Terra Ecological Guide: Understanding Luna and UST in one article

"UST has gained the trust of the DeFi community. It is a veritable decentralized stable currency that does not require a central management agency to ensure sufficient reserves to support prices. Stable currencies play a role in DeFi through pledge, liquidity management and yield generation. important role.”

Cover source: Terra

Article author: CryptoMonster

01. What is Terra?

Terra is a blockchain project developed by Terra Labs in South Korea. Luna and TerraUSD (UST) are the two original tokens of the Terra network.

Terra is a blockchain based on the Cosmos SDK. Cosmos SDK is a framework on which developers can create custom blockchains and build their own Dapps for various scenarios on Terra.

So far, the Terra ecosystem has covered more than 100 original creation projects, including NFT series, DeFi platforms, and Web 3 applications.

Terra ecological map

The Terra ecosystem was founded by Do Kwon, a former Stanford computer science graduate. The current Terra ecosystem is in a trend of rapid growth. Among them, the market value of UST has grown from US$180 million in early 2021 to nearly US$15 billion in March 2022, while the price of LUNA has soared 138 times.

Additionally, the Washington Nationals announced in February a five-year sponsorship deal with Terra’s DAO organization worth $40 million. It is said that the baseball team plans to choose UST as the payment method in the future.

02. What is Luna?

From Terra's white paper, we know that the founders aimed to realize the original goal of Bitcoin: a peer-to-peer electronic currency system. To achieve this, Terra has created a stablecoin system. The value of stablecoins is pegged to different assets such as commodities or fiat currencies.

UST, the most popular of these stablecoins, tracks the price of the U.S. dollar so that the value of the UST token hovers around the $1 mark. UST is pegged to the U.S. dollar by using LUNA, another currency in the ecosystem.

Luna plays a vital role in maintaining the price of the Terra stablecoin, while also reducing market volatility and keeping it stable (see below).

Last year, the price of the LUNA token experienced a huge surge. In 2021, LUNA traded at $0.66, ended the year at $89, and then reached an all-time high of $104.58 on March 9, 2022; meanwhile, most other cryptocurrencies are tied to global capital due to the Ukraine crisis The markets are in a downtrend.

Among relatively unpopular currencies, UST has become the fourth largest stable currency after USDT, USDC and BUSD, with a market value of more than 15 billion US dollars.

03. What is UST? How does it work?

Stablecoins are a special type of cryptocurrency, and what makes them unique on the Terra blockchain is the way their prices are usually pegged to a state-issued fiat currency such as the U.S. dollar, thereby maintaining price stability.

Unlike USDC and USDT, which rely on asset reserves to maintain price stability, Terra assets are algorithmic stablecoins. Terra assets will use a contract-based smart algorithm to permanently burn LUNA tokens to mint new UST tokens and fix the price of UST at $1.

So, how does UST work?

The whole operation process is a process of arbitrage, which generally refers to the process of earning small profits by discovering the price difference between assets on different exchanges. However, as far as LUNA and UST are concerned, it works slightly differently.

In the Terra ecosystem, users can exchange one LUNA token for UST at a guaranteed price of $1, and vice versa, regardless of the token’s market price at the time.This is notable because it means that if demand for UST increases and its price grows above $1, then LUNA holders can earn one UST token by exchanging $1 of LUNA (in this case, due to demand increases, and its value exceeds $1), thereby making a risk-free profit.

During the swap process, a certain percentage of LUNA is destroyed, and the rest is deposited into the community treasury. Funds from the treasury will then be used to invest in applications and services that expand the utility of the Terra ecosystem.

Burning a certain percentage of LUNA tokens will reduce the number of tokens remaining in circulation, so LUNA tokens will be more scarce and therefore more valuable. By minting more UST tokens, the existing tokens in circulation can be diluted, bringing the overall price back down to the $1 level.

Similarly, if demand for UST is low and the price drops below $1, UST holders can exchange UST tokens for LUNA tokens at a 1:1 ratio, which is more valuable due to the scarcity of LUNA, Therefore, users can earn risk-free profits among them.

While UST remains the most common stablecoin in the ecosystem, a range of other stablecoins can be pegged to various fiat currencies such as:

• TerraCNY (Chinese yuan)
• Terra EUR (euro)
• TerraBGP (British pound)
• TerraJPY (Japanese yen)
• TerraKWR (South Korean kwon)
• TerraSDR (the International Monetary Fund)

The IMF's SDR is one of the outliers, as everyday users can't use or buy anything related to it. The SDR is a special unit of account used as an international reserve asset denominated in a basket of fiat currencies of the world's largest economies.

Terra denominates all transaction fees, rewards, and incentive donations on the blockchain through TerraSDR, minimizing price fluctuations between currencies issued by different countries. After all, a basket of currencies can diversify risks, is more stable than a single currency, and rarely fluctuates violently, which is very useful for determining stable rates and returns.

How Terra works

The Terra smart contract platform is built on the Cosmos SDK, known for its interoperability between blockchains communicating with each other. Terra also builds bridges with other blockchains such as Ethereum, Binance Smart Chain, Harmony, and Osmosis, enabling seamless transfer of data and exchange of tokens between non-native ecosystems.

Terra uses "Tendermint"'s Proof-of-Stake (DPoS) consensus protocol, token holders can delegate their funds to certified validators (individuals or groups responsible for proposing new blocks) to ensure the security of the blockchain, and Add new transactions to the blockchain.

Terra works like a house of representatives or parliamentary politics. Luna token holders (like citizens) can delegate their tokens to validators (House of Representatives), and the more tokens delegated to them (number of votes in elections), the more power they have To propose a new transaction block, get rewarded by voting on its validity, and play a certain role in the governance of the blockchain.

Validators are responsible for running the Terra network using full node programs and validating transactions and blocks on the blockchain. Full node validators are required to use the latest version of the Terra Core software to ensure there are no delays or downtime. Validators can also stabilize the price of the Terra stablecoin by arbitrating any deviations from the peg and vote for relevant proposals for network development.

Validators’ voting power is weighted by the total amount of tokens delegated to them (including their own holdings), meaning those with the largest stake pool have a higher chance of adding new blocks to the chain , to earn staking rewards generated from transaction fees.

Luna tokens can have three different states:

• Bonding: Staking or delegating tokens to a staking pool. Rewards are obtained by locking tokens in the stake pool, which cannot be traded freely.
• Unbound: Tokens that are freely traded and not stored in a collateral pool.
• Unbonded: Tokens withdrawn from staking or delegation. It takes 21 days to complete the withdrawal and cannot be canceled during the waiting period.

04. What can you use Terra for?

Terra has become a global user-friendly electronic cash platform. Terra first won the favor of Korean e-commerce platforms because of its high cost performance (compared with most credit card companies and payment processors, Terra's transaction fees are lower).

The gas fee generated during the transaction is usually less than 1% of the transaction value, and this fee will be given to the validators as a reward. Users can seamlessly use Terra stablecoins to pay, and merchants can also accept this payment method to reduce costs. More recently, people can use Terra for things other than payments, including:

• Lending
• Borrowing
• Insurance
• Investing
• Charitable causes

Below are some of the popular applications built on the Terra blockchain.

Anchor Protocol

Anchor is a decentralized currency market built on the Terra blockchain. If UST holders deposit their tokens into the platform, they can get an industry-leading 20% ​​annual rate of return, which the protocol is known for. Anchor works like a regular bank account, and users can earn income through loans and savings; pledgers will earn returns from borrowers' interest payments and deposited mortgages.

Chai

As the payment channel of the Terra network, Chai supports users and merchants to send and receive UST. Chai will cut out the middleman through the Terra blockchain and offer merchants lower transaction fees than mainstream payment processors and credit card companies. Chai also supports buyers to accumulate points through debit cards (Chai cards), which can be used to redeem large discounts at designated merchants. Launched in South Korea in June 2019, the Chai payment app already has millions of users.

Mirror Protocol

The Mirror Protocol is a DeFi platform that enables users to create and trade "mirror assets" (mAssets), "mirror" stock prices, including mainstream stocks traded on U.S. exchanges. Mirror works like a derivative, allowing you to track the value of an asset without buying the underlying asset.

Other major applications on the Terra platform include:

• Ozone, a decentralized insurance protocol
• Pylon, a savings and payment platform
• Valkyrie, Chain Marketing Services

05. Why LUNA and UST are so popular nowadays

The fate of Luna and UST tokens is directly related to how successfully the Terra stablecoin maintains its price peg amid volatile market conditions.

The cryptocurrency market downturn from late 2021 is a stress test for the algorithmic peg. The price of UST/Luna remained between $0.998 and $1.006 amid wild price swings in most digital asset markets.

UST has gained the trust of the DeFi community. It is a veritable decentralized stable currency that does not require a central management agency to ensure sufficient reserves to support prices. Stablecoins play an important role in DeFi through staking, liquidity management, and yield generation. While the number one stablecoin competitor gets a lot of attention for its private reserves, there is no such problem with UST because UST dampens market volatility by burning and minting LUNA. According to data from CoinGecko, the market value of UST surged in November 2021, rising rapidly from less than $3 billion to more than $15 billion in March 2022.

The onboarding of new applications and users also drives the development of UST. For example, data from DefiLlama shows that the total value locked in the Anchor protocol has exceeded $15 billion within a year. According to reports, by January 2021, Chai users will exceed 2.5 million, supporting transactions with Terra stablecoins.

06. Risks associated with LUNA and UST Tokens

Algorithmic stablecoins are a relatively new method of pegging cryptocurrencies to fiat currencies. They will stand the test of time as we have no way of knowing how they will respond to prevailing market pressures and shocks. A research paper published by the University of Calgary found that algorithmic stablecoins are “inherently destructible” and “in reality are not stable at all, but exist in a permanent state of vulnerability.” The Federal Reserve's research on the stablecoin market shows that design flaws may cause the peg to fail , such as the difficult journey of the launch of Fei, which is also an algorithmic stablecoin, which plummeted instantly after its release in April 2021.

There has been a great deal of scrutiny over whether issuers of stablecoins have sufficient collateral to back the price, and what assets secure the value of these tokens. Algorithmic stablecoins are designed without any collateral. The so-called collateral is the governance token of the stablecoin, which can be minted or burned to stabilize the price. If the design proves to be invalid, the value of the token will drop unguarded.

The Singapore-based Luna Foundation Guard (LFG), a non-profit organization working to develop the Terra ecosystem, has addressed these concerns by adding an additional $1 billion in bitcoin as a reserve asset for the stablecoin.

It’s worth noting that stablecoins, as well as decentralized finance, are mostly still unregulated around the world. How nation-states decide to regulate this part of the cryptocurrency market, and what rules issuers must abide by, poses some risk to the future value of your investment in LUNA or UST. For example, because of the Mirror agreement, Terra CEO Do Kwon received a subpoena from the US Securities and Exchange Commission (SEC) to provide derivative products on stocks such as Apple or Tesla. Do Kwon and Terraform Labs are now battling the SEC in court.