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Monolith Spotlights: Terra, the Layer 1 stablecoin-focused blockchain

Crypto moves fast. As the technology evolves so quickly, the space often sees new developments that could shape the future of the industry. In some cases, new projects can attract a wave of users and see rapid growth. One of the major trends of 2021 was the ascent of alternative Layer 1 blockchains. While Ethereum is still the leading smart contract blockchain by some distance, several other networks have seen significant user adoption as their DeFi ecosystems have evolved in recent months. One of the most widely used blockchains to have emerged during this boom is the stablecoin-focused network Terra. While we’ve long been committed to Ethereum and its roadmap to achieving scalability, we’ve also been paying close attention to Terra and DeFi projects like Anchor Protocol as its ecosystem has grown. In this guide, we cover how the Terra blockchain and its stablecoins work.

Terra Explained

Terra is a Layer 1 smart contract blockchain built for stablecoins. Unlike other Layer 1 networks such as Ethereum, Terra focuses on creating an ecosystem for real world payments. To achieve this, it uses algorithmic decentralized stablecoins that track the price of traditional fiat currencies.

Terra launched on mainnet in April 2019, making it one of the newest smart contract blockchains. Prior to its launch, the protocol had been in development since January 2018. It was developed by the Korean firm Terraform Labs, which was founded by Daniel Shin and Do Kwon.

Terra integrates several stablecoins known as “Terra stablecoins.” It also has a native governance token called LUNA. Terra stablecoins and LUNA are named as such because they work in balance with each other, similar to how the Earth (Terra in Latin) and the Moon (Luna in Latin) have gravitational force with one another.

The network supports several Terra stablecoins, but its most used by far is TerraUSD (UST), a stablecoin pegged to the US dollar. One of the fastest-growing digital assets on the market, UST recently overtook DAI to become the world’s fourth-largest stablecoin with a market capitalization of over $10.8 billion.

Terra Stablecoins and LUNA

Terra stablecoins are algorithmic stablecoins that achieve stability via a dual token mechanism. While other algorithmic stablecoins use over-collateralization, fraction reserves or rebasing mechanisms to achieve price stability, Terra stablecoins work in tandem with LUNA. They have an elastic monetary policy, meaning their supply changes according to the level of demand.

Seigniorage is key to Terra stablecoins maintaining their price peg. Seigniorage refers to the value of the asset and the cost of minting it.

To mint UST, users burn the equivalent amount of LUNA. Let’s take a look at an example:

To mint $100 worth of UST, Alice must burn $100 worth of LUNA.

LUNA is currently priced at $82.

Alice must therefore burn 1.22 LUNA.

Similarly, to mint $100 worth of LUNA, Bob must burn $100 worth of UST.

Bob therefore burns 100 UST tokens.

Market forces help ensure that Terra stablecoins maintain their price peg. This is because there are a vast number of users looking to mint both UST and LUNA, keeping the two assets in balance. If the peg falls below $1, arbitrageurs can take advantage by burning one UST to receive $1 worth of LUNA. If the peg exceeds $1, they can burn $1 worth of LUNA to receive one UST. In these instances, they keep the seigniorage as profit.

Importantly, LUNA is a volatile asset similar to other cryptocurrencies like BTC and ETH. However, it absorbs the volatility of Terra stablecoins. When a Terra currency is minted, LUNA gets burned, meaning the supply becomes more scarce. Additionally, as Terra’s native currency, LUNA is used for validating every Terra transaction. Terra users can earn transaction fees by staking LUNA as part of its Proof-of-Stake consensus mechanism.

Terra Under the Hood

Terra is built using the Cosmos Software Development Kit and Tendermint’s Delegated Proof-of-Stake consensus algorithm.

It currently has 130 validators with an increase to 300 validators slated for the future. As such, Terra is less decentralized than other blockchains like Ethereum.

Terra validators verify transactions and run nodes to add new blocks to the chain. Anyone can become a validator by locking LUNA tokens for at least 21 days or having a stake delegated by other users. While the minimum requirement to stake is only 0.01 LUNA, it makes sense to stake higher amounts to cover the cost of transaction fees to claim rewards. As running a validator node has a high barrier to entry for many users, most stakers opt for delegating their LUNA tokens to other users. Terra validators currently earn roughly 7% annualized.

Delegators and validators have the same responsibilities and both stake tokens to earn a portion of the validator fees. However, validators can lose their staked tokens via slashing if they misbehave. This means that delegators risk losing their tokens if they delegate their tokens to a malicious validator.

LUNA stakers can also take part in the protocol’s governance. Terra validators can submit improvement proposals, and stakers vote on changes with voting power proportional to their staked LUNA.

The Road Ahead for Terra

Terra recently launched a major upgrade called Columbus-5, which included an update to become interoperable with networks like Polkadot and Cosmos. It also introduced a deflationary update akin to EIP-1559 that sees a supply of LUNA get burned, making the asset more scarce.

Terra has already seen significant adoption, particularly in Korea. Moreover, its DeFi network has grown at a rapid rate over the last year. As interest in newer Layer 1 projects has grown, projects like the lending protocol Anchor have also flourished.

Terra’s DeFi ecosystem leverages the UST stablecoin. As Terra focuses specifically on stablecoins, it’s hoping to become a major contender for ushering in mass crypto adoption. Thanks to a boom throughout 2021, Terra has become the 9th largest cryptocurrency by market cap at just over $29.6 billion. Its total value locked, meanwhile, is $18.6 billion, which is second only to Ethereum.

While we see huge potential in Terra, this does not change our commitment to supporting Ethereum. We believe that crypto is heading towards a multi-chain future, in which Ethereum is the likely contender to become the main hub for DeFi, NFTs, and settlement layer for a new, decentralised financial system. As crypto moves in this direction, Terra is also poised to become one of the dominant smart contract platforms.

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