The “decentralized bank” in focus: How does Terra (LUNA) work?

Terra is a decentralized financial network that focuses on stable crypto currencies (so-called stablecoins). The various stablecoins (e.g. TerraUSD, TerraEUT) are algorithmically covered by the LUNA token. The LUNA token can also be staked out and used to vote on protocol changes. An overview of the “decentralized bank” Terra.

Who invented Terra (LUNA)?

Behind Terra is the South Korean start-up Terraform Labs. Terraform Labs was founded in 2018 by Do Kwon and Daniel Shin. Terraform Labs’ investors include VCs Pantera Capital and Coinbase Ventures.

How does Terra work?

Supply and demand determine the price – this principle is enforced in Terra by algorithms. Stablecoins in the Terra network have a dynamic supply that is based on demand. If the demand for a certain stablecoin – for example UST – increases, the amount in circulation is increased so that the target value (USD 1) is restored. When the demand falls, the UST supply is reduced. The lower offer increases the VAT price back to $ 1.

The LUNA token as “collateral”: an example

The LUNA token is used for both processes – the expansion and dismantling of the Terra offer. For example, suppose an app decides to introduce UST as a payment option. This would mean that the demand for UST and thus the number of UST transactions would increase. According to the law of the (secondary) market, the UST rate also rises because the UST supply has not yet been adjusted to the demand – for example to USD 1.1.

Now we have a problem: As a USD stablecoin, UST is aiming for an exchange rate of 1 USD. Of course, the new UST units have nowhere to go to increase supply and bring the course back up to target – after all, the UST has to be covered by something. This is where LUNA comes in.

LUNA holders have the option of exchanging 1 LUNA worth 1 USD for a (newly created) VAT. We remember that the UST rate is USD 1.1 due to the high demand in the example. This allows LUNA owners to sell the exchanged VAT with an immediate profit of 10 percent. The whole thing also works the other way around: If the UST rate falls below 1 USD, UST holders can exchange 1 UST for LUNA with the equivalent of one USD.

Every time LUNA is exchanged for new Terra Stablecoins, a percentage of the LUNA is destroyed. The rest flows back into the system, more precisely: a community pool that finances the expansion of the ecosystem. The project calls this process “seigniorage” – based on the money generated by the central banks.

Saynora, Seigniorage: Columbus-5 turns on the LUNA stove

On September 9, 2021, Terra will go through an important update with Columbus-5. One of the central innovations is that in Columbus-5 the entire seigniorage is first destroyed instead of flowing into the communal pool. The background for this step was a problem that initially sounded like a luxury problem: the municipal coffers were simply overcrowded. Terra founder Kwon discovered this in March 2020. On Agora, Terra’s governance platform, Kwon wrote:

Due to the rapid seigniorage generation, too much seigniorage flows into the community pool and oracle reward pool, resulting in overfunding […] and this trend is likely to continue if nothing is done about it.

Columbus-5 should therefore bring the following changes to Terra’s token economy:

The Luna economy is simplified by the fact that all fees for the use of Luna are used and burned when 1 UST Luna worth 1 USD is minted. The community pool should remain well funded as new distributions are made when the proposals are in the voting phase while at the same time preventing it from becoming overfunded. The staking rewards will be attractive but not exorbitant.

What is the maximum LUNA supply?

In contrast to the “digital gold” Bitcoin, Luna has no upper supply limit. This would be impractical given the dynamic expansion and contraction of the monetary base in the Terra network. Finally, if necessary, new LUNA tokens have to be “printed” in order to compensate for a shrinking demand for stablecoin. However, that does not mean that LUNA has runaway inflation. The “Burn all Seigniorage” policy of Columbus-5 in particular will exert deflationary pressure on the LUNA offer – provided the LUNA ecosystem continues to grow.

LUNA Staking: Delegating is (for most) about validating

Transactions in Terra are confirmed by so-called validators. These are operators of special network nodes who have (staked out) a large number of LUNA in the network. You write new blocks in the blockchain and in return receive a staking reward, which (up to Columbus-5) is generated from the seigniorage and the transaction fees. They also participate in the administration of the state treasury by voting on administrative proposals. In addition, they serve as a network-internal Oracle, in which they register the exchange rates within the Terra ecosystem and pass them on to the network. The operation of Validator Nodes requires a high level of technical know-how and hardware requirements and is therefore not for crypto-laypeople.

Basically, the higher the LUNA reserve of a validator node, the greater its influence. At the time of writing, there are 130 validators in Terra / Luna. In the future, the number is to be increased to 300. Anyone who has the know-how and the necessary change can apply as a validator with a special transaction. The network automatically selects the 130 richest addresses as validators.

Smaller wallets can also take part in the staking process; by delegating your LUNA to a validator. However, the latter usually charge a commission that is between 0 and 20 percent of the staking income.

Use cases: Which apps and dApps do Terra (LUNA) use?

Chai: 2 million users are already using Terra – whether they know it or not

Terra wants nothing less than to build a global payment network around programmable money. This is to be achieved through the increasing commercial acceptance of its stablecoins, especially the flagship UST. With the South Korean payment app Chai, Terra has already achieved a great coup in this regard. Chai has 2 million users – and uses Terra in the backend.

Anker: the better savings account?

With the Anchor Protocol introduced in March, the Terra ecosystem has a kind of savings account that generates a return on stablecoin reserves. At the time of writing, for example, investors receive an impressive 20 percent (annualized) on the value added tax that they deposit in the Anchor dApp.

Mirror Protocol: Synthetic Assets on Terra

Terra can also do DeFi: you can see that not only in Anchor, but also in the Mirror protocol. This is a synthetic assets platform. These are tokens that represent real values ​​(such as an inverted oil price or a share). These so-called mA assets must be over-collateralised before they are created. For example, in order to create a mAsset that corresponds to a share of 10 US dollars, Terra Stablecoins (optionally other mAssets) with a value of 15 US dollars must be deposited.

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