Important update: As of May 2022 the Terra Luna ecosystem has collapsed and is seeking ways to regenerate itself. The death spiral that Terra’s founders didn’t think was possible actually happened. In order to understand Terra and its Luna currency I still highly recommend you read the article below which will walk you through the basics.
Luna Terra basics explained
The first thing to note about Terra Luna is that it is a whole new ecosystem and rabbit hole to go down. As such it stands apart from other blockchains.
While exploring Terra and Luna in this foundational article, we will branch out to at least 3 initiatives that the Terraform Labs team is focused on: Terra USD, Mirror, and Anchor
Let’s start with the basics
To understand Terra you need to know what a stablecoin is. If you do, you can skip this paragraph and go to the next one.
First, a primer on stablecoins
Stablecoins are digital currencies that are pegged to a country’s currency.
For example, Tether Ltd is a company that issues Tether Dollars (USDT) where each USDT is backed by a real US dollar.
For every USDT you buy with cash they hold and owe you a real USD, or so they claim.
Pegging a currency to the US dollar is not a new concept.
Many countries with less stable economies have pegged their currencies to the USD. Examples include Eritrea, Djibouti, Cuba, many of the Caribbean countries, and others.
Why do people need stablecoins?
Stablecoins appeared because there was a need to be able to transfer digital currencies from person to person or exchange to exchange.
In the early days of crypto if you wanted to buy cryptocurrencies you needed to find a way to convert your cash to Bitcoin and then go on an exchange and convert that Bitcoin to the cryptocurrency you wanted to buy.
But because the price fluctuated so much you needed to act fast.
Stablecoins, as their name indicates, allow you to manage digital cash that is stable and familiar. It is stable because it follows the US dollar 1:1.
And it is familiar because you have a better sense of the purchasing power of 1,000 USDT, which you know is US$1,000 as opposed to 0.000017 BTC.
In addition, stablecoins allow you to manage digital cash so that you can easily move it about.
For example, you may decide to pull out of Bitcoin for a while because you think the price is going to tank and buy back later.
You can convert your BTC to stablecoins and wait it out.
Another key benefit is that stablecoins allow more conservative investors to test the water.
They can invest it to earn interest just like with a savings account rather than purchase a cryptocurrency which they might be hesitant to do
All in all, stablecoins allow people to manage a fiat currency such as US dollars in digital form.
This way users can transact with all the centralized and decentralized crypto products in a smoother fashion.
The introduction of stablecoins helped to fuel the crypto market as many more people entered the crypto space in a more linear manner.
What is Terra?
Terra is a blockchain that can mint stablecoins in any currency.
Founder, Do Kwon, saw the opportunity for Terra because up until then there were only a few stablecoins in existence and these were pegged to the USD.
Terra allows for the creation of stablecoins for any currency from the Korean Won to Euros to Mongolian tögrög.
The unique advantage of Terra is that there is no central entity managing its stablecoins. TerraUSD is minted in a decentralized trustless manner.
Let’s unpack this sentence.
Going back to the Tether example.
Tether Ltd acts as an intermediary which is still unregulated for the most part and whose word we have to take to be true.
They claim to back every USDT with a US dollar or equivalent such as US treasuries.
While Tether is the most widely used stablecoin to date there is no independent third party that systematically audits them to guarantee that what they claim is true.
Mind you there have been audits but the results have not been fully transparent.
To get around the lack of transparency with Tether an alternate model appeared in the crypto space.
The moment you hear a lack of transparency your mind should go to some entrepreneur somewhere thinking “What if I built a stablecoin on a blockchain where anyone would be able to verify transactions …this way we would have full transparency”.
MakerDAO and DAI as stablecoin
Enter the MakerDAO platform and DAI.
Built on Ethereum, this decentralized platform uses automated smart contracts to create a stablecoin that is backed by cryptocurrencies as collateral.
Because cryptocurrencies fluctuate one has to deposit 1.5 times the value of the stablecoin dollars that they want to withdraw.
Effectively, MakerDAO is a lending platform where you deposit ETH in exchange for a loan in DAI which is pegged 1:1 with the USD.
If I deposit $150 worth of ETH I can withdraw 100DAI = $100. If the price of ETH drops so that my total ETH drops below $100 then I either need to top up or else MakerDAO sells my ETH at $100.
The platform is risk-free and I get to borrow instantly at low interest without needing to go through credit checks etc.
If you are wondering whether to invest in DAI check out my assessment: Is DAI crypto a good investment?
In a nutshell, stablecoins like DAI are great because they solve the transparency issue. On the flip side, they do require over-collateralization.
How Luna Terra works
Terra offers a third way of making stablecoins called algorithmic trading.
Algorithmic stablecoins are backed by their own token.
Terra’s token is called LUNA.
