What Is Terra (LUNA)?
Table of Contents
Introduction
What does Terra do?
What are Terra stablecoins?
How does TerraUSD (UST) work?
What's LUNA?
Staking rewards from LUNA
How does Terra's Delegated Proof of Stake consensus mechanism work?
What is Terra Station?
What is Anchor Protocol (ANC)?
Closing thoughts
What Is Terra (LUNA)?
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What Is Terra (LUNA)?

What Is Terra (LUNA)?

Intermediate
Published Oct 13, 2021Updated May 13, 2022
8m

TL;DR

Terra is a blockchain network built using Cosmos SDK specializing in stablecoin creation. Rather than use fiat or over-collateralized crypto as reserves, each Terra stablecoin is convertible into the network's native token, LUNA.

LUNA allows holders to pay network fees, participate in governance, stake in the Tendermint Delegated Proof of Stake consensus mechanism, and peg stablecoins.

To peg a stablecoin like TerraUSD (UST), a USD value of LUNA is convertible at a 1:1 ratio with UST tokens. If UST's price is, for example, at $0.98, arbitrageurs swap 1 UST for $1 of USD and make 2 cents. This mechanism increases UST demand and also reduces its supply as the UST is burned. The stablecoin then returns to its peg.

When UST is above $1, say at $1.02, arbitrageurs convert $1 of LUNA into 1 UST and make 2 cents. The supply of UST increases, and demand for UST also decreases, bringing the price back to peg.

Apart from reducing stablecoin volatility, validators and delegators stake LUNA for rewards. These two actors play an essential part in keeping the network secure and confirming transactions.

You can purchase LUNA via Binance and then store it, stake it, and participate in governance with Terra Station, the official wallet and dashboard for the Terra blockchain network.


Introduction

For stablecoin lovers, there are now multiple options to pick from when choosing where to invest. And it's not all fiat-backed stablecoins either. There's a wide variety of methods and networks experimenting with ways of keeping stablecoins pegged. Terra is one such project developing a unique approach to stablecoins and the tools developers can use to create their own pegged tokens.


What does Terra do?

Terra is a blockchain that lets users create stablecoins pegged to fiat currencies. These coins primarily use the network's seigniorage mechanism. The network was founded by Do Kwon and Daniel Shin of Terraform labs in 2018 and uses Tendermint Delegated-Proof-of-Stake (DPoS) as its consensus mechanism. Terra provides smart contract capability for the creation of a wide range of different stablecoin types.

The project has proved popular in the Asian markets for e-commerce and has a large userbase in South Korea. For example, taxi users in Mongolia can pay some drivers in the stablecoin Terra MNT pegged to the Mongolian tugrik. Tokens minted on the platform are known as Terra currencies and exist alongside the network's native LUNA token for governance and utility. Terra and LUNA have a complementary relationship.

Terra already has stablecoins pegged to the US Dollar, South Korean Won, and Euro, among others. Within a short time, the project has seen wide popularity with the stablecoins minted on the platform. TerraUSD has, as of writing, already made it to the fourth-largest stablecoin by market cap.


What are Terra stablecoins?

Stablecoins on the Terra network use a different method to maintain price parity than collateralized fiat-backed stablecoins and crypto-backed stablecoins. Collateralized stablecoins typically allow the holder to exchange their stablecoin for an equivalent amount of fiat or some amount of crypto. This is the case with BUSD, which maintains audited US dollar reserves. The same is true for DAI, which is backed up with over-collateralized cryptocurrencies.

Terra's stablecoins, however, use algorithmic methods to control their supply and maintain the peg. Each stablecoin is, in effect, backed up and exchangeable for the governance and utility token LUNA. Terra acts as a counterparty for anyone looking to swap their stablecoins for LUNA and vice versa, which affects the two tokens' supplies.


How does TerraUSD (UST) work?

Imagine you want to mint $100 of TerraUSD (UST), which is equal to 100 UST at the peg. To mint the UST, you'll need to convert an equivalent monetary amount of LUNA tokens. Terra will then burn the LUNA tokens you supply. So, if the price of LUNA is $50 per coin, the algorithm would require you to burn 2 LUNA to mint 100 UST. Previously, Terra only burned a portion of the tokens provided, but with the introduction of the Columbus-5 update, 100% is burned.

You can also mint LUNA with Terra stablecoins. Minting $100 of LUNA (2 LUNA) would require burning 100 UST. Even if the market price of UST isn't $1 per token, the conversion rate for minting treats 1 UST as equal to $1. This exchange mechanism is what gives UST its price stability.

Let's look at an example to see exactly how the algorithm works to try and keep the price stable:

1. The price of 1 UST falls to $0.98, 2 cents lower than its intended pegged value. However, for all conversions between Terra stablecoins and LUNA, 1 UST is treated as being worth $1.

2. An arbitrageur sees this price difference and notices an opportunity to make some profits. They proceed to buy 100 UST for $98 and then convert it to $100 of LUNA on the Terra Station Market Module.

