Terra: The Cosmos DeFi Hub
With an algorithmic stablecoin as its base, Terra is gradually becoming the DeFi Hub of the Cosmos ecosystem. In this post, I will explore all the parts of this ecosystem and how they all work together.
The stablecoin
The first product built on top of the Terra blockchain is an algorithmic stablecoin.
I do not intend to cover all the intricacies of that system in this piece (as they deserve a piece of their own), but rather highlight the interesting aspects that make their design unique.
The first one is that, as an algorithmic system, it scales with demand. As demand rises, stablecoin supply adjusts to keep the peg stable and vice-versa. However, one key nuance with the Terra system is that, to mint new stablecoins (to increase supply), an equal value of Luna (the native asset of the Terra blockchain) must be burned.
The key implication here is that the success of the Terra stablecoins is directly tied to the economic value of Luna (and thus, to the Terra blockchain). As opposed to Ethereum, in which current DeFi apps are parasitic to the blockchain, Terra stablecoin demand directly accrues value to the Terra blockchain. In this sense, the Terra blockchain is similar to Ethereum with EIP-1559 already implemented.
The other unique aspect of the Terra stablecoin design is the way in which seigniorage is managed. Seigniorage, which is the profit made by issuing new currency, is a very powerful tool. Think of it as the difference between the face value of the minted currency and the cost of producing it. For it to exist, however, there must first be excess demand for the currency; otherwise, inflation would ensue and the benefits of seigniorage would be lost. In the case of Terra, seigniorage can be realized whenever the stablecoin is above the peg — which means there is excess demand for the stablecoin.
So, how does the Terra system allocate seigniorage? Well, it does this in a very clever way. One part of the seigniorage is allocated to the validators of the blockchain. The other part, which is what makes the design beautiful, is allocated to the apps built on top of the Terra blockchain. This is done proportionally to their contribution to the ecosystem, which is basically measured by how much revenue each app generates for the blockchain. The nuances behind how that distribution works can be found here.
The key takeaway, though, is that this system design creates a virtuous cycle in which the more a dapp contributes to the ecosystem, the more demand there is for Terra stablecoins, the more seigniorage there is to be distributed, the more dapps can earn, the more they can invest in their product to continue growing.
At the same time, this dynamic contributes value to the Terra blockchain since the more seigniorage there is, the more Luna is burned, and thus, the more scarce it becomes. It’s brilliant!
The first app built on top of Terra is Chai, which given its success deserves a section of its own.
Chai
In essence, Chai is a payments app with some key differences that make it a one of a kind product.
The first one is that, given that it was the first (and up until now the only) app built on top of Terra, it has been the sole benefactor of the seigniorage subsidy allocated to dapps within the Terra ecosystem. This subsidy has been intelligently used by Chai to bootstrap their network by offering discounts and cashback to users making purchases through the app.
The other key aspect that makes Chai unique is that it uses the Terra blockchain (and Terra stablecoins) to settle payments between users and merchants. This has some important benefits for merchants. First, they pay a much lower settlement fee for every transaction compared to traditional payments processors. While Terra currently charges 0.574%, traditional payments processors charge around ~2.5%. The other important benefit is that, while traditional payment settlements can take up to two weeks to clear up, with Terra payments settle within seconds.
Both these aspects (coupled with a seamless and beautiful UI) have made Chai a success. Within a bit more than 1 year, the app has been able to garner impressive traction: it now boasts more than 1.9 million users, ~1 million USD in daily transaction volume and more than 30 stores (including some of the biggest e-commerce players in Korea).
Although these numbers are outstanding by themselves, to me, the most impressive metric is the fees generated by the app. In an analysis made by Lasse Clausen from 1kx, from January to April of this year, the total fees generated on Terra (mainly by Chai) stood as the third largest among all blockchains, only behind Bitcoin and Ethereum. The following graph comes from that analysis.
Year to date, Terra has generated more than $5 million in fees. To put that into perspective, during the same period of time Bitcoin has generated ~ $157 million in fees. That means Terra is generating 3.4% as much fees as Bitcoin; an impressive feat for a Blockchain that’s only been around for 17 months.
Now, as a PoS blockchain, these fees represent cash flows generated by Terra, which accrue to Luna holders (via validating or delegating). At a rate of ~$7 million in annualized fees and a fully diluted market cap of ~$300 million, that would imply a P/S ratio of ~43 and, given validator commissions between 1 and 20%, a worst-case P/E ratio for delegators of ~53. There have been some really good valuation analyses by Hashed and Maple Leaf Capital that put these numbers into context, so it’s not worth repeating that here (but I highly suggest you check them out).
Something that’s worth noting regarding those fees, as Cristopher Heymann suggests, is that “after being live now for [only] 17 months on mainnet, Terra has established itself as an attractive source for non-dilutive revenue for validators.” What this means is that, as opposed to other blockchains (or dapps) where staking income comes mainly from inflation, Terra offers validators (and delegators) a source of income that comes from fees paid by real-world merchants using the payments network. In this analysis, Daniel Hwang explores the importance of this dynamic for network security and valuation.
Now, Chai may also face some challenges going forward. As network growth naturally slows down (it’s still early though), seigniorage will decrease and discounts will have to be reduced. However, the team is aware of this and is already working on some alternatives to make the platform stickier. One of those, which I find interesting, is shifting focus from discounts to cashback (which are given in Terra stablecoins), thus achieving two goals: 1) Making users come back to the platform as they’ll have some money parked in their account; and 2) Reducing money velocity, thus increasing seigniorage. These efforts seem to be working quite nicely, as user retention data shows (see Figure 3).
Additionally, it is worth noting that Chai is still relatively small and may still have ample room for growth. At the same time, other initiatives such as the Chai card (which will go global soon) and Chai’s expected SEA expansion, will probably keep propelling network growth.
More than payments
Even though up until now the Terra blockchain has been used mainly to support a stablecoin system and a payments app (Chai), the future holds more for this blockchain.
With smart contract capabilities soon to be incorporated, Terra will offer a platform with a stablecoin system, 1.8 million users, and a popular payment app for developers to build on top of. Additionally, as a Tendermint-based blockchain, Terra will offer developers a door to the entire Cosmos ecosystem.
Although these smart contract capabilities are not online yet, some teams are already envisioning and working on some important DeFi primitives to be built on top of Terra.
Anchor
One of the team building on top of Terra is led by the newly formed Interchain Asset Association (IAA), which is a group composed of some prominent members of Polkadot, Cosmos, and Terra. A few weeks ago they unveiled Anchor, a money-market protocol that will focus on offering stable rates to its users through the use of PoS derivatives as collateral. It’s worth highlighting that, as an interchain effort Anchor aims to support assets from the main PoS blockchains out there, including DOT, ATOM, LUNA, and SOL. That means it’s an ambitious effort that aims to go beyond Terra and the Cosmos ecosystem themselves.
What Anchor can mean for Terra going forward cannot be overstated. First of all, as a new protocol built on top of Terra (that will naturally use Terra stablecoins), any new demand generated by the protocol will kickstart the seigniorage virtuous cycle shown in Figure 1, driving value to Terra and Anchor itself. It will be interesting to see how Anchor decides how to use this subsidy (subsidizing rates is the obvious option but there may be other interesting alternatives).
Additionally, up until this point, Terra is almost exclusively used in Korea (as Chai has been the only app on the network). Anchor, as a decentralized protocol, will inevitably open the doors to a new, global market of users, as anyone that’s currently staking assets of the major PoS blockchains out there will be a potential user. In this sense, Anchor can globalize Terra.
The last important point to highlight is that, if Anchor succeeds, Terra will offer a strong ecosystem with two important DeFi primitives already developed on top of it: a money-market and a payments network. These two primitives, coupled with a strong incentive mechanism (the seigniorage subsidy), could draw significant developer traction going forward. If this were the case, Terra would be well on its way to becoming the de facto DeFi Hub of the Cosmos ecosystem.
Community
For anyone that’s spent time on crypto, it’s clear that a strong community is a key aspect for any project to be successful. Spartan Black goes so far as to calling the community (and not the tech) the real moat of any crypto project. I strongly agree.
In this critical aspect, though, Terra seems to be lacking when compared to other crypto projects. Although it’s difficult to measure the strength of a community, it’s something any crypto native user can feel. Through a combination of Discord, Twitter, Telegram, and the project’s forum, a crypto user/investor can get a feel for how engaged a community is. In the case of Terra, unfortunately, community engagement seems to be low relative to other crypto projects. The Discord channel is relatively quiet, the Terrans (or Terra Troopers) don’t have a strong presence on Twitter and the forum’s participants are limited to a really small number of individuals (mostly the team and validators).
Even though I think this is definitely an aspect the Terra team should work on, especially after the launch of Anchor, I don’t think comparing Terra’s community to that of any other DeFi project is fair. The main reason for this is that, up until now, Terra hasn’t focused on the crypto market. Its main app, Chai, is designed for mainstream users, not crypto native ones. Furthermore, it’s been designed with crypto in the background so mainstream users don’t even need to know they’re interacting with a blockchain. In this sense, it’s only natural that Terra’s community engagement differs from that of other DeFi projects out there.
Going forward, though, with the launch of Anchor, I think the game fundamentally changes for Terra. For this new primitive to succeed, Anchor will need to attract crypto users to the platform. When this happens, a crypto community will become as important to Terra as to any other DeFi project out there.
Conclusion
Up until now Terra has been generally seen and valued as a stablecoin network that powers a payments app. However, Terra is more than that: it’s a blockchain that is positioning itself to support an entire DeFi ecosystem.
Thanks to Daniel Hwang for the feedback for this piece.
Disclosure: I’m long LUNA.
