was that little ago.

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The Case Of The Billion Dollars In Bitcoin

Fast forward to the present and Do Kwon is promising billions of dollars in bitcoin purchases. He literally tweeted, “$UST with $10B+ in $BTC reserves will open a new monetary era of the Bitcoin standard. P2P electronic cash that is easier to spend and more attractive to hold.” 

However, when cypherpunk legend Adam Back asked him where did the money come from, he responded, “It's not 10B today - as UST money supply grows a portion of the seigniorage will go to build BTC reserves bridged to the Terra chain. We have 3B funds ready to seed this reserve, but technical infrastructure (bridges, etc.) is still not ready yet.” 

In reality, the rumor is that the Terra Foundation bought $125 million, which at the current price is about 2,840 BTC. They plan to keep buying, though. And there’s an even bigger rumor that says that the Terra Foundation is actually buying $125 million every day and this wallet with 21.323 BTC is theirs. It’s just a rumor, though. 

As to how they’ll use the bitcoin, there’s already a “Bitcoin Reserve Pool” proposal. It says, “proposing a pool that facilitates rapid BTC liquidity to support UST during downwards peg deviations, and relies on traders to replenish the reserves outside of crises.” So, it will work similarly to the UST/ LUNA peg. If the proposal passes, of course.

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Is The Terra Ecosystem The Future Or The Past?

Will Terra be a major player in the years to come? There are many factors that favor the protocol. They have functioning bridges to Ethereum and the Binance Smart Chain. Plus, Terra is part of the Cosmos Ecosystem. And, thus, compatible with all those blockchains. 

Their controversial bitcoin war chest, if it exists, is a bold and decisive move that speaks to the protocol’s resilience. However, with the acquisition, are they admitting that the algorithmic stablecoin model doesn’t work? Or are they playing 4D chess and executing a play we don’t yet see? Is this the end for Terra or the beginning of something new?

More importantly, can the Anchor Protocol maintain those 20% APY yields in the long run? Most of the Total Value Locked in Terra is in the Anchor Protocol, which is driving adoption as the flagship and most successful product. Can they keep the party going forever? And if the answer is no, what will happen to the ecosystem once those huge numbers disappear?

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