|Image Source: Terra Luna|
Terra is a next-generation blockchain payment network powered by LUNA token and interwoven with Stablecoins. In this article, let’s look at the Terra protocol. Terra is a protocol for algorithmic Stablecoins with the goal of rebuilding the legacy financial system in a decentralized way.
What is Terra?
Terra is a decentralized blockchain platform founded by Do Kwon and Daniel Shin from Terraform Labs in 2018. And the project has scaled new highs traction by bringing several unique innovations to the world of Stablecoins.
Terra blends the price stability of Fiat currencies with the censorship resistance of cryptocurrencies to offer fast and affordable settlements. So with Terra, you can earn high interest on Stablecoins. You can spend your crypto easily with merchants and you can actually replace most of your banking needs with one seamless DeFi protocol and ecosystem, all in one.
Importantly, the Terra ecosystem does much more than issue Stablecoins. It’s also a smart contract-enabled blockchain connected to Cosmos via the Inter-Blockchain Communication Protocol.
|Image Source: Cosmos Network|
Terra’s long-term ambition as I see it is to fully disrupt traditional banks, credit networks, and payment systems like PayPal or Visa and replace the entire traditional retail financial services industry with an open and permissionless blockchain native user experience.
So the team does know how to set a high bar. In fact, Terra has already built out the Terra Alliance, which is a growing group of eCommerce companies from South Korea and all over Southeast Asia.
What problem is Terra trying to solve?
The Terra team is noted in their white paper that the core issues they want to solve are Bitcoin’s extreme price volatility, and the Concept of time, which can be thought of as a variable that would discourage people from seeking to use crypto such as Bitcoin in everyday life because its volatility can be a negative for use as a long-term financial instrument given its spikes up and down.
For example, if you need to make long-term financial payments or installment payments, Bitcoin could move up or down against you. And that’s not really good from a long-term perspective. So the Terra protocol seeks to solve these issues with a cryptocurrency that has an elastic monetary policy to maintain a stable price.
And they also retain all the censorship resistance of Bitcoin and they make it viable for use in everyday transactions.
Another key insight from the Terra team was that price stability alone would not be sufficient for the widespread adoption of any currency. And the team at Terra figured out early that a successful currency must have strong network effects.
For example, a customer is unlikely to switch over to a new cryptocurrency unless there is a critical mass of merchants that are ready to accept it. But at the same time, a merchant might not have a reason to invest in resources and education about this new cryptocurrency. Staff also has to accept the new currency, but there has to be significant consumer demand for it.
How does Terra work?
Unlike other decentralized algorithmic Stablecoins like MakerDAOs and Dai token, which use an over-collateralization system to maintain their peg. And this just means that you provide collateral at some greater ratio.
Elastic Monetary Policy
For example, for every one Dai, the peg is over collateralized to 1.5 or two or even three. Terra Stablecoins leverage in contrast to an elastic monetary policy. By elastic monetary policy, this means that Terra Stablecoins achieve price stability by adjusting their supply according to real-time fluctuations and demand. This elastic concept came from Robert Sam’s work on the concept of Seigniorage back in 2014.
|Image Source: slideshare.net|
Around the genesis launch of the protocol, Terra issued currencies pegged to the US Dollar, Euro, Chinese Yuan, Japanese Yen, and IMF FCR. The Terra ecosystem of currencies has access to shared liquidity and the Terra blockchain supports atomic swaps among Terra currencies at their market exchange rates.
This is key because of fallen demand for one currency can quickly be absorbed by another one in the network.
The Role of Miners in Terra
The Terra protocol runs on a proof of state blockchain where miners need to stake the native cryptocurrency Luna to mine transactions. Miners also function as decentralized price oracles to estimate the true exchange rate for Terra Stablecoins within the ecosystem.
In order to ensure the accuracy of pricing of the Fiat pegs, the miners have a reward incentive to vote on the Fiat peg exchange rate as soon as possible and no later than one standard deviation of the elected miner median vote.
This structure ensures that as a policing mechanism for miners, in addition to tracking their voting and allows for a token reward and penalty slashing of tokens to be levied on non-responsive miners. As a security measure, Luna stakes are time-locked to the system and this means that if miners coordinated to manipulate their vote and set an incorrect Fiat peg all miners would face a higher loss in value of their stakes compared to any gains they could receive via coordinated action.
Achieving stability with consistent mining rewards
The algorithmic peg in Terra responds to automatically adjusting changes in the Fiat currency peg. Once the system has detected that the price of a specific Terra currency has moved up or down from its peg, the algorithm works to stabilize the price and Terra do this using the rules of supply and demand.
For example, expanding the money supply to all conditions equal will result in lower relative currency price levels. That is when price levels are rising above the target, increasing money supply sufficiently will reduce the price level.
Contracting money supply, all conditions held equal in converse will result in relatively higher currency price levels. That is when price levels are falling below the target, reducing the money supply will return the price levels to normal levels.
