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The Beginner’s Guide to Terra Money

Terra has shown the progress that only a few projects in the DeFi space have been able to achieve. Join us as we take a look at what it is all about!

There are many cryptocurrencies floating around in the Decentralized Finance (DeFi) market today. With so many of these around, it can get confusing very fast for users to understand where to invest in. 

It’s not just about making the right bets. It’s also about connecting with the project, feeling like you’re a part of something bigger than yourself.

Amidst all the rapid movements happening in the DeFi space, the emergence of Terra Money has taken over, not only the DeFi space, but also the crypto industry at large by storm. So what is Terra all about, and should you invest in the Terra ecosystem or not? Let's find out.

What is Terra?

Terra is a blockchain network built on top of and working on Cosmos SDK. It is an ambitious and rapidly growing crypto project spearheaded by the Terraform Labs team.

You must’ve already heard a lot about it in the news. There has been quite a buzz around it—and for a good reason. You see, the project has a bit of a quirky feature that sets it apart from more or less all of the DeFi platforms out there. And that feature is that all of the stablecoins in the Terra ecosystem can be converted into the network’s native governance token, LUNA. So, no more using fiat or over-collateralized crypto as main reserves. And it works.

LUNA makes things go around in the Terra ecosystem—be it the payment of network fees, pegging stablecoins, taking part in governance, or even putting in a stake in the Tendermint Delegated Proof of Stake consensus mechanism.

I know, the last part of the previous paragraph sounded gibberish, but let me explain. Let’s say you want to peg a stablecoin, say the TerraUSD (which is arguably more easily identifiable with its symbol, UST) for example. Now, for pegging 1 UST, 1 LUNA is taken with your UST token. So, it’s a 1:1 ratio.

Let’s say that UST decreases in value. Naturally, arbitrageurs would jump in and take this opportunity to buy more tokens, effectively increasing the price of UST. But even if they didn’t, the platform has a mechanism in place for bringing the price of the stablecoin back to normal. In such an event, Terra would burn UST which would lower its supply and hence increase the price.

To mint new UST tokens, a percentage of the digital tokens and reserve asset LUNA get burned. If the demand for UST goes up as more people start to use the digital currency, more LUNA gets burned automatically and diverted towards a community pool. This is a balancing act that helps stabilize the price to some degree. LUNA directly benefits from the economic growth led by the Terra ecosystem.

As a stablecoin, LUNA is doing a great job at staying stable. Compared to cryptocurrencies like Bitcoin, this is almost unreal.

Unlike some other stablecoins in the market today, such as Tether that are pegged to more conventional currencies like the US dollar through cash and cash equivalents, LUNA is an algorithmic stablecoin that powers the blockchain payments network. 

Because of this, it aims to become the first commonly used cryptocurrency by pushing through the adoption of its native token through various e-commerce alliances, including Baemin, Carousell, TMON, Tiki, and Qoo10.

Thus far, it has successfully managed to keep its price steady with the use of the same mechanism that the central banks of the world commonly use—that is increasing and decreasing the supply of LUNA.

As LUNA’s transaction volume and economy continue to grow, it is possible to use money supply growth, known as seigniorage, to fund discounts that benefit retail customers.

How Does Terra Work?

As mentioned earlier, the Terra ecosystem works on a blockchain that lets its users create stablecoins pegged to conventional fiat currencies.

At present, the Terra ecosystem has stablecoins pegged to the US Dollar, the Euro, the South Korean Won, and many others. These stablecoins make use of the network's seigniorage mechanism mentioned in the previous section.

The ecosystem uses the 'Tendermint Delegated-Proof-of-Stake' (DPoS) as its primary consensus mechanism while also providing smart contract capabilities to users to allow them to create a variety of different stablecoin types.

What Makes Terra Stablecoins Special?

Stablecoins on the Terra platform use different techniques to collateralize fiat-backed stablecoins as well as crypto-backed stablecoins.

The benefit of using collateralized stablecoins is that it allows the holder to exchange that stablecoin for its equivalent amount of a fiat currency or the same amount of crypto-asset as well.

Terra stablecoins are unique in that they use algorithmic mechanisms to control the overall supply. Each stablecoin on the Terra platform is backed up and can be exchanged for Terra's own utility token Luna, as well as governance rights. Terra works as a counterparty for anybody who wants to trade their stablecoins for LUNA and vice versa. This is what impacts the supply of the two tokens.

Let me explain how it all works with an example. Let’s say you want to mint 100 USD worth of UST. In order to mint this amount of UST, the first thing you would need to do is first convert an equivalent monetary amount of LUNA tokens on the Terra platform.

The Terra platform then goes ahead and burns the number of tokens you have provided. This means that if the cost of LUNA is 50 USD per coin, the algorithm will need you to burn 2 LUNA tokens in order to mint 100 UST.

Previously, Terra users were only allowed to burn some part of the tokens provided. However, recently, after the Columbus-5 update, it is not possible for Terra users to burn 100% of their tokens.

