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How does Terra (LUNA) work?

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INTRODUCTION

Terra, in its basic form, is a payment system. It's system is supported by several stablecoins, backed by fiat, and by algorithmic stabilization are pegged to a set fiat value through utilization of the LUNA token to manipulate supply. Huh? Well, the purpose of this subsection of the Terra (Luna) Coin Guide is to try and cut through all the techno-babble and give you a clear, simple, and concise presentation into how Terra (Luna) works.

*HOW DOES TERRA (LUNA) WORK?

To better understand how Terra (LUNA) works, it is better to break it into it's component parts and examine each separately:

  • *WHAT IS TERRA?

    • "Terra is a blockchain protocol that uses fiat-pegged stablecoins to power price-stable global payments systems. According to its white paper, Terra combines the price stability and wide adoption of fiat currencies with the censorship-resistance of Bitcoin (BTC) and offers fast and affordable settlements". [CoinMarketCap. "Terra-Luna". (Accessed August 18, 2021)].
    • "Terra stablecoins are the 1st stablecoins that are decentralized, scalable, yield generating, and inter-chain. TerraUSD, TerraKRT, TerraMNT are stablecoins built on the Terra blockchain. While TerraUSD is new, TerraKRW has a successful track record in South Korea and TerraMNT in Mongolia". [Sekharan, T. "What is Terra (LUNA)?". (Accessed August 18, 2021)].
    • Terra also provides other stablecoin products: TerraCNY, TerraJPY, TerraGBP, TerraKRW, TerraEUR, and the International Monetary Fund’s TerraSDR
    • "Chai is Terra’s e-commerce focussed payment gateway that allows a seamless user experience to customers who themselves have no direct exposure to cryptos....In the front end, it is like any other credible payment gateway that integrates with the top 15 Korean banks. On the backend, it uses Terra’s blockchain to service merchants who enjoy the benefits of substantially quicker settlement times (6 seconds) and lower costs (0.5-1.3%) than traditional payment systems". [Id.].
    • Anchor is Terra's application that allows for staking in Proof of Stake networks with the goal of earning a staking reward (transaction fees and block creation payments) as earnings yield. In essence, Anchor is Terra's savings hub protocol.
    • Mirror is Terra's protocol that offers investors access to the US Stock Markets by providing tokens that 'mirror' the underlying base US stock. Mirror operates in much the same way as its competitor, Synthetix. However, the Terra 'Mirror' protocol is much more of a capital efficient system than Synthetix as Mirror uses TerraUSD as collateral in lieu of SNX, with the former providing a higher degree of stability. In this manner, Mirror applies a 150% collateralization rate, far lower than Synthetix 750% rate.
  • *SUMMARIZING TERRA

"Terra was built using Cosmos blockchain technology and is designed to challenge incumbent retail payment apps. As a comprehensive end-to-end payment solution, Terra manages to circumvent the entire existing fragmented payment infrastructure. This model allows Terra’s technology to potentially save payment service providers hundreds of millions of dollars per year". [Cryptopedia. "Terra (LUNA): A Stablecoin-Powered Payment Platform". (Accessed August 18, 2021)].

  • *WHAT IS THE LUNA TOKEN USED FOR?

The LUNA token is the native token of the Terra protocol. The LUNA token is essential to the Terra ecosystem as the same provides security for the network through staking, governance, and most importantly, LUNA provides the mechanism responsible for holding the Terra stablecoins at peg.

*Security and Governance

The Terra ecosystem consensus runs on Tendermint, and as such, a number of validators secure the network (by the number of LUNA tokens they own plus the amount delegated to them by stake). The Terra protocol is based on a Delegated Proof of Stake (DPoS) consensus. The Validators run full network nodes and the Validator's work product not only provides for network consensus but also provides adding new blocks to the network for which they are compensated in LUNA tokens. So, for governance purposes, the weight of the Validator's vote is dependent upon the amount of the Validator's stake plus the sum of tokens delegated to them.

*Stabilization of Stablecoin Prices to Peg

Terra's stablecoins are all pegged in value to specific fiat currencies. As these stablecoins are intended to be used for e-commerce, it is essential that they retain a specific constant value. This stabilization in the Terra network is achieved by adjusting the supply of the stablecoin in question appropriately to fluctuation in demand that moved the value from peg. This is best explained (and understood) by way of example. Using TerraUSD as the example, we find:

TerraUSD is pegged 1:1 against the US$. The stabilization of TerraUSD is controlled by the native currency of the Terra blockchain, LUNA. Terra’s algorithm brings TerraUSD back every time it deviates from its peg by either minting or burning coins.

If the value of TerraUSD falls to say 0.98, then arbitrageurs will have the option of selling 1TerraUSD (worth $0.98) and receiving $1 worth of LUNA in exchange. On the backend, the protocol will mint new LUNA to pay the arbitrageurs and burn the TerraUSD sold by arbitrageurs which would reduce the total supply of TerraUSD. In other words, the drop in value of TerraUSD will be absorbed by LUNA holders as the total supply of LUNA will increase.

If the value of TerraUSD rises to say $1.02, then arbitrageurs will have the option of buying 1 TerraUSD (worth $1.02) for $1 worth of LUNA. The protocol will mint more TerraUSD increasing the supply. On the backend, the LUNA paid by arbitrageurs will be burnt. In other words, the increase in the value of TerraUSD will accrue to LUNA holders as the total supply of LUNA will fall.

[Sekharan, supra.].

From this example we conclude that price stabilization is achieved as a function of balancing the value of currency on one hand and collateral on the other, with the balance being met through the exchange of the two. This seigniorage model used by Terra is dependent on swift reaction by arbitragers to system price deviations and market supply/demand imbalances.

*CONCLUSION

Growth and expansion of the Terra (LUNA) ecosystem into a worldwide payment processor is key to its continued success. At the time of the writing of this subsection a price pump of Terra (LUNA) tokens is underway over recent days. As more businesses agree to utilize Terra's payment system, and expansion into more specific fiat based stablecoins continues, the future for Terra (LUNA) is indeed very bright.

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