A recent analysis delivered by the 1kx team notes that the total transaction fees of the Terra network accrued in 2020 (Jan — April) fell just 3rd behind that of Bitcoin and Ethereum. Given the success of the CHAI payments app that has on-boarded more than 1.5 million users to date and more importantly contributed 1.4+ million USD in transaction volume per day, we’ve seen this relatively significant accumulation of network fees as a natural result of product market fit for our continued model of Terra’s adoption.
In this piece we’d like to go beyond the numbers to reflect on the key role that transaction fees play in determining network value and security. The fundamental driver of transaction fees in the Terra network is the broad adoption of CHAI by consumers and merchants. There are evident network effects in the rapid increase of our consumer exposure to the $25+ billion in GMV of integrated merchants across South Korea. Transaction fees themselves, nevertheless, do not merit sole standing as a key indicator of a blockchain network’s success, as they can be trivially spoofed. It is the fact that transactions are done by real, highly engaged users that find utility in Terra which makes transaction fees a meaningful metric. This capture of transacted value ultimately accrues to the Luna holders who participate in Proof of Stake (PoS). Transaction fees of a blockchain network, we will argue, are instrumental to both determining valuation and assessing network security.
The valuation of a PoS network is generally thought to be a function of the rewards that accrue to the staking asset discounted to the present. Most PoS networks reward validators either via transaction fees or inflation rewards. As we have argued in the past, we believe that transaction fee rewards provide an objective basis for network valuation, while inflation rewards do not. In the case of Luna, transaction fees represent value that is captured externally (consumers and merchants paying to use Terra), as opposed to value issued internally (inflation). We believe that this property of externally captured rewards sets Luna apart from the vast majority of PoS assets. From an earlier piece that we wrote on the topic (lightly edited):
Let’s imagine a fictitious inflation-based PoS token called Mare (sea) that pays a 10% annual yield. This means that if Alice stakes 10 Mare for a year, the network will print 1 new Mare and give it to her as a reward. If Bob holds 10 Mare over the same period without staking he receives no reward. What’s essentially happened here is that Alice’s share in the network has increased (her stake relative to Mare’s total supply), while Bob’s has decreased. In other words, the network has used inflation to redistribute Mare ownership, thereby taxing people like Bob who do not stake. What if everyone stakes (say Alice and Bob, the only two holders)? Then they both maintain their network ownership, so their yield net of inflation is zero. In other words, staking in an inflation-based PoS network is a way to protect one’s ownership from being diluted, and “yield” is a measure of punishment for not doing so rather than a measure of reward. It is safe to assume that at steady state, the majority of holders will stake precisely for this reason. All in all, knowledge of Mare’s “yield” leaves us none the wiser as to what it is worth.
Contrast this reward system to one based on transaction fees like Luna’s: when value is transferred on the Terra network, Luna captures a small fraction of that in the form of Terra rewards. This happens every time someone uses Terra to transact or make a purchase. Hence, value external to the network accrues to Luna in a predictable manner, i.e. proportionally to aggregate “value flow”. In our case the underlying economy from which value is captured is well understood — the fast growing Asian e-commerce market which Chai is rapidly infiltrating. It is in this vein that we are able to conduct straightforward analysis to project the value that will accrue to Luna over time. What is more, value accrues in a fiat-pegged currency (Terra) rather than in the staked asset (Luna), thus creating an objective basis for quantifying said value. Discounting Terra to the present is meaningful; discounting Luna to the present is circular.
The stark contrast between value-based and inflation-based rewards mechanisms has significant implications for valuation of the PoS asset. Assets which are rewarded in value-capture terms are easy to value: one simply needs to project value flow (in our case: Terra transaction volume) and the rate of value capture (in our case: transaction fee). On the contrary, inflation-based rewards offer zero basis for valuation — as we saw earlier the “yield” of a PoS asset has nothing to say about its value, only about how fast it inflates (how fast it loses value). To value such assets, one needs to resort to more ill-defined methods that are independent of their yield. The ability to value an asset in a systematic way is a core requirement for sustainable demand. We see Luna’s value-based rewards system as a significant advantage relative to its PoS peers.
Beyond forming the basis for systematic network valuation, transaction fee rewards have significant implications for network security. An attack on a blockchain generally attempts to create an alternate “history” of transactions — a fork. The opportunity cost of an attack attempt is represented by the block rewards doled out to validators on the honest chain. The higher the fees an attacker stands to lose by building an alternate history, the higher the cost of attacking the network. On a second level, PoS networks are secure insofar as attackers do not control a majority of the staked assets. For BFT blockchains like Terra and Cosmos, attackers require a ⅔ supermajority in voting power to successfully hijack the network. The higher the network’s value and the more sustainable the demand for the staking asset, the harder and more expensive it is for attackers to hijack it. A robust transaction fee reward system therefore raises the bar for attacks on PoS networks.
Cryptocurrency adoption has been measured with as many changing goalposts as there have been with decentralization. Terra has proven a path to broad adoption via e-commerce, and we expect to see many more applications to contribute to Terra’s growth. We see Terra’s transaction fee reward model as superior to inflation rewards in driving sustainable network value and network security, with high fee revenues as a key driver for both.
Burniske, Chris. “Value Capture & Quantification: Cryptocapital vs Cryptocommodities”. Placeholder VC blog. April 2019. https://www.placeholder.vc/blog/2019/4/26/value-capture-and-quantification-cryptocapital-vs-cryptocommodities
Buterin, Vitalik. “A Proof of Stake Design Philosophy.” Medium. Medium, December 30, 2016. https://medium.com/@VitalikButerin/a-proof-of-stake-design-philosophy-506585978d51.
Clausen, Lasse. “Why Transactions Fees Are A Good Measure of Value Of Blockchains”. FEEDweave. May 7, 2020. https://feedweave.co/post/84v1ElMk7FwJ77LD-bRq9HFr8fYqmydonO4HglYG56U
Kim, Baek Kyoum. “Capitalizing on Terra’s Growth: A Valuation Framework for Luna”. Medium. November 27, 2019. https://medium.com/hashed-official/capitalizing-on-terras-growth-a-valuation-framework-for-luna-f7d2e4b750f8
Platias, Nicholas. “Terra Money: Analysis of Luna Staking Rewards.” Agora. May 2019. https://agora.terra.money/t/analysis-of-luna-staking-rewards/52
— Generous contributions from Nick Platias (Head of Research)