DeFi Token Spotlight: Terra
A Detailed Dive into one of Ethereum’s Up and Coming Competitors
A Detailed Dive into one of Ethereum’s Up and Coming Competitors
With a total supply exceeding $100 Billion, it is abundantly clear that the demand for stablecoins is strong. One of the biggest critiques about DeFi is its dependency on centralized stablecoins. Centralized stablecoins are digital assets backed by off-chain value, usually in the form of fiat currency. The most popular centralized stablecoins right now are Circle (USDC) and Tether (USDT). Both companies have reserves of US Dollars that back each digital asset. USDC and USDT are redeemable for US Dollars 1:1, which means USDC and USDT are still bound to the traditional monetary system.
This has sparked the development of products known as non-custodial stablecoins, which aim to replace the centralized authority within central banks with unbiased smart contracts and algorithms. Non-custodial stablecoins are also referred to as Algorithmic Stablecoins. Algorithmic stablecoins aim to create an open-source, decentralized banking system that adjusts accordingly to market conditions. One of the most successful protocols within the algorithmic stablecoin space is Terra. Terra is at the forefront of exploration within the stablecoin industry, focusing on creating a unique monetary policy that adjusts according to market conditions. Terra Forms Labs (TFM) has built this product as its own Layer 1 smart contracts platform, allowing developers to build decentralized applications utilizing Terra’s integral UST stablecoin.
Algorithmic Stablecoins have taken the industry by storm with the ultimate purpose to create an algorithm that acts as an open-source, unbiased Central Bank with no centralized, authoritative control. They combine open market participation along with the traditional mint/redemption model used by companies like Circle and Tether. Algorithmic stablecoins aim to control supply elasticity and maintain a stable price for the stablecoin token. These algorithms interpret market volatility and adjust the system accordingly to maintain stability. The way this stability is maintained can is unique depending on the model used for the overall system, in Terra’s case a seigniorage share model.
To start, seigniorage is the difference between the value of a currency and the cost to produce it. In traditional methods, banks and governments are the ones who profit from positive seigniorage (value of currency > the cost to produce it). Using the benefits of blockchain technology, it is now possible to create algorithms that act as central banks but have no bias or authoritative control. This positive seigniorage can now be redistributed back into the protocol which users of that protocol reap direct benefits from.
Seigniorage Share models are often known as two-token models. One token is intended to be a “stablecoin” to maintain a peg to a specific value, usually $1. The other token can be referred to as “Network Shares”. Terra has a set variety of fiat-pegged stablecoins to utilize, the most popular being UST (US Terra). These fiat-pegged stablecoins act as the supply-elasticity currency of the protocol. LUNA, on the other hand, would be the network share of the protocol. LUNA is also the native governance token for the Terra protocol. This means for users to vote on proposals for the future development of Terra, they must hold and stake LUNA.
Terra’s stablecoins maintain their peg through a fusion of a corruption-resistant, decentralized oracle system and open market arbitrage incentives. The overall objective for Terra is to constantly rebalance the number of assets and liabilities of the protocol to maintain peg parity for UST. The Terra protocol acts as a decentralized market maker throughout this whole process. In simple terms, when the supply of UST increases, the supply of LUNA decreases. On the flip side, when the supply of UST decreases, the supply of LUNA increases.
LUNA essentially acts as the absorber of all UST’s market volatility. When the market experiences high volatility, the changes in these supply dynamics are how the protocol maintains peg parity. When the demand for UST rises, users on the Terra platform are incentivized to mint UST with LUNA and sell this UST for a premium on the market. The “machine” behind Terra is instructed to swap $1 of LUNA for 1 UST. This fixed rate of $1 of LUNA for 1 UST (for on-chain swaps) is a differential factor when compared to other seigniorage share stablecoins. Some of the LUNA is burned throughout this process, but a small portion is siphoned off into a “seigniorage pool”. Part of this seigniorage can later be used by the protocol for further developments. The last portion of LUNA is redistributed to network validators. The action of minting UST inherently increases the total supply of UST, which reduces the arbitrage opportunity and brings UST back to a peg at $1. On the contrary, when the demand for UST is low, users can profit by swapping buying UST off-chain for a discount and swapping 1 UST back into $1 of LUNA at the fixed on-chain rate. This process decreases the supply of UST while increasing the supply of LUNA and lowering the per-unit value for LUNA stakers.
Although algorithmic stablecoins have a lot of growth potential, they are still very new and have a lot of risks associated with them. The algorithms that maintain the stability of the coin must be able to withstand severe market volatility. If an algorithmic stablecoin loses its peg to $1, the protocol must act accordingly to bring the value back to parity. Also, a user must do their due diligence before investing in any cryptocurrency. When depositing into an algorithmic stablecoin protocol, the user trusts that the code is not malicious. Therefore, it is important to have a communicative team that engages often with the users. An educated community is an essential foundation for any protocol’s success. Users can be at risk of losing substantial amounts of money if the algorithmic stablecoin they are invested in loses peg and is unable to bring the stablecoin back to peg. Having a proper understanding of the algorithm’s mechanics is important before depositing money into any protocol.
For more information regarding Terra: https://docs.terra.money/docs/learn/protocol.html
DeFi applications built on Terra have seen a capital increase, attracting roughly $30 Billion to its products. Terra’s flagship product, Anchor is one of the most popular DeFi products on any blockchain with $17 Billion in total deposits.
Terra has seen explosive growth in many metrics within its ecosystem in the past year. LUNA has notched its way into the Top 10, growing from about $5 in July 2021 to roughly $100 by December 2021. UST (US Terra) has also seen exponential growth in the past year, currently sitting around $16 Billion in circulation. Through several periods of severe market volatility, Terra’s mechanism has proven its durability of being able to withstand tough market conditions and adjust accordingly.
As digital assets become mainstream, the second largest cryptocurrency (by market capitalization), Ethereum, has generated major discussions at wealth management offices across the United States. Historically, Bitcoin has attracted most of the attention in the digital assets’ ecosystem, however, investors are starting to increase their knowledge and participation in Ethereum as the number of decentralized applications (“DApps”) built on the Ethereum blockchain continues to rise. This resource includes: