The Moonshot that is Luna
This report assumes the reader has a basic understanding as to the workings of the Terra ecosystem. If unfamiliar, I have posted a separate article detailing the Terra/Luna ecosystem.
Intro
Terra is an exciting and ambitious project spearheaded by Do Kwon and Daniel Shin who set out to create a crypto native ecosystem that incorporated many of the innovative and unique facets of DeFi, without overwhelming the end-user as to the complexities of blockchain technology.
The Terra ecosystem mirrors that of a traditional bank through its suite of product offerings which facilitate payments, transfers, investments, loans, and savings but in a decentralized, permissionless way that is fully automated. As Terra utilizes blockchain technology, it is completely transparent, community-owned/governed and accessible to anyone with an internet connection (imagine if your local bank was like that). Luna, as the native crypto asset of the ecosystem, is essentially the blood flowing through Terra, supporting all its functions and helping it grow.
Stablecoins
Terra’s initial product offering was to introduce a basket of decentralized, fiat pegged stablecoins such as the UST (pegged to USD) that are algorithmically rebalanced via an elastic supply method where the circulating supply of tokens expands or contracts as a function of dollar demand. The variation in demand leads to the stablecoin deviating from its peg, requiring a rebasing to push it back towards equilibrium which is achieved through the use of Terra’s native asset, Luna. TerraUSD (UST) is as such, an algorithmic stablecoin.
Luna
Luna, as the lifeline of the Terra ecosystem helps maintain the stablecoin peg to the dollar by an arbitrage mechanism. Whenever UST trades above the peg, users can send $1 dollar worth of LUNA to the system and receive $1 worth of UST, which can instantly be sold for a profit (spread between market rate and mint rate). Conversely, when UST trades below the peg, users can send 1 UST to the system to receive $1 worth of LUNA (UST and Luna are redeemable at a 1:1 ratio). In both cases, users are incentivized via arbitrage to help maintain UST’s peg to the dollar. While not explicitly stated, LUNA thus acts as an indirect source of collateral for Terra stablecoins.
Aside from serving as a peg stabilizer, Luna has two other major functions in the Terra ecosystem. The first of which are validators/delegators securing the network through the staking of Luna. In doing so, validators are rewarded with the following:
1) Gas Fees: In order to perform transactions on the network, users must pay a small fee denominated in Luna.
2) Stability Fees: Every transaction incurs a 0.1%-1.0% fee (capped at 1 TerraSDR) and paid in any Terra currency.
3) Seigniorage: When Luna is swapped for UST (ie: UST is minted), a certain % of that Luna is burned and recaptured by the community. This process is called Seigniorage and a portion of this value is distributed back to validators that participate in the Luna Exchange Rate Oracle as a reward for accurately reporting oracle prices.
The second function of Luna is Governance. Anyone who has staked their Luna may participate in Terra’s governance process through voting, with voting power proportionally weighted to one’s stake.
Stablecoins, Centralized, Decentralized, Made Up?
Stablecoins offer a simpler approach to handling your fiat currencies on blockchains and hold a theoretical 1:1 exchange rate with its fiat counterpart. The rise of stablecoins, particularly in its use among DeFi protocols, has led to an exponential growth of these assets which have accrued just shy of $100b in total market capitalization (Chart 1).
While 2021 alone saw this figure triple, the majority of this growth was fueled through the rise of centralized fiat-collateralized stablecoins like USDT and USDC which are backed 1:1 by real dollars and held by a single custodial entity. USDT and USDC are the most prominent stablecoins used in the crypto space and make up ~70% of all circulating stablecoins. (Chart 2).
Fiat-collateralized stablecoins offer advantages such as being the most stable (assured peg) and scalable (widely used) offering while also being easily redeemable for fiat. Stablecoins however do come with a specific set of inherent risks due to the way it operates (Chart 3).
These concentrated risks have already manifested into legal trouble for the majors, being USDT and USDC which have both had their history of regulatory run in’s and scrutiny. USDT as recently as January 2020 was indited by the State of New York which launched an investigation into the company’s involvement of market manipulation. Tether now faces its newest challenges with skeptics criticizing it for being un-audited, with no transparency as to how the reserves are broken down and if the supply in circulation is even fully backed (It was recently discovered that Tether does not in fact hold a 1:1 ratio of USD:USDT and claims “commercial paper” backs a portion of its issuance). USDC has seen numerous orders from regulatory bodies issued to it as well, where in April 2021 USDC was forced to blacklist multiple addresses through an order passed down by the Centre Consortium. Even with prior bumps in the road, these stablecoins are viewed as legitimate as they comply with regulations and have seen some real-world adoption (Visa approving USDC settlements). However, an ever-changing legal landscape and calls for tighter regulation could impose a real threat to the operations of these centralized stablecoins.
While crypto-collateralized stablecoins alleviate some of these regulatory issues, they come with their own set of problems (Reference chart above). Crypto-collateralized stablecoins are backed and secured via multi-asset pools. To reduce price volatility risks, these stablecoins are often over-collateralized, mainly through the use of other crypto assets, so they can absorb price fluctuations in the collateral. DAI is the most popular crypto stablecoin and has achieved considerable adoption within the Ethereum ecosystem as a decentralized stablecoin, with many DeFi dApps providing useful utility for it. The over-collateralization which is required to mint DAI leads to large capital inefficiencies as users are only able to borrow up to 50% of the value of their collateral, making it difficult to scale and capital intensive. Another issue prevalent with these stables is that the collateral backing them is often highly volatile in it of itself, with Ethereum being the primary use of collateral leading it to be highly susceptible to exogenous market-wide shocks (Chart 4).
As of recently, the volatility experienced within these stables has been greatly reduced due to the incorporation of fiat-backed stables as collateral, with 52% of all circulating DAI now being collateralized by USDC¹. The introduction of USDC as collateral draws some of the decentralized aspects away from the initial value proposition of crypto stablecoins. Currently, all other crypto stablecoins that hold no centralized, fiat stables as collateral have failed to maintain their pegs.
UST (TerraUSD) can be categorized as a non-collateralized algorithmic stablecoin as it does not house other crypto assets or fiat to absorb volatility to maintain its peg, but rather achieves its peg through market efficient arbitragers. UST, when compared to the other majors, offers a true source of decentralization and censorship resistance, a hallmark of crypto’s ethos. While its creation is highly experimental and relatively nascent, UST has performed strongly since inception, with only a few instances of peg deviation (Chart 5). The crash of May 2021 saw the UST trade down to $0.94 as a result of cascading liquidations and Luna redemptions. In light of these events, the Terra community was quick to propose multiple solutions to minimize these occurrences going forward as well as backstop the peg. Among these solutions came a new partnership with Unslashed Finance which gives users the opportunity to dynamically purchase insurance in the event of peg deviation, where users will be reimbursed should the peg be broken for a specified period of time.
Algorithmic stablecoins come with their own potential set of risks but a major reason as to why Terra has been able to maintain its peg and avoid the so called “Death Spiral” is due to real underlying demand for UST. Terra cleverly incentivizes this demand through its network of applications that all require the use of its stablecoin. As a result, demand for UST has been continually growing since its inception (Chart 6).
When comparing these various stablecoins against one another we see that USDT demand in 2021 has grown by ~195%, USDC demand has grown by ~470%, DAI demand has grown by ~340% and UST demand has grown by ~930%. What’s important to note however is that the increase in UST demand is simultaneously paired with an increase in Luna burns to mint the stables. The rapid increase in the UST market cap since the beginning of the year implies a daily minting of ~$11.4m UST, with an equivalent $11.4m worth of Luna being burnt (151 day window used in calculation, Jan 1/2021 — June 1/2021). Since inception, over 66m Luna have been burnt from the total supply of 1b, representing 6.6% (Luna burns peaked at 110m prior to the May market crash). Additionally, only 130m Luna tokens are liquid out of the current circulating supply of ~410m, as the remaining 68% of tokens are currently being staked in the network (Chart 7).
Where Does This Demand Come From?
As noted by Robert Sams of Clearmatics on the subject of algorithmic stablecoins:
“Ultimately the ingredients for stability require an incentive-compatible mechanism, but you also need an ecosystem of usage, meaning organic demand that wants the stablecoin: no mechanism alone is going to bootstrap that”.
The vast majority of attempts to create non-collateralized stablecoins have either failed or remain theoretical, mainly because of the design complexity in the bootstrapping phase². Terra took a novel approach to this challenge by creating an ecosystem around it to that bootstraps its own community and adoption. Unlike other algorithmic stablecoins which launch with the hopes of being integrated into other protocols to provide utility, all dApps built on top of the Terra network utilize its own stablecoin.
CHAI was the first major application to integrate Terra stablecoins into its existing network of users based in South Korea and Mongolia. CHAI offers the same seamless payment experience as mainstream apps, where users simply add their bank account to pay (ie: Paypal). Payments are facilitated via Terra’s blockchain technology which offers lowers transaction fees and provides instant settlement through the use of Terra stablecoins. CHAI offers significant efficiency advantages to its merchants in terms of cost (0.5% vs 2–3% transaction fees from traditional credit card companies) and speed (instant finality) and has grown to over 2.4m users, or 5% of the South Korean population (Chart 8).
In December of 2020, CHAI received a $60m Series B financing round led by Korean conglomerates Hanwah Investment & Securities, with participation from Softbank Ventures Asia, SK Networks, Aarden Partners, Hashed and more. This Series B comes on the heels of an earlier Series A which was completed in February 2020 which saw $15m in financing raised. The funds will be used to further develop and expand CHAI across Asian markets and to continue the build-out of its product offerings as demand for businesses to adopt online channels continues to grow.
Mirror, as the first true dApp built on Terra, allows users to trade synthetic assets (Mirror Assets, aka”mAssets”). These assets are fungible assets that reflect or ‘mirror’ the price/ value of real-world assets without the user actually having to own the underlying itself (ie: stocks, ETF’s, etc). Mirror Assets are ‘minted’ and created in a decentralized manner by users of the protocol by depositing and locking up >150% of the current asset value via Terra stablecoins (ie: UST) or other mAssets as collateral. If the value of the asset rises above the collateralization threshold, the collateral is liquidated to guarantee the solvency of the system. To ‘mirror’ the price of the underlying asset, the protocol reads prices via the Band Protocol (A decentralized data oracle) every 30 seconds. The use of this protocol allows users to trade these synthetic assets 24/7, without capital restriction, censorship from centralized exchanges, or geographical restrictions/regulations. Since its launch, Mirror has accumulated considerable volume on its platform (Chart 9).
The popularity of the protocol since inception has also seen its Total Value Locked (TVL) continually rise (with the exception of the may market crash) as the use and popularity of synthetic assets grows (Chart 10). Additionally, new mAssets are continually voted on via on-chain governance utilizing the MIR token, with successfully approved and voted on assets being added to the platform.
Mirror Assets are currently available on decentralized exchanges on the Terra, Ethereum and BSC blockchains. Further cross-chain support to other large and popular blockchains will be made possible with the use of the Shuttle bridge and future transition to Wormhole, a decentralized bridge to Solana. As the Terra blockchain is built on Cosmos SDK it will also take advantage of the Inter-Blockchain Communication (IBC) protocol and the Stargate upgrade.
Anchor is the 3rd and final major application to have launched on the Terra network. Anchor is the first fixed income protocol that produces a reliable stream of crypto-native returns. By aggregating Proof-of-Stake (PoS) block rewards, Anchor targets a stable and self-regulating interest rate, becoming DeFi’s only source of un-levered debt-free yield. To generate yield, Anchor lends out deposits to borrowers who put down liquid-staked PoS assets from major blockchains as collateral which are interest bearing. Anchor’s yield is thus powered by the block rewards of major Proof-of-Stake blockchains.
Anchor functions similarly to how a traditional bank does, facilitating the flow of money via lenders and borrowers. Lenders, being users who deposit their stablecoins (ie: UST) on the platform to earn yield and borrowers, being users who borrow stablecoins (ie: UST) and deposit collateral in the form of bonded assets (bAssets) against the loan (has to be a yield generating asset which is deposited, ie: staked PoS assets). When a lender deposits UST on the Anchor Protocol, the lender receives aUST (Anchor Terra) which represents a claim to the deposit + interest. Currently, there is no utility for the aUST token except that it can be used to redeem the principal and interest amount earned on it. The loan can remain outstanding as long as the user maintains a minimum Loan-to-Value (LTV) ratio, usually being 50% (ie: loan can only be max 50% of collateral value). See Chart 11 for a walkthrough of how Anchor functions:
Anchor’s overarching vision is to become the “Stripe of Savings” for the DeFi ecosystem. One future implementation is to incorporate Anchor into other payment apps or ecosystems to give a broader user base access to these stable yields. CHAI could be one of those implementations where merchants could leave excess cashflows in Anchor to earn passive yield. Additionally, with the launch of Mirror 2.0 in May 2021, users can now use their aUST tokens as collateral for minting mAssets, brining further utility to Anchor. Since inception, Anchor has accrued over $600m in TVL, ~$200m of which is via deposits (UST) and ~$400m of collateral (Luna). (See Chart 12).
Use-cases for UST were non-existent until the launch of Mirror in December 2020 and then Anchor in March 2021. From these two native Terra applications and the integration of payment merchant CHAI, UST has catapulted in market capitalization from nothing to ~$2B, becoming the 5th largest stablecoin and largest algorithmic stablecoin whilst only having liquidity on 8 exchanges compared to Tether’s 361 (Uniswap is its most liquid exchange). While still in its infancy, Terra’s vision is to build out the largest network of dApps and e-commerce partners that will facilitate and usher a new era of modern finance on the blockchain. Terra has a large list of up-and-coming projects looking to deploy on its network over the next year which should continue to drive demand for UST (and Luna through association) as users gain access to a broad range of financial products and services (Chart 13). Terra is thus able to continually facilitate demand for UST by building out an ecosystem of products around it.
Columbus 5, Like the Sailor?
Terra plans to release its newest mainnet upgrade, Columbus-5 which is tentatively scheduled to come online late Q2/Early Q3 2021. Among the proposed updates, a major feature is a refined seigniorage distribution model that further tightens the supply of Luna. In this new model, the recaptured Luna value currently earned through UST minting will be fully burnt and no longer re-routed to the community and oracle reward pools, inherently reducing the overall supply of Luna. As the maximum supply of LUNA is 1 billion tokens(Issued at genesis), it now becomes more deflationary as Luna value recaptured via seigniorage is completely removed from the supply. As the demand for Terra stablecoins grows, the circulating supply would only continue to reduce over time. Additionally, Columbus-5 mainnet upgrade will also see a portion of community funds being used to finance the build-out of Osmosis Zone (An AMM DEX set to launch on Cosmos) allowing for any connected blockchain in the Cosmos ecosystem to swap for Terra assets. With the recently approved Cosmos Inter-Blockchain Communication (IBC), pending integration into Solana’s Wormhole Bridge (Will Connect Ethereum, Solana and Terra) and the upcoming Columbus-5 upgrade, UST will become accessible to previously isolated blockchains
Analysis
When analyzing currencies, economists often times look to the velocity of the currency itself to gauge whether users are saving or spending their money. Velocity refers to the frequency at which one unit of currency exchanges hands. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy and vis-versa. In his 2014 paper titled, “A Simple Macroeconomic Model of Bitcoin” Joseph Chen-Yu Wang of Bitquant Research Laboratories explored the notion of Fisher's equation as it pertains to the value of cryptoassets via the relationship between money supply and its price level. The implication of his model concluded that the value of a cryptoasset has an inverse relationship with velocity, mainly, high levels of velocity lead to lower cryptoasset valuations. Wang determined that the price of BTC is determined solely by the likelihood that BTC will be saved (ie: low velocity).
This notion was again re-iterated by Vitalik Buterin in his 2017 paper “On Medium-of-Exchange Token Valuations” where he noted that the value of a cryptoasset “depends crucially on the holding time” of the token and argues for token sinks — mechanisms which reduce the token supply or token velocity.
Monetary velocity is an important output to measure because it captures how economic participants are using the money in circulation. Put simply, the velocity of money and demand for money are inversely related as velocity is a byproduct of how a currency is being used. If velocity is very low, then one would deduce that most participants have a bias to hold on to their money. Conversely, if velocity is very high then one would assume that most participants would rather spend their money than hold on to it.
