What Is Terra (LUNA)? Terra DeFi Blockchain Explained

Jun 4, 2021

Terra (LUNA) is a blockchain protocol for issuing algorithmic stablecoins and creating decentralized financial infrastructure. With Terra, you can earn interest on stablecoins, spend crypto easily with merchants, and replace most of your banking needs with one seamless DeFi protocol.

To accomplish its basic premise as a stablecoin platform, Terra uses an elegant seigniorage model that minimizes volatility to keep a close fiat currency peg.

However, Terra does much more than issue stablecoins. It's also a smart contract-enabled blockchain hosting a burgeoning DeFi ecosystem connected to the Cosmos IBC protocol

Over time, Terra aims to pave over banks, credit networks, and payment systems like PayPal with one uninterrupted and rewarding blockchain experience.

In this article, we will explore what the Terra blockchain is, how the LUNA, TerraSDR, and UST crypto tokens work, and where Terra apps like Mirror Protocol fit into the ecosystem.

What is Terra (LUNA)

Founded in 2018 by Terraform Labs, Terra is a decentralized finance blockchain building a simple yet powerful global payment network. Do Kwon, a South Korean software engineer and Terra's CEO, believes stablecoins are instrumental in setting up such a system.

The stablecoin is the most important product in crypto, uniquely serving the currency function of cryptocurrencies. — Do Kwon

Terra's ultimate goal is to disrupt traditional banking via the mass adoption of stablecoin cryptocurrencies and DeFi infrastructure. Plenty of ground has already been gained in this respect with Terra-powered CHAI, a payments app used by 25 million South Koreans.

In Terra’s future, people will buy and sell things using digital cash stored in blockchain-based mobile phone wallets. Merchants will accept multi-fiat stablecoins that are automatically swapped behind the scenes and on-chain. And you'll earn interest on unused cash by keeping it in Terra DeFi applications similar to the way you might rent out unused apartment space on AirBnB.

Even more alluring, Terra believes it can reduce merchant transaction fees to 0.5% (or less), which should bring more partners on board. In turn, more people will use Terra, fueling growth that enables the platform to offer users discounts on their purchases (more on this later).

To build this future, Terra has two significant components. Terra is the blockchain protocol for issuing algorithmic stablecoins pegged to any regional denomination. Luna is the protocol token used to stake and govern Terra while also locking value into the Terra ecosystem.

Feeling a bit lost? Not to worry — the next section is an easy guide to how Terra works.

How the Terra DeFi platform works

The Terra mission is to popularize crypto payments and create a massive payment ecosystem that rolls banks, credit networks, and payment gateways into one open system.

Terra believes stablecoins are the key to this task because they can accomplish two things:

  1. Retain purchasing power
  2. Enable simple, low-cost payments

Because cryptocurrency is global, retaining purchasing power means different things to different people and economies. For some, the US dollar may be too volatile, whereas it's a haven for others. That's why the current reign of stablecoins like USDT and USDC is not ideal. So, Terra created a mechanism that issues regional stablecoins that can also be swapped easily.

If you are familiar with dollar-pegged stablecoins like USDT and USDC, you know that they are not only pegged to the dollar but are backed by dollars too. For every 1 USDT issued, there is $1 held in reserve to match it.

Terra also has a cross-chain system that bridges the gap between Ethereum, BSC, and Terra.

Terra stablecoins are not backed by dollars, Korean won, or any other fiat currency, for that matter. Instead, Terra issues crypto-collateralized algorithmic stablecoins. These stablecoins hold a pegged value using a circular dual-token system that creates arbitrage opportunities via seigniorage.

Understanding Terra seigniorage

Seigniorage is the difference between the cost of issuing an asset and the asset's worth at face value. If it costs the US government $.05 to produce a $1 bill, the $.95 difference is profit. 

However, as Do Kwon explains in this informative article, for a stablecoin asset, seigniorage is defined as seigniorage = new minted currency - cost of acquiring collateral.

For Terra, every time a stablecoin is algorithmically issued due to demand, the platform profits. It places those profits in the Terra seigniorage pool to fund projects in the Terra ecosystem and reward Terra users.

