Stablecoins have emerged as an important, if sometimes controversial, component of the cryptocurrency ecosystem, bridging the gap between fiat and digital currencies. The total capitalization of the stablecoin market has grown from US$20 billion in October 2020 to more than US$156.2 billion today. 

Amid a proliferation of stablecoin projects, Terra, whose LUNA coin has hit all-time highs three times in the past month — including today — is among the first blockchain networks with purely algorithmic stablecoins built for e-commerce. Terra’s smart-contract blockchain and stablecoin ecosystem aims to offer next-generation digital money.

Terra seeks to offer programmable money that’s easy to spend, with low fees, instant settlements and utility for cross-border transactions. Dubbed “Alipay on the blockchain” by technology news site TechCrunch, Terra boasts an interface more closely resembling that of a mainstream fintech platform than a stablecoin network, despite the fact that its inner workings involve blockchain technology and cryptocurrency.

The cryptocurrency market has long been a volatile one, hampering crypto’s use as a medium of exchange. After all, nobody wants to pay off a mortgage with money whose value fluctuates 10-20% on a daily basis. Terra aims to address this issue by creating a price-stable digital currency ecosystem for faster, cheaper digital transactions.

So what is Terra, and how does it differ from other contenders in the stablecoin and e-commerce markets? This Forkast.News Terra explainer will explore:

What is Terra?

Terra bills itself as a next-generation blockchain payment network interwoven with stablecoins and powered by its native LUNA token. In technical terms, Terra is a layer-1 blockchain protocol with smart-contract functionality that works as a payments-focused fintech ecosystem leveraging algorithmic stablecoins, the stability of whose value is maintained by internal algorithms. 

Terra was founded by Daniel Shin and Do Kown, who also founded Terraform Labs — the South Korean company behind the Terra ecosystem — in 2018. The project kicked off after Terraform Labs secured US$32 million of funding, with its lead investors including Binance Labs, OKEx, Huobi Capital and Dunamu & Partners, the investment arm of Seoul-based crypto exchange Upbit. 

The white paper for the Terra blockchain was released in April 2019, the same month its mainnet was launched. The document describes Terra as a price-stable, growth-driven stablecoin that achieves price stability via an elastic money supply, enabled by stable mining incentives. The protocol also uses seigniorage — the profit made from issuing currency — to stimulate transactions and facilitate wider adoption.

The protocol has issued stablecoins pegged to the U.S. dollar, the euro, the Chinese yuan, the Japanese yen, the British pound, the South Korean won and the International Monetary Fund’s special drawing rights, an international reserve asset that supplements the currency reserves of the multilateral lender’s member nations. They are all collateralized by the LUNA token, with TerraSDR being Terra’s flagship currency. Terra’s main stablecoin, Terra USD (UST), aims to reduce the volatility associated with cryptocurrencies such as Bitcoin and Ethereum. 

Terra USD is secured not by U.S. dollars, but only by smart-contract algorithms and the LUNA coin. By contrast, USDT, the biggest stablecoin by market capitalization, had been touted by its operator, Tether, as being backed by U.S. dollars. When it was discovered that USDT was backed mostly by assets such as commercial paper, certificates of deposit and U.S. Treasury bills, Tether was fined US$41 million for having made misleading claims about its reserves.

Terraform Labs nevertheless hopes that its tokens’ fiscal foundations, paired with the protocol’s elastic monetary governance, will drive widespread adoption. Terra’s fiscal governance and spending regime are managed by a treasury that acts in a manner similar to a central bank. Community members can submit proposals that compete for stimulus programs, the proposals are vetted and voted upon by the rest of the ecosystem, and those that promise the highest level of adoption are approved.

How does Terra work?

Say you want to buy a movie ticket, one of the products most often purchased using CHAI (one of Terra’s most popular decentralized apps, or dApps). First, you’ll have to mint your own Terra stablecoin on the website, burning the requisite number of LUNA tokens in the process. Once you have your stablecoins, you can use CHAI’s mobile app to pay for your tickets online or in-store.

Once you buy a ticket with your stablecoins, Terra’s blockchain generates a small transaction fee that is distributed between LUNA delegators — token holders who choose to delegate their LUNA coin to a staking pool, in order to secure the network.

Terra was built on Cosmos SDK and uses a delegated proof-of-stake consensus secured by decentralized validators who settle transactions in exchange for rewards. Validators and stakers can also participate in the network consensus, having voting power that’s proportional to their delegated stake. The 130 active validators with the most LUNA tokens are chosen to secure the network.

Terra’s stablecoins are algorithmic stablecoins, meaning that the protocol is designed to achieve price stability by using algorithms. For instance, the value of UST is equivalent to US$1 and should remain stable thanks to the LUNA token. When UST drops below US$1, LUNA supplements the UST supply to help it maintain its peg to the dollar.

Users who want to mint Terra stablecoins need to burn the dollar-equivalent amount of LUNA. A small portion of LUNA tokens used to mint stablecoins — also known as seigniorage — is sent to the community treasury, which makes minting stablecoins profitable for the network. It’s a process similar to the seigniorage from which central banks profit when they print money.

Algorithmic stablecoins are considered a very controversial stablecoin class that can be susceptible to extreme price volatility. The prices of algorithmic stablecoins are secured by smart-contract algorithms, financial engineering and the market incentives of independent participants — factors that have proved to be unreliable in times of crisis. This was the case with Iron Finance’s bank run, as IRON, an algorithmic stablecoin, lost its peg and crashed from US$1 to nearly zero — and wiping out over US$1 billion in market cap — in a single day due to poor tokenomics.

Terra’s native token: LUNA

LUNA is the Terra protocol’s native token, used for staking, governance and collateral for the network’s algorithmic stablecoins. LUNA coin holders can stake their tokens to earn rewards and use their weight to vote on governance proposals for the ecosystem. LUNA has a dynamic supply of 1 billion coins. Exceeding that number will prompt the protocol to burn LUNA tokens automatically.

LUNA is now the 12th-largest cryptocurrency by market capitalization, at US$24.4 billion at press time, when the coin was changing hands for US$62.84. The token is important to the ecosystem’s collateralizing mechanism to ensure the price stability of Terra stablecoins. This is why LUNA is designed to have a dynamic supply that fluctuates according to the protocol’s collateralization algorithm.

In a nutshell, LUNA is responsible for the stability of Terra stablecoins, and vice versa. The protocol’s name is intended to be analogous to the symbiotic relationship between the earth and the moon, and the way in which the two celestial bodies confer gravitational stability upon one another.

As mentioned above, each Terra token is pegged to a fiat currency as a crypto-collateralized, algorithmic stablecoin. The first stablecoin issued by Terra was TerraKRW (KRT), a stablecoin based on the South Korean won. Others include TerraUSD (UST), TerraJPY, TerraCNY, TerraEUR, TerraGBP and TerraSDR.

Terra’s achievements

Terra has built a system with a six-second average block time, according to its founders. All transactions on the Terra network pay gas fees, in which the minimum price is set by each validator. For transactions involving stablecoins, extra fees are added on top of the gas fees to maintain stability and discourage foreign exchange arbitrage. The most common type of stablecoin fee, the stability fee, is levied on all non-market swap stablecoin transactions, and fees range from 0.1% to 1%, hard-capped at 1 TerraSDT. Spread fees are market swaps that involve stablecoins and LUNA. Its minimum fee is set to 0.5% and may fluctuate when there is market volatility. For market swaps between stablecoins, a “Tobin tax” is applied by on-chain governance. Most market swaps will incur in .35% tax, and some stablecoin pairs have had to pay as much as 2%.

Terra’s CHAI payment app is another significant component of the ecosystem, providing an experience that aims to be as frictionless as existing mainstream payment apps.

Interoperability is also being addressed with Terra Bridge — a cross-chain system facilitating asset transfers between Terra, Binance Smart Chain and Ethereum. And developers are working on bringing Terra stablecoins to Solana.

Two projects also add to the ecosystem: Mirror and Anchor. Mirror Finance allows users to create synthetic assets, called mAssets, which mirror the price of stocks — designed to enable UST holders to gain exposure to equities. Mirror’s Shuttle bridge also enables mAsset swaps on the Ethereum network, making the ecosystem more interoperable.

The Anchor Protocol is a crypto platform that offers access to stable interest rates. Crypto deposited on the protocol is automatically staked to a proof-of-stake blockchain network, without users having to find their own liquidity pools.

Concerns around Terra

DeFi is a complex industry, and no platform is perfect, particularly projects in their early stages, such as Terra. Terra has significant ground to cover to catch up with leading DeFi chains such as Ethereum and Binance Smart Chain. Terra stablecoins are also playing catch-up, although they are slowly gaining on Tether’s USDT, currently the most popular stablecoin.

The primary criticism of Terra among blockchain purists is that it is less decentralized than other networks. Its 130 validators are far outnumbered by the 3,038 validators that secure the Ethereum network. Another concern regarding decentralization is that the top 10 network validators currently hold about 40% of the delegated LUNA supply.

Lastly, Terraform Labs has received a subpoena related to the Mirror protocol as part of a U.S. Securities and Exchange Commission investigation of potential violations of securities laws, such as the unregistered operation of brokerages and sales of securities outside that bypass regulated securities exchanges. Todd Cipperman, managing principal of Cipperman Compliance Services, which offers services to finance industry businesses, told Forkast.News: “Terraform and Kwon have almost no recourse but to comply with the SEC.” Nevertheless, industry participants are eager to see Terraform Labs’ next move.

UST’s rollercoaster ride

Adding to the general concern around algorithmic stablecoins, Terra’s UST has had more than its fair share of volatility.

On May 9, 2022, UST started de-pegging from the US dollar, dropping to US$0.72 by the end of the trading day. Part of the reason UST lost its peg was due to highly volatile markets and macroeconomic conditions — which also caused Tether’s USDT to briefly de-pegg, before burning 3 billion tokens to stabilize.

According to Terra founder Do Kwon, the deviation was caused by the network’s price stabilization mechanism absorbing over 10% of UST supply, which widened the on-chain swap spread to 40%, driving down LUNA prices in the meantime.

On May 11, Kwon shared a recovery plan for UST, stating that “the only path forward will be to absorb the stablecoin supply that wants to exit before $UST can start to re-pegg.” Consequently, Kwon endorsed the community proposal 1164 to increase the daily minting capacity from $293M to ~$1200M, to help the network absorb the UST supply quicker.

That didn’t work. UST plunged to US$0.17 on May 13, according to data by CoinMarketCap.

The UST crash led to speculation that it was attacked by short sellers. One theory said asset managers Blackrock and Citadel borrowed 100,000 Bitcoin from crypto exchange Gemini to short UST. Cardano founder Charles Hoskinson shared an image describing this hypothesis, subsequently deleting his tweet when Gemini denied it had made such a loan.

At press time, UST was trading at US$0.17. The blockchain has now shut down and is no longer producing blocks at the time of writing.

What the future may hold

Terra is a permissionless, decentralized, programmable payments network. The protocol offers low-cost payments and transactions for online vendors and their customers. Terra’s open infrastructure is also well suited to dApps, creating a budding ecosystem around the protocol.

Terra has signed partnerships with more than 15 e-commerce companies, including Tiki, Qoo10, Carousell and Woowa Brothers. Other partners include mobile payment service CHAI and financial services company BC Card.

Terra has also set up a US$150 million ecosystem fund led by investors such as Arrington Capital, BlockTower Capital, Galaxy Digital, Hashed and Lightspeed Ventures. Developers can openly submit proposals to the fund, which it is hoped will accelerate the ecosystem’s development.

Terra’s most anticipated update, the Columbus-5 mainnet upgrade — also known as “Col-5” — aims to introduce the burning of seigniorage fees, integrate mutual insurance protocol Ozone, and integrate the Wormhole Token Bridge — enabling easier tokenized asset transfers between Terra, Solana and Ethereum. 

Terra currently has US$12.9 billion in total value locked across the ecosystem’s protocols. Terra’s strategy to create an interoperable, user-friendly payment platform may make it an attractive alternative for crypto beginners, subject to the still-emerging list of risks and caveats associated with the stablecoin space.

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