This example seems intuitive, this is because it is a very simplified version of exactly what traditional central banks do, where you hear that they’re expanding or contracting the money supply. In real life, this has an impact on financial assets going up or down in price.
Terra Proof of Stake Blockchain
The Terra protocol runs on a proof of stake blockchain where miners need to stake the native cryptocurrency in order to participate in the network. Because Terra is a proof of state blockchain, miners provide proof of stake security to the network.
A miner typically earns rewards by solving math problems to earn block rewards in the form of Bitcoin on that network or Luna in the form of the Terra ecosystem.
Since Terra is a proof of stake network, miners’ share of rewards is determined in relationship to the amount of Terra that they stake on the network and their Luna token stake represents their pro ratas of receiving rewards in a similar way to hash power, representing a miners portion of potential pro-rata rewards on the Bitcoin network.
Thus, a miner that is investing in infrastructure to mine Terra has a financial incentive to stake more Luna token because they would potentially receive a larger portion of the network fees and we look at the stability of the network, miners absorb Terra transaction costs through mining power dilution in the short-term, but in the mid to long-term, miners are compensated with increased mining rewards.
Different from Bitcoin and other blockchains as well is the exact way in which Terra rewards miners, which is by a combination of Protocol Transaction Fees and the rate of Luna burn, which is also called Seigniorage.
I will get more into this shortly, but the key takeaway is that Terra uses this reward system to create a predictable reward stream for miners and hopefully this approach can prevent some of the boom and bust mining cycles that other blockchains have experienced during downturns in crypto markets.
How does Terra maintain the Peg?
The Luna token acts as a central bank defending its currency when there are price fluctuations in Terra SDR or Terra USD, etc. The system uses Luna to make the price for Terra by agreeing to be the counterparty for anyone looking to swap Terra USD, for example, and Luna at the Terra USD exchange rate.
For example, when Terra USD’s price is less than 1 USD users and market participants can send 1 Terra USD to this protocol and receive 1 USD worth of Luna in return. When Terra USD’s price is greater than 1 USD, users and market participants can send 1 USD worth of Luna to the system and receive 1 Terra USD in return.
The key idea here is that there’s a financial incentive to Arbitrage away any difference in the value above or below the peg level to maintain that stability.
I previously mentioned the role of miners in securing the network. Miners also play a key part in the stability of the network’s ability to maintain the Fiat peg. So let’s dig into that:
- Transaction fees: All Terra transactions pay a small fee to miners. Fees default from 0.1% and are capped at 1%, meaning that transacting with Terra and e-commerce will be much cheaper than transacting with traditional payment options, such as credit cards.
- Luna Burn: Then we have Seigniorage or Luna burn. When demand for Terra increases the protocol mince and creates new Terra, which is the peg Stablecoin like Terra USD or Terra KRW Stablecoin to the network and earns Luna in return. This is called Seigniorage, the value of newly minted currency minus the cost of issuance, which in this case is zero.
The system burns a portion of the earned Luna, which makes mining power scarcer and benefits the miners on the network. The remaining portion of Seigniorage goes to the treasury to fund fiscal stimulus.
Code-Based Fiscal Policy
So far we’ve gone over Terra as a protocol and how miners fit into the algorithmic stabilization of the Fiat pegs. Now let’s look at how Terra used a Luna in its treasury to act as a decentralized central bank and parliament merged all into one.
Let me give you some context for the use of the term Fiscal policy as it compares to Monetary policy. The central bank has the ability to create money and credit out of thin air and manipulate interest rates and this is generally what monetary policy refers to.
On the other hand, when Congress in the US or parliament in most of the countries allocates money to spend on roads or bridges, that’s broadly speaking fiscal policy. This is a simplified version of the global traditional financial system today, and many nations, but of course their country-specific variations.
What Terra has done with their algorithm Stablecoin is to effectively create a math and rules-based version of a central bank, with the policy being written in code for everyone to see.
The other really interesting thing that Terra has done is the adoption of a parliamentary like role through the spending of Luna to stimulate the growth of the Terra ecosystem in the same way a national government would spend money in your country to build roads and bridges or to send you a direct cash payment.
Terra’s fiscal policy is specifically designed to grow its DApp ecosystem, to allow Terra to continue to expand its use cases.
The Ecosystem of Terra DApps
The Terra treasury’s main focus, as I said, is to all allocate resources generated by the Seigniorage process to decentralize the applications, or DApps for short, that run on the Terra network. Conceptually, you can think of Netflix as DApp that lives on top of Amazon Web Services and Amazon Web Services is just a DApp built on top of the internet.
Terra does this using a system where a DApp much registers for consideration as an entity operating on the Terra network to be eligible for funding based on the Terra networks treasury guidelines.
Let me know in the comments, what you think about Terra and the unique approach they’re taking to algorithmic Stablecoins.
Disclaimer: Because the cryptocurrency market is so volatile, it’s always a good idea to conduct your own research or counsel with your financial advisor before purchasing any cryptocurrency.