3. The arbitrageur can either keep their $100 of LUNA or convert it to fiat and cash out their profit. While $2 doesn't sound like much, bigger profits can be made on a larger scale. This difference between the price of minting the tokens and their value is known as seigniorage

But how does this end up stabilizing the price at $1? First, the increased purchasing of UST by arbitrageurs increases UST's price. Additionally, Terra burns the UST during the exchange to LUNA, reducing its supply and contributing to increasing UST's price. Once 1 UST reaches $1, the arbitrage opportunity closes.

The same process works in reverse when the price of UST is above $1. Let’s see another example.

1. The price of 1 UST rises $1.02, which also provides arbitrageurs a way to make a profit.

2. Arbitrageurs purchase $100 of LUNA and convert it to $102 worth of UST on the Terra Station Market Module. Terra burns the LUNA and mints UST in the process, increasing supply.

3. The arbitrageurs can then sell that UST on the open market to capture the profit. This selling pressure on UST brings the price back to peg.

The LUNA token is integral to Terra’s algorithmic stablecoins as it absorbs the stablecoin’s demand volatility. With an elastic monetary policy, LUNA carefully controls the supply of Terra’s currencies. Compared to over-collateralized projects like MakerDAO, the Terra model is highly scalable and affordable.


What's LUNA?

LUNA is Terra's cryptocurrency that plays four different roles in the Terra protocol:

1. A method to pay transaction fees in its gas system (utility token).

2. A way to take part in the platform's governance system. By staking your LUNA tokens, you can create and vote on proposals with changes regarding the Terra protocol.

3. A mechanism to absorb demand fluctuations for stablecoins minted on Terra to maintain price pegs.

4. A token to stake in the DPoS consensus mechanism behind validators processing network transactions.

LUNA has a maximum target supply of one billion tokens. If the network exceeds one billion LUNA, Terra will burn LUNA until its supply returns to the equilibrium level.


Staking rewards from LUNA

Holders of LUNA tokens can stake their tokens in the Terra ecosystem's consensus mechanism. By staking LUNA, users receive rewards taken directly from swap fees on the Terra protocol. Users pay these fees any time they switch between LUNA and a Terra stablecoin.
Before the Columbus-5 update, rewards were also taken from a portion of each swap's seigniorage. The new system should, in theory, provide staking yields of around 7-9%. These rewards provide an incentive for users and validators to take part in the Tendermint DPoS system. If you're familiar with mining on the Bitcoin network, the principle is similar.


How does Terra's Delegated Proof of Stake consensus mechanism work?

The Terra blockchain was built using the Cosmos SDK, making Tendermint DPoS a natural choice. The consensus mechanism is part of the Cosmos technology suite and is an environmentally-friendly alternative to Proof of Work.

As of October 2021, Terra uses a group of up to 130 validators to process transactions. Users (or delegators) stake their tokens behind a validator. In turn, the validator secures the network by processing transactions similar to the work of a miner on Bitcoin. A delegator will stake their LUNA tokens behind a validator they believe will effectively and honestly process network transactions. Each validator can also set a custom percentage of the rewards they will distribute to their delegators.

Validators must also lock up a set amount of LUNA for at least 21 days. This process is known as bonding. Delegators also experience a 21-day lockup period and risk losing their stake if the validator is a bad actor.

For example, the validator may process double-spent transactions or include false ones. In this case, the validator can have their rewards slashed or even lose their initial stake (bond). “Terra taxes” on transactions and airdrops provide the rewards given to delegators and validators. Each delegator's share will depend on the amount they stake and the validator's commission rate.


What is Terra Station?

Terra Station is the official Terra crypto wallet and dashboard that allows LUNA holders to access their funds, stake, and participate in governance. It's available as both an app for mobile devices and as a browser extension.

1. The Terra Station dashboard displays a range of on-chain data, including transaction volume, staking returns, and the number of active accounts.

2. Terra Station's wallet is non-custodial, meaning that only you have access to your private keys. If you open a Terra Station wallet, make sure to keep your seed phrase in a safe and secure place. If you lose it, there's no way to retrieve your funds.

3. The governance portal allows you to create new proposals and take them to the voting stage by depositing 512 LUNA. Other users may deposit the 512 LUNA for you instead if you don't have the funds. When a new proposal is created, other LUNA holders can stake their tokens to cast their votes.

4. The staking tokens section lets you delegate, check your rewards, bond LUNA as a validator, and take part in every stage of the DPoS consensus mechanism.


What is Anchor Protocol (ANC)?

Aside from managing Terra, Terraform Labs also develops and maintains Anchor Protocol, the blockchain’s leading application by TVL. The project is community-governed and offers a lending and borrowing platform for Terra users. With Anchor Protocol, you can earn interest, borrow, and lend crypto through over-collateralization. You can earn Anchor Protocol’s token, ANC, in several ways:
  1. You can stake ANC-UST Terraswap LP tokens to receive ANC rewards. 
  2. You can stake ANC by itself.
  3. You can borrow stablecoins through Anchor Protocol.


You can also use ANC as part of Anchor Protocol’s governance mechanism for creating and voting on proposals. You can buy ANC on Binance using the same method outlined for LUNA above.


Closing thoughts

In the future, there will be a lot of opportunities for Terra to take advantage of its cross-chain compatibility with other Cosmos SDK blockchains. As the stablecoin topic is important globally regarding regulation and mainstream adoption in payment systems, there's room for Terra to grow and improve its user base outside of Asia.