Stablecoins within the crypto universe currently see high levels of velocity (Chart 14).
Whereas Terra stablecoins on average, display a lower velocity (Chart 15).
The idea of token sinks, as coined by Buterin, is an important aspect to consider as Terra native Anchor will act as the largest token sink in the ecosystem due to its predictable, fixed yield nature. Anchor can be viewed as counter-cyclical to the broader DeFi ecosystem as users can park/save their funds (ie: UST) in the protocol to earn a steady yield while adding an additional layer of diversification to their portfolios (Fixed-Income). Up and coming projects such as Orion also aim to leverage and build upon the Anchor protocol, offering users more variety in its services. The release of Anchor’s SDK will allow for traditional depository institutions and corporates the ability to seamlessly integrate with the protocol and earn steady yield on cash reserves, greatly magnifying UST demand in the process should this manifest. Currently, ~26% of all UST outstanding is deposited in Anchor. As such, with the low money velocity of UST users will be forced to mint more and more dollars due to its inherent low turnover nature, thereby also increasing the amount of Luna burnt as a by-product.
The implications of continuous UST minting also imply continuous Luna burning. As Luna is a fixed supply asset, this acts as a deflationary force due to the inherent seigniorage burn mechanism. Taking a look at a recent example, Terra’s Anchor protocol launched March 16th, 2021. The subsequent 2 weeks following its launch saw UST market cap increase from ~$1.14b to ~$1.62b, implying an average daily mint of ~$34.2m UST. Referencing Chart 7 from above, we can see that Luna’s current liquid circulating supply sits at ~130m tokens. Carrying forward the assumption that we will see similar mint rates as new projects launch, paired with its current liquid supply, we can begin to extrapolate some interesting insights. Using Luna’s current price of ~$5/USD and an implied ~$35m daily mint of UST, we see that the current liquid supply would run out in a mere 19 days. Under a much more conservative $5m/day UST mint at current Luna prices, we see supply would evaporate in 130 days. Exploring these results against various other scenarios, we can see a range of potential outcomes as to when Luna’s current liquid supply might run out (Chart 16).
All things equal, a big pickup in UST demand will force the price of Luna upwards as the liquid circulating supply decreases. With a current Fully Diluted Market Cap (FDV) of ~$5b, Terra and subsequently UST, should be poised for growth as the ecosystem continues to onboard new high-quality projects. If you believe decentralized stables will continue to gain market share and will rise in popularity amidst a truly decentralized narrative then look no further than Terra. Terra as the 3rd largest Layer 1 blockchain by Total Value Locked (TVL) offers great asymmetric risk/reward opportunities via its deflationary Luna token that currently has limited liquid supply available in the markets. The network is also among the cheapest Layer 1’s by dollar value ($) when comparing its TVL/FDV against other blockchains(Chart 17 + Chart 18).
Conclusion
Terra is a unique algorithmic stablecoin that is able to maintain peg via natural market forces and self-sustain through its native applications and network of partnerships through Terra Alliance that drive demand for its currency (Partnered with big-name E-Commerce corporations in South Korea). What most algorithmic stablecoin projects fail to achieve is to create organic demand for their stablecoins as they are too reliant on other projects for adoption and integration. If there is no demand other than speculation and liquidity mining rewards, de-pegging will eventually occur once high yield APYs diminish. No matter how complex the design mechanics are, there is no use case if no one uses it (ex: FEI)³. As the only true decentralized algorithmic stablecoin in the top 5 by market cap, Terra’s resilience and success has been well proven to date and as more and more projects look to launch in the upcoming months, we can conservatively expect to see more UST minted as users look to interact with these new various product offerings.
Written by Patrick Meister, June 25th 2021
This article does not constitute Financal/Investment advice but is rather an expression of my own thoughts and opinions
1. Tim Sawnson, https://twitter.com/ofnumbers/status/1404480471455633411
2. The Block Research Stablecoins: Bridging the Network Gap Between Traditional Money and Digital Value
3. Benjamin Hor,Understanding the Biggest Algorithmic Stablecoin: UST by Terra, CoinGecko
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