The Terra blockchain is an open source platform that supports decentralized applications such as popular DeFi products like Anchor Protocol and Mirror Finance. How Terra Docs puts it, the Terra blockchain is built on the Cosmos SDK which utilizes a Delegated Proof Of Stake consensus mechanism called Tendermint. This consensus mechanism is comparable to that of EOS, Cosmos, and to some degree Polkadot. Due to Terra’s tokenomics, Terra operates more like a Layer 1 rather than a Layer 2 blockchain built on Cosmos. At the time of writing, Stake ID shows 130 node validators that participate in consensus of the Terra blockchain.
For comparison, a variety of sources show well over 200k validator nodes (Blocktables, Stakers.info). When Ethereum officially merges to Proof of Stake, the number of validator nodes should increase. What Terra sacrifices in decentralization, it gains the upper hand in transaction costs and transaction speeds. The block time is around 6 seconds which means your transactions will be settled very quickly. Terra separates itself from its counterparts by offering a dual token fee structure. This allows users to have the option to pay transaction fees in either Luna tokens or UST. Both of which I will get into later in this article.
Just like any other blockchain, the transaction fees vary depending on network activity. However, Terra transaction fees include gas fees and a tax. In simpler terms, you can get away with sub 10 cent transfer fees. Some protocols charge 25 cents for transaction fees however. Both of which are much cheaper than other chains such as Avalanche, Ethereum, Bitcoin etc. According to Terra Engineer, the Terra ecosystem supports 15 different stablecoins (South Korean Won, Euros, US Dollars, British Pounds), 24 protocols, 33 tokens, 30 decentralized Applications, 6 bridges to other blockchains, and 10 projects. DeFi Llama puts Terra as the most valuable chain second to Ethereum. Terra has over $29 billion USD worth of value being utilized on its chain.
UST and the Mint/Burn mechanism
What makes the Terra blockchain most interesting is its algorithmic stablecoin nature. Whereas most layer 1 blockchains have a native token that is used to pay for transaction fees and used in governance, Terra took a different approach. Terra allows its users to use either Luna (the native governance token of the Terra blockchain), or UST and stablecoin equivalents to pay for transaction fees. This allows users to retain their Luna (an appreciating asset) and spend their UST (a depreciating asset) instead. Terra takes it a step further by having the UST maintain its peg using a series of price oracles and arbitrage to keep its peg with 1 US dollar. The price oracles send pricing information to smart contracts from various exchanges where UST is traded. This system allows the smart contract to automate the process of knowing whether UST is $1 USD or not. The UST peg is maintained by arbitraging the mint of UST by burning LUNA and the burn of UST to mint LUNA (Brings UST price up). As Terra Docs put it; by minting UST, the circulating supply increases, which in theory should decrease the value of UST. For instance, if the demand of UST has caused UST to trade at $1.05 on most exchanges, arbitrageurs are incentivized to burn $1 USD worth of Luna so they could mint 1 UST and sell it for $1.05 on the open market. The profit of 5 cents would be the incentive to keep UST at $1 USD. By burning UST and minting Luna, the same effect is true but in reverse. By burning UST the circulating supply of UST decreases, which in theory should increase the price of UST because arbitrageurs are incentivized to do so. The same holds true with other stablecoins that live in the Terra Ecosystem. The creation of an algorithmic stablecoin solves a lot of problems with DeFi. The most popular stablecoins like USDT or USDC rely on centralized issuers which claim that for each stablecoin out there, there is an equivalent dollar in a bank account.
By looking at audits of popular stablecoin issuers, this is not entirely true. All stablecoins are partially collateralized by commercial paper, a short term debt instrument. In a black swan event scenario, there is a possibility that stablecoins can become undercollateralized. To solve this, Makr DAO created DAI which is a stablecoin that is issued using ETH as collateral. This offered a less centralized approach to stablecoins, but like we saw during the covid crash, DAI lost its peg due to the sharp decline in ETH prices which caused cascaded liquidations. Centralized stablecoins are not fully collateralized, and decentralized stablecoins like DAI have highly volatile collateral which can throw it off peg. Algorithmic stablecoins solve this issue by taking collateral out of the equation. Instead it incentivizes arbitrageurs to maintain UST’s peg with the US Dollar. There have only been two instances where UST lost its peg by over 10% momentarily due to volatility of Luna.
However, steps have been taken to prevent this from reoccurring. By solving some issues, the UST stablecoin introduces some other unique issues, which I will elaborate on further in a separate article. Nonetheless it will be interesting to see where the future of algo-stablecoins will take us.
According to Terra Docs, participating in consensus of the Terra network requires the staking of LUNA tokens in a validator node. At the time of writing, Terra has capped the amount of validator nodes to 130. However, any individual can join a staking pool and have a validator node stake LUNA on their behalf. LUNA stakers are incentivized to hold and stake LUNA to get fees from mint/burn fees, taxes, protocol fees, and airdrops from popular protocols like mirror and anchor. At current prices Stake ID estimates LUNA stakers are earning about 7.34% in LUNA tokens. Where most L1s economic drivers come from the demand to use the network, wherein demand for the native asset is realized, Luna also includes the economic driver of demand of UST.
As more UST is demanded, more LUNA is required to be burnt to mint UST. As more people want to use LUNA’s blockchain, the demand of LUNA or UST is increased because both are native assets on the Luna blockchain which can be used to pay for transactions. In other words, regardless of a crypto bull market or not, there will always be demand for either LUNA or UST. This is a unique aspect of Terra which differentiates it from other crypto ecosystems which synthetically derive its value from a bull market.