Stablecoin Primer — Terra UST shallow dive
This article is part of the Stablecoin Primer article series Section 4. If you are interested in reading the other articles, check out this post.
Shallow dive format is as follows: Protocol -> Token(s) -> Design Principles -> Key Metrics -> Why use or mint UST?
PROTOCOL
UST is an algorithmic stablecoin that is created and managed by the Terra Protocol. Terra Protocol is a decentralized, open-source blockchain ecosystem whose goal is to make permissionless money accessible and useful to the masses. Terra Protocol believes that decentralized stablecoins can offer a better substitute to fiat currencies, volatile cryptocurrencies, and centralized stablecoins, and proposes that the answer to stablecoins’ mass adoption lay in making them as useful as possible. With a strict focus on use cases, Terra Protocol offers a rich venue of decentralized applications where users can spend, invest, and save their Terra stablecoins. Because what good does money have if you can’t spend it anywhere? With that in mind, we can think of Terra Protocol as a self-sufficient economy (e.g., the US Economy) where users can do a lot with their money.
Another complementary strategy that Terra Protocol leverages to make permissionless money as accessible as possible is to house a variety of stablecoins pegged to different fiat currencies (e.g., TerraUSD to US dollar, TerraKRW to South Korean won). By giving users the ability to seamlessly swap between different Terra stablecoin denominations, Terra allows its users to transact in their local currency and save in stronger currencies. For example, a Korean merchant that receives payments in TerraKRW can instantly convert this payment into TerraUSD at a negligible cost, preserving their wealth in a more stable currency.
In terms of governance, Terra Protocol is governed by a decentralized group of contributors who hold the protocol’s staking token Luna. Similar to Maker’s MKR token, Luna holders vote on ecosystem and monetary policy related proposals as well as taking part in consensus making for the Terra Blockchain.
TOKENS
Two tokens lie at the core of Terra Protocol. The algorithmic stablecoin Terra and the multipurpose staking token Luna. Let’s double click into both.
Terra refers to a pool of algorithmic stablecoins that are pegged to different fiat-currencies, with TerraUSD (UST) being the most popular by far (Terra and UST will be used interchangeably in the rest of this section.) Think of Terra as the consumer-grade end-product of the Terra Protocol. Because Terra is neither backed by any fiat currency nor by any fiat-backed stablecoin, it is completely censorship resistant. While this is a blessing, no stable backing makes price-stability a big challenge. Terra Protocol leverages two mechanisms to achieve stability: decentralized oracle voting and open market arbitrage incentives, which will be discussed in the stability section below.
LUNA is the multi-purpose token of the Terra Protocol that allows things to operate smoothly for the Terra stablecoins. At a high-level, Luna has three interconnected functions:
- Absorbing Terra’s volatility: As UST goes above peg (i.e., $1), Luna is bought from users and burnt, pushing its price up. As UST goes below peg, Luna is minted and sold to users, pushing its price down. This way the supply and thus the price of UST is controlled.
- Staking: Terra is a proof-of-stake blockchain, meaning participants need to prove that they have assets at stake (e.g., Luna) to participate in the operations of the blockchain. More specifically, transactions in the Terra blockchain are confirmed by a set of trustless participants called validators. Validators stake Luna to the blockchain to partake in the consensus process and get rewarded for their participation. Consensus process is basically confirming that transactions on the Terra blockchain are valid and can be finalized. Ordinary users can stake their Luna to validators, taking a pie from the reward validators receive.
- Governance: Governance is the democratic process that allows users and validators to make changes to the Terra protocol by staking their Luna.
If you’re going to remember one thing about Terra Protocol’s tokens, it should be this: The more UST is used (in transactions), the more valuable Luna gets. Every time the Terra economy expands, Luna is burned, driving Luna’s price higher. At the same time, as the number of transactions increase, validators and delegators earn more rewards.
DESIGN PRINCIPLE — STABILITY
Stability of the UST stablecoin is achieved by a variety of mechanisms unique to the Terra Protocol. Let’s review these mechanisms:
Decentralized oracle voting: Terra Protocol’s main target is to keep UST’s value at $1 (and TerraKRW value at 1₩,…). The problem is, Terra is a closed circuit blockchain with no access to external data (e.g., real world data such as the price of the US dollar or temperature in NYC.) If the system relied on a centralized data provider like Bloomberg to obtain price data, it would not be entirely decentralized given a failure in Bloomberg’s data feed would impact the entirety of Terra users. There’s just too much at stake. As a solution, Terra Protocol relies on a decentralized oracle voting mechanism, whereby a set of trustless participants vote on the price data — more specifically, on the correct exchange rate between Luna and different Terra pegs. Similar to the consensus process, participants lock a significant amount of assets to participