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What You Need to Know About Terra (LUNA, UST)

DeFi

Though known for its stablecoin UST, Terra is an emerging L1 blockchain with an ecosystem currently focused on DeFi applications.

At a glance

  • Terra is most well-known for its US Dollar-pegged stablecoin, UST. Though now partially collateralized, UST was one of the most prominent and widely adopted algorithmic stablecoins to-date.
  • That adoption has mostly come via Anchor Protocol, which has showered prospective UST users with rich, lower-risk yields. It is unclear how Anchor becomes more sustainable and what happens to UST adoption afterwards.
  • Terra is focused on building its ecosystem across its L1 chain, which has largely gone overlooked to-date. So far, payments apps like Chai have shown promising outlooks for its viability.

How UST works

UST’s prodigious rise in the last year (Source: CoinMarketCap)

The conceptual model: UST is a “dual coin” algorithmic stablecoin: the first (UST) is pegged to the target price (here: $1 USD) and the second (LUNA) is allowed to fluctuate. Stablecoins use arbitrage to expand or contract the supply of the two coins to ensure the stable remains pegged. Read: What You Need to Know About Stablecoins

Terra provides a function that allows users to trade in $1 worth of LUNA and receive 1 UST, and vice versa. This allows UST supply to change as needed for UST to reach $1.

The invisible hand: Using this mechanism, arbitrage helps keep UST at $1:

  • If UST is at $1.01, you can trade in $1 worth of LUNA and receive 1 UST, netting you $0.01 profit and expanding the UST supply to meet the new demand. LUNA supply shrinks and price increases.
  • If UST is at $0.99, you can trade in 1 UST to receive $1 worth of LUNA, netting you $0.01 profit and contracting the UST supply to meet the new demand. LUNA supply expands and price decreases.

Implication: You might notice that if UST continues to grow in popularity, more LUNA is burned, which increases the price of LUNA. If you wanted to bet on the growth of UST, you’d buy LUNA. For LUNA to keep increasing in price, UST issuance has to continue growing or demand for LUNA via its blockchain has to go up.

Newly partially collateralized: History shows the difficulty algorithmic stablecoins face in maintaining peg. In March 2022, Terra announced it will be buying $10 billion worth of Bitcoin. In emergency situations, users will be able to trade UST for Bitcoin, which helps UST maintain its value at $1.

Anchor Protocol

Given two stablecoins with the same stability and utility, you wouldn’t have a preference between the two. But if one of them gave you 20% interest, you’d jump at using it.

UST’s success to-date is due to Anchor Protocol, where you can lend and borrow UST. At time of writing, Anchor offers you 20% (!) if you deposit your UST and charges you 11% if you want to borrow.

Cash reserves of Anchor Protocol from Feb ’22 to Mar ’22 (Source: Mirror Tracker)

Expensive marketing: If your nose is telling you the math doesn’t seem sustainable, you’d be right. Anchor pays out more than it earns, requiring a $70M infusion of cash in July 2021 and another $450M in February 2022. This is a marketing cost for Terra – in that timeframe, UST has gone from ~$1 billion in market cap to over $10 billion.

The takeaway: Terra needs to decrease its reliance on Anchor. Cash infusions can last a while, but they won’t last forever, as shown by recent Anchor proposals to manage the burn. Expanding the Terra ecosystem and adoption of UST across all chains is critical.

What’s exciting: ecosystem and other stables

Though often underreported, Terra is a fully-fledged L1 blockchain, and its ecosystem expansion will be critical to watch. Teams are mostly deploying DeFi protocols, with some looking at NFT-related functionality. Terra will face the same challenges and opportunities as any L1, though more similar to a Cosmos or Osmosis, given Terra’s connection to the IBC.

While UST is Terra’s most well-known stablecoin, it’s worth noting that Terra has other stablecoins pegged to various currencies: TerraCNY, TerraJPY, TerraGBP, TerraKRW, TerraEUR. For other geos, it has TerraSDR, pegged to the International Monetary Fund’s reserve asset called Special Drawing Rights.

Chai, a payments app using Terra stablecoins, is Terra’s most significant protocol, with 2+ million users in South Korea and recent launches in Vietnam and Thailand. As a user, you pay using fiat (e.g., Korean Won), but the transfers are handled using Terra stables (e.g., TerraKRW) on the backend. The Chai and the Terra payments ecosystem could be a real barometer for payments as a “clear winner” use case for crypto.

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