What are LUNA and UST? A Guide to the Terra Ecosystem

Published on 09/May/2022 21:11

TerraUSD (UST) and LUNA tokens have been making waves in the crypto market lately. Here's why.

Luna (LUNA) and TerraUSD (UST) are two native tokens of the Terra Network, a blockchain-based project developed by Terra Labs in South Korea.

What is LUNA?

According to Terra's white paper, the founders' goal was to fulfill what Bitcoin was originally intended to be: an electronic peer-to-peer cash system. To achieve this, Terra uses a system of stablecoins - cryptocurrencies whose value is linked to various assets such as commodities or fiat currencies.

UST is by far the most popular of these and is pegged to the price of the U.S. dollar, with one UST token close to the $1 mark. The peg to the dollar is achieved by using the ecosystem's other token, LUNA.

LUNA plays an important role in maintaining the price of Terra stablecoins, reducing market volatility so that they remain stable (see below).

The price of the LUNA token has seen an astronomical rise over the past year. In 2021, LUNA was trading at $0.66 and closed the year at $89. It subsequently reached its all-time high of $104.58 on March 9, 2022, at a time when most other cryptocurrencies fell in lockstep with global capital markets, catalyzed by the Ukrainian invasion crisis.

From relative insignificance, UST has grown to become the fourth largest stablecoin behind Tether (USDT), USD Coin (USDC), and Binance USD (BUSD), reaching a market capitalization of over $15 billion.

What is UST and how does it work?

Stablecoins are a specific type of cryptocurrency whose price is usually pegged to a government-issued fiat currency like the US dollar. What sets stablecoins on the Terra blockchain apart from others is the method they use to keep the price stable.

Rather than relying on a reserve of assets to maintain their peg, as is the case with USDC and USDT, Terra assets represent algorithmically stabilized coins. This uses a smart contract-based algorithm to maintain the price of TerraUSD (UST) at $1 by burning (permanently destroying) LUNA tokens to mint (create) new UST tokens.

How does this actually work?

It has everything to do with arbitrage. This usually refers to making small profits by finding discrepancies between asset prices on different exchanges. In the case of LUNA and UST, however, it works a little differently.

In the Terra ecosystem, users can always exchange the LUNA token for UST and vice versa, at a guaranteed price of $1 - regardless of the market price of the two tokens at the time. This is important to know because it means that if the demand for UST increases and its price rises above $1, LUNA holders can book a risk-free profit by exchanging $1 of LUNA for a UST token (which is worth more than $1 due to an increase in demand in this example).

During the exchange process, a portion of the LUNA is burned (permanently removed from circulation) and the remainder is deposited into a community treasury. The funds in the treasury are then 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 in circulation, making them scarcer and therefore more valuable. By minting more UST tokens, the tokens in circulation are diluted and the overall price drops back to the $1 level.

Similarly, if demand for UST is low and the price falls below $1. Then UST holders can exchange their UST tokens at a 1:1 ratio for LUNA, which are worth more due to their scarcity, allowing the user to book another risk-free profit.

While UST remains the most widely used stablecoin in the ecosystem, there are a number of other stablecoins pegged to various fiat currencies, such as:

TerraCNY (Chinese Yuan)
TerraEUR (Euro)
TerraBGP (British Pound)
TerraJPY (Japanese Yen)
TerraKWR (South Korean Kwon)
TerraSDR (International Monetary Fund)

The SDR of the International Monetary Fund is an outlier among currencies because the ordinary user cannot buy or use anything with it. It is a special unit of account used as an international reserve, calculated from a basket of different fiat currencies from the world's largest economies.

Terra uses TerraSDR to denominate all of its transaction fees, rewards, and funding on the blockchain to minimize price volatility between different government-issued currencies. Finally, a basket of currencies diversifies risk and is therefore less susceptible to wild swings than a single currency - something that is useful when determining stable fee rates and rewards.

How Terra works

The Terra smart contract platform was built on the Cosmos SDK, which is known for its interoperability between chains to communicate with each other. Terra also has bridges to other blockchains such as Ethereum, Binance Smart Chain, Harmony, and Osmosis - allowing for the seamless transfer of data and tokens between non-native ecosystems.

Terra uses the Delegated Proof-of-Stake (DPoS) consensus protocol known as "Tendermint," where token holders can delegate their funds to certified validators-individuals or groups of individuals responsible for proposing new blocks-to secure and add new transactions to the blockchain.

It works much like a House of Representatives or a Parliament in politics. LUNA token holders (like citizens) can delegate their coins to validators (the representatives). The more coins delegated to them (votes in an election), the more power they have to propose new transaction blocks, vote on their validity to earn rewards, and also play a role in managing the blockchain.

The validators are responsible for running the Terra network with a program called Full Node, which validates the transactions and blocks on the blockchain. The software they use for this is Terra Core, and Full Node Validators must run the latest version of it without delays or downtime. They also stabilize the price of Terra stablecoins by balancing any deviation from the peg and voting on proposals to develop the network.

A validator's voting power is weighted by the total number of coins transferred to him for use, including his own coins. This means that those who have the largest stake pool have a higher chance of adding a new block to the chain, and in return for the stake, receive rewards from transaction fees.

LUNA coins can exist in three different states:

Tied: Coins are deposited into or delegated to a stake pool. They are locked to earn rewards and cannot be traded freely.
Unbonded: Coins that are freely traded and not bound to a stake pool.
Unbound: Coins that have been withdrawn from staking or delegating. The process takes 21 days and cannot be canceled during the waiting period.

What you can do with Terra

Terra was created as a global, user-friendly electronic money platform. It was first used by South Korean e-commerce platforms because it offers cheaper transaction fees than most credit card companies and payment processors.

Transactions incur a calculation fee, usually less than 1% of the value transferred, which goes to validators as a reward. Users can seamlessly pay with Terra Stablecoins and merchants can accept them as a payment method to reduce their costs. More recently, people can use Terra for a variety of additional things beyond payments, including;

Lending
Lending
Insurance
Investing
Charitable causes

Below are some examples of leading applications based on the Terra Blockchain.

Anchor Protocol

Anchor is a decentralized money market built on the Terra Blockchain. It became known for its industry-leading 20% annual return that UST holders can earn when they deposit their tokens on the platform. It works like a regular bank account. Users can borrow and deposit savings to earn a return. The returns, which come from the borrower's interest payments and the use of the collateral they deposit to take out loans, are distributed to the stakers.

Chai

Chai is a Terra Network payment channel that allows users and merchants to send and receive UST.

Chai uses the Terra blockchain to cut out middlemen and offers merchants lower transaction fees than traditional payment processors and credit card companies. It also offers a debit card (Chai Card) that allows shoppers to earn points that they can redeem for above-average rewards at certain merchants. The payment app was launched in South Korea in June 2019 and has millions of users.

Mirror Protocol

Mirror Protocol is a decentralized financial platform (DeFi) that allows users to create and trade "mirrored assets" or mAssets that "mirror" the price of stocks - including large stocks traded on U.S. exchanges. They work like derivatives, allowing you to track the value of an asset without actually buying the underlying asset.

Other notable applications based on Terra include:

Ozone, a decentralized insurance protocol
Pylon, a savings and payments platform
Valkyrie, an on-chain referral marketing service

Why LUNA and UST are so popular right now

The fate of Luna and UST coins is directly related to how successfully Terra stablecoins are able to maintain their price peg in volatile market conditions.

The crypto market downturn that began in late 2021 served as a stress test for the algorithmic peg. The UST/Luna duo performed well, staying within $0.998 and $1.006, even as broader digital asset markets experienced wild price swings.

UST gained the trust of the decentralized financial community (DeFi) as a truly decentralized stablecoin that does not require a central organization to ensure sufficient reserves to support the price. Stablecoins play an important role in the DeFi community through stakes, liquidity management, and revenue generation. While competing stablecoins have come under criticism for their opaque reserves, this issue does not arise with UST as LUNA is burned and minted to absorb volatility. UST's market cap exploded in November 2021, starting the month at less than $3 billion and rising rapidly to reach a market cap of more than $15 billion in March 2022, according to data from CoinGecko.

UST's growth is also fueled by new applications and users joining the network. For example, the Anchor protocol reached a total value of more than $15 billion within a year, according to data from DefiLlama. Chai reportedly surpassed 2.5 million users in January 2021, bolstering transactions with Terra stablecoins.

Risks associated with LUNA and UST tokens.

Algorithmic stablecoins are a relatively new way of tying cryptocurrencies to a fiat currency. As a result, they have yet to prove their worth, as we have yet to see how they perform in the face of major market stresses or shocks. A research paper published by the University of Calgary concluded that algorithmic stablecoins are "inherently fragile" and "are not stable at all, but are in a state of constant vulnerability." The Federal Reserve's research on the stablecoin market points out that design flaws can lead to de-pegging, as evidenced by the bumpy launch of Fei - an algorithmic stablecoin that temporarily collapsed after its April 2021 launch.

With stablecoins, there are always questions about whether issuers have enough collateral to back the price and what assets guarantee the value of the coins. Algorithmic stablecoins have no collateral by design - the collateral is their governance tokens, which can be minted or burned to stabilize the price. If the design proves flawed, the value of the coin can drop without collateral.

Singapore-based Luna Foundation Guard (LFG), a non-profit organization dedicated to developing the Terra ecosystem, addressed concerns by putting $1 billion in Bitcoin as a reserve asset behind stablecoins.

It's worth noting that stablecoins, like decentralized finance, are still largely unregulated around the world. How nation-states decide to regulate this part of the crypto market and what rules issuers must follow also poses a risk to the future value of your money invested in LUNA or UST. For example, the U.S. Securities and Exchange Commission has subpoenaed Terra's CEO, Do Kwon, in connection with the Mirror Protocol to offer derivatives on stocks such as Apple (AAPL) or Tesla (TSLA). Do Kwon and Terraform Labs are challenging the SEC in court.