It is also possible for users to mint LUNA if they have UST tokens. If you want to mint 100 USD worth of LUNA tokens (which is equivalent to 2 LUNA), you will need to burn 100 UST. So even if the market price of UST is not at 1 USD per token, the conversion rate for the minting process will still consider 1 UST to be equal to 1 USD. This is the benefit of using this exchange mechanism, and this is also the reason why TerraUST has rapidly grown in popularity.

The following example explains how the Terra algorithm works to maintain price stability within the platform.

Let’s say the price of UST falls to 0.98 USD. This is 2 cents lower than the actual intended pegged value of the UST. However, despite any conversion that takes place between LUNA and Terra stablecoins, 1 UST will still be considered equivalent to 1 USD.

In this case, an arbitrageur can notice the difference in price and find the perfect opportunity to make a quick profit. So they go ahead and purchase 100 UST for 98 USD and then convert it to 100 USD worth of LUNA tokens.

Now, the arbitrageur can either keep holding onto their 100 USD worth of LUNA tokens or convert it back to fiat current and make a profit. Even though 2 USD in profits does not seem to be much, when you invest on a larger scale, you will end up making huge profits. This difference between the actual price of minting the tokens and the value you get is known as seigniorage.

But again, how does the process of seigniorage keep the pricing stable across the Terra network? Well, it is important to keep in mind here that the increased demand for UST by arbitrageurs increases the cost of UST. Terra then burns the UST during the exchange process while converting the tokens to LUNA. This decreases the supply of UST while also increasing the price of UST. So, once the value of 1 UST reaches the value of 1 USD, the arbitrage opportunity closes, which is what keeps the price stable.

The same holds true for when the same process takes place in reverse as well. This means when the price of UST goes above 1 USD. So, let’s say the price of UST goes up to 1.02 USD.

This immediately attracts the attention of arbitrageurs who want to make a profit. Arbitrageurs buy 100 USD worth of LUNA and then exchange it for UST, ending up with 100 UST which is worth 102 USD.

Terra then proceeds to burn the LUNA, and there is a sudden increase in the supply of UST within the Terra network. Combined with a fall in demand for UST because of its high price, the price of UST now decreases to $1, which again keeps the price stable.

Amongst all of this, it is the LUNA token that is of importance. The LUNA token functions as collateral for all the Terra stablecoins. Due to this, there is no need for users to over-collateralize. The LUNA tokens are well-equipped to absorb the price volatility of UST.

What is the Delegated Proof of Stake Consensus Mechanism used by Terra?

If you want to understand how the Terra platform works, it is important to understand the functioning of the Tendermint DPoS. The Terra blockchain is built on the Cosmos SDK, which is why the Tendermint DPoS works well with Terra.

As of October 2021, there is a group of 130 validators on Terra that process the transactions. Users or delegators stake their tokens behind any such validator. In return, the validator secures the network by processing transactions.

This is very similar to the work a bitcoin miner does in the Bitcoin network.

A delegator stakes their LUNA tokens behind a validator who they will be most likely to process the network transactions honestly and efficiently. Every validator sets a custom percentage of rewards that they will then give to their delegators or users who supported them with their LUNA tokens.

Validators also have to keep aside some amount of LUNA tokens for at least 21 days. This process is known as bonding. Delegators also need to follow this 21 day lockup period.

However, what happens in cases where the validator turns out to be a bad player?

There is a possibility that the validator processes double-spent transactions or may even include false transactions. In this case, the validator's rewards will be cut, and they might even end up losing their entire stake.

Remember that there are Terra taxes that are put on transactions that provide the rewards that are given to the validators and delegators. The share of each delegator, therefore, depends on the amount they put at stake and the commission rate of the validator.

What are the Advantages of Using Terra?

One of the biggest advantages of using the Terra Money platform is the interoperability and accessibility it provides.

The entire Terra ecosystem features a development platform including a blockchain agnostic framework that allows software engineers to build their own protocols along with decentralized applications within the Terra network.

Two of the biggest DeFi protocols that are based on the terra platform at the moment are the Mirror Protocol and the Anchor Protocol. So while the Mirror protocol allows synthetic asset creation and usage, the Anchor Protocol offers users incentivized staking yield services.

While there already is a huge number of services that are being built on the Terra platform, the Terra Protocol is also aiming to become completely interoperable with other Layer-1 blockchain solutions in the near future.

This means that it will soon become possible to move any tokenized crypto assets and other data to and from multiple blockchains simultaneously.

Already Terra stablecoins are available for cross-blockchain asset trading and transfer between the Solana and Ethereum blockchains and the Terra blockchain. More network interoperability is likely to be added by the end of this year.

Before You Go…

The Columbus-5 Mainnet update has shaken things up quite a bit. A lot of good things have come out of the update and a lot more is expected to be rolled out soon.

The platform is expected to provide a wide variety of opportunities for users to benefit from cross-blockchain compatibility with other Cosmos SDK-based blockchains.

But whether this commotion is here to stay or just a ripple is something only time will tell.

Arian P

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