How Terra stablecoins stay stable

As mentioned above, Terra uses the interplay between two tokens to capture value and stabilize prices.

  • LUNA is the platform token that collateralizes and stabilizes the price of Terra stablecoins.
  • TerraSDR is the basket of currencies asset collateralized by LUNA tokens.

TerraSDR is pegged via Band oracles to the price of the IMF SDR — a special asset made up of a weighted basket of currencies (USD, EUR, YEN, GBP, RMB). Because the SDR is composed of globally important currencies, it creates a non-volatile reference point for TerraSDR.

When the price of 1 TerraSDR = .95 SDR, you can send 1 TerraSDR to Terra's smart contract to receive 1 SDR worth of LUNA. This reduces the supply of TerraSDR to boost its value back to parity with SDR.

Conversely, when the price of 1 TerraSDR = 1.1 SDR, you can send 1 SDR to Terra's smart contract to receive 1.1 TerraSDR. This increases the supply of TerraSDR to dilute its value back to parity with SDR.

By expanding and contracting the pool of money, Terra can keep stablecoin prices pegged to the oracle-fed values of fiat currencies without physically holding those assets in reserve.

Are you a visual learner? This YouTube video explains how the Terra token balancing mechanism works.

How Terra transactions benefit LUNA stakers

The arbitrage trading activity reducing price volatility for Terra stablecoins like UST creates transaction volume on the Terra blockchain. Every transaction captures value for LUNA stakers in three ways.

  1. Gas fees, while minimal, are added to transactions and paid to LUNA stakers.
  2. Tax fees from 0.1% to 1% are charged for every transaction and paid to LUNA stakers.
  3. Seigniorage creates rewards for validators and profits the community pool.

In short, LUNA stakers (both validators and delegators), and the Terra ecosystem as a whole, benefit from the economic activity of expanding and contracting Terra stablecoin supplies.

Terra (LUNA) token explained

In the previous sections, we've described in detail how the LUNA token is used. Here's a quick recap of LUNA token utility.

  • Collateralize & stabilize Terra stablecoins
  • Stake & govern the Terra blockchain
  • Fees & rewards from Terra transactions

Another somewhat hidden benefit derives from holding and staking LUNA tokens. This benefit comes in the form of airdrops. When new applications and their tokens arise in the Terra ecosystem, LUNA stakers receive them for free as airdrops in proportion to their stake.

If you're wondering whether Terra ecosystem airdrops have been profitable for LUNA holders, check MIR and ANC crypto prices using Shrimpy. These two tokens, representing Mirror Protocol and Anchor Protocol, respectively, have been immensely profitable airdrops.

Aside from the sheer value derived from arbitraging stablecoins and fees collected to Terra stakers, holding LUNA for governance is an immensely underrated benefit. Terra is a DeFi platform, so all decisions are made by the community of LUNA stakers.

Community decisions include how to use the funds amassed by the community pool via seigniorage. By the end of Q1 2021, Terra had collected 24 million LUNA — an amount worth roughly $391 million today.

Half of that amount went to paying oracle rewards, while the remaining 50% went to the community pool.

The Terra community decides how the massive amounts of LUNA are spent. Burning them might increase LUNA scarcity and drive prices up. But so far, the community has chosen to reinvest in the Terra ecosystem to drive adoption and long-term goals.

Terra DeFi ecosystem is growing fast

Holding LUNA and being involved in the Terra ecosystem is rewarding community members just as promised in the Terra whitepaper. As a result, Terra is growing remarkably fast, both in terms of community and adoption.

Several flagship apps have launched to bolster the Terra ecosystem and give users DeFi tools for trading, spending, and saving money. Amongst them are Mirror Protocol, a synthetic asset exchange, and Anchor, a crypto savings account offering high 20% yields for UST deposits.

Besides CHAI and its vast user base, Terra boasts PayWithTerra and MemePay, a popular Mongolian payment app. Moreover, Terra co-founder Daniel Shin also founded Ticket Monster (TMON), a South Korean commerce site doing $3.5 billion in annual transactions.

Terra has a real, non-zero chance at gaining significant adoption in South Korea and abroad. Thanks to DeFi apps like Anchor, it has a shot at vaulting to the top of the charts, too.

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