Here is how Luna Terra works
Imagine I have some Monopoly money. For those who don’t know, Monopoly is a board game for kids where you buy property and houses with fake bank notes.
Say I start off with 100 notes of Orange paper money and 100 notes of Blue paper money.
We all agree that as a banker I can print as many of these notes as I want.
All I need to do is cut out some pieces of paper and color them in with a marker. I also have a lighter at my disposal that can light up and burn notes.
This way I fully control the amount of notes in circulation. But I don’t operate at a whim. Rather, I follow certain rules.
Let’s say the Orange paper is worth $1 in this game.
I declare that the only way you can buy Orange money from me is with Blue money.
I also declare that whenever you give me $1 worth of Blue notes I will give you back an Orange note.
Next, I take a lighter and burn your Blue note.
Similarly, if you give me an Orange note I will give you a dollar worth of Blue notes and burn your Orange note.
So you go to the market with some cash.
At the market, Blue money is pretty popular.
Many people want Blue money to play Monopoly because you can do various cool things with it like buy Orange money.
People at the market are willing to pay $2 for every Blue note. So you pay $2 in cash to get one Blue note.
You then take this blue note, worth $2, and exchange it for 2 Orange notes at the Bank. The banker takes your Blue note and burns it.
So that’s how the mechanics play out.
What happens when demand changes
Now imagine that Orange money becomes very popular.
Say the Monopoly rules change and you get extra points when you buy houses with Orange money.
Because everyone needs Orange money there will be upward pressure on its price if there is not enough Orange money in circulation.
Imagine that people are willing to buy orange money at $1.1.
Again you go to the bank and exchange your blue note for 2 orange notes. The banker burns my blue note and gives me two orange notes.
Remember the bank will always give me an Orange note for a dollar’s worth of Blue notes no matter what is happening on the market.
So I get 2 Orange notes from the nice banker person and sell them for $2.2 making a nice 10% profit.
Many people will do the same.
But as they do so the supply of Orange money increases causing a downward pressure on orange money’s price.
And the price of Blue notes increases blue notes are burned and their supply drops.
If the price of orange money drops to less than $1, say $0.5 then people will do the opposite.
They will go to the bank and exchange one orange note for a dollar worth of blue notes and make a profit.
In our example, if I own 2 orange notes I can buy a blue note. I then take the blue note and sell it for $2.
So I had 2 orange notes worth 2*0.5=$1 and sold it for $2 making a 100% profit.
When I exchange my Orange notes for blue the banker burns the Orange notes. The supply of Orange notes drops causing an upward pressure on its price.
These dynamics bring the price of orange notes to always equal one US dollar.
Tying it all up: Terra USD and LUNA
In our example, Orange notes are the Terra stablecoin: Terra USD (UST). Blue notes are LUNA coins.
The banker is the blockchain that swaps Terra for Luna and burns one or the other.
LUNA fluctuates on the open market but Terra is always stable at $1.
In essence, demand and supply shocks for Terra are transferred to LUNA keeping Terra stable. The price of LUNA fluctuates reflecting the value that people find in it.
Terra is denominated as UST.
The risk of a Death spiral for UST.
Terra is not the only algorithmic stablecoin in circulation.
But it is the largest one and the one that has survived the longest. The biggest risk with algorithmic stablecoins is the death spiral.
Going back to our Monopoly example, imagine there is a contraction and the demand for orange (Terra) notes drops causing its price to drop.
Normally this would be an opportunity to profit using Blue (Luna) notes.
But there could be a scenario in that people become spooked and decide that “ok this game is ending and I am out so I won’t buy any Luna”.
This causes the price of Luna to drop which in turn causes Terra to drop and so on until the market is wiped out.
This is not theoretical and has happened with many coins in the past.
The reason why Terraforms Labs feels confident this won’t happen is that LUNA has other uses apart from supporting a stablecoin.
When a stablecoin kicks off it needs to offer some kind of incentive for users to purchase the equivalent LUNA coin and prop the stablecoin up.
Usually, this incentive is in the form of a yield reward. “Buy LUNA and keep it with us and we will offer you a 20% annual return”.
However, because returns are so high right now in the crypto space investors can easily change their minds and seek returns elsewhere. Hence there needs to be further reason to hold LUNA and UST.
So let’s explore other reasons that LUNA & UST hold value
The Mirror protocol is a platform that allows you to buy tokens that reflect or mirror the real value of a stock.
Each of these tokens is represented with an m in front.
For example, you buy mAAPL which is a token that mirrors the price of Apple stock.
The mechanics of how Mirror works require a separate article but the key point to keep is that in order to make such purchases you need UST.
Demand for these types of mirrored stocks, also known as Synthetics, is high because not all geographies can access US stock exchanges, and just like with any crypto token you can purchase a portion of a stock rather than a whole stock.
For example, you may not have $3.5K to purchase Amazon stock (AMZN) but you could invest $500 in mAMZN
If you want to find out more about Mirror I recommend studying this article
The Anchor protocol is a platform that allows you to invest your UST or other terra stablecoins and earn a high-interest rate of almost 20%.
This is not a fixed savings account so you can withdraw your money at any point.
Because this is an attractive proposition it is bound to increase demand for UST.
Mechanics of Anchor in a Nutshell
There are 2 ways that Anchor is able to deliver such a high-interest rate.
When you save your money with Anchor you are effectively lending it.
Just like with a bank, Anchor offers your UST to borrowers.
The main difference with a bank however is that the interest earned on the loan is given back to you, the lender.
The loans are almost risk-free.
In order to borrow from Anchor borrowers need to offer a larger amount of crypto as collateral.
Say, for example, that I own some ETH and I expect its price to go up. So I don’t want to sell.
At the same time, I want to invest in a new cryptocurrency that I believe has good growth potential.
I could deposit my $10,000 worth of ETH with Anchor and take out a loan of $5,000 UST to purchase my crypto.
Later, if all goes well, I can pay back the loan and will have benefitted from both the ETH upside and the upside from the other crypto that I bought.
If the value of ETH drops then I will need to top up more ETH. Otherwise, Anchor sells my ETH.
This protects the depositor who saves with Anchor.
The second way that deposits earn interest is that Anchor pools assets and uses them to stake them on various blockchains to earn a reward.
Remember, blockchains that operate with a Proof of Stake consensus mechanism require validators to stake funds.
Validators stake their assets and if they do anything dodgy they lose their assets.
Hence they have an economic incentive to behave and do proper validation for which they get rewarded.
However, they do not always have sufficient funds. As a result, they borrow funds from users like you and me who want to earn a yield on their crypto.
In our example, Anchor will use the borrowers’ ETH to stake it. It will then pass on the rewards to the savings depositor.
CHAI: the first product developed by Terraform Labs
The first product that Terraforms Labs developed is CHAI.
It is a simple digital wallet that allowed users to pay at partnering e-commerce stores with Terra’s stablecoin for Korean Won called KRW.
Terraform Labs wanted to bring the benefits of fast and cheap transactions to the masses.
CHAI charges much lower commissions compared to other payment providers (VISA, Mastercard, and local equivalents).
It was the success of CHAI that allowed Terra to expand. CHAI is notable because it is one of the few crypto products with mass adoption.
To use CHAI you don’t need to be a crypto fan or own Bitcoin or ETH. You just use it to pay and you know it is cheaper.
At the beginning of this article, I mentioned that we would branch out to the 3 main initiatives that the Terraform Labs team focused on: Terra Luna, Mirror, and Anchor
However, you should be aware that the Terra ecosystem has grown massively. It will continue to do so with new projects and protocols emerging every day.
There were 69 projects on the Terra website. Another 160 projects were expected over the next few months.
Other things you should know about Luna Terra
Terra vs. traditional stablecoins
The Terra team believed that UST was the future because it is the largest decentralized stablecoin at the time.
While the US government may crack down on companies such as Tether it is impossible to stop UST.
At the end of the day, it is just code.
The other thing to note is that Terra is based in Korea. This makes it harder for US law enforcement to enforce anything.
Having said that, the Thai government recently announced that the Terra Thai Baht Stablecoin was not compliant and that their citizens should not use it.
On the other hand, the Thai baht stablecoin continues to be available on the platform.
Columbus 5 upgrade
Terra is built on the Cosmos SDK.
Cosmos is a blockchain that allows blockchains to talk to each other. You can find out more about Cosmos in my article here: What is Cosmos crypto?
If you have read my explanation on Polkadot it is similar to Polkadot except it only allows coin-based blockchains to talk to each other.
The Columbus-5 upgrade allows Terra to integrate With Cosmos’s Inter-Blockchain communication protocol.
This means that Terra can connect to the 100s of dApps on the Cosmos network.
Luna Terra Founders
Terra Labs was founded by Do Kwon, a whizz kid from Stanford who joined Microsoft out of school.
During his stint there some friends introduced him to the crypto space.
He later decided to try something more entrepreneurial and set up Terraform Labs out of Seoul.
He raised funds from major crypto-focused funds and kicked off his journey by developing the highly successful CHAI app.
His vision is to build the ecosystem in as much a decentralized way as possible.
Wrapping up Luna Terra
Terraform Labs has deployed a serious contender in the crypto space.
It is common to hear that the future is multi-chain. I feel that Terra and Luna will play a big part.
With a growing ecosystem, the third largest stablecoin in terms of market cap, and popular consumer-facing apps this blockchain holds a lot of promise.
If you enjoyed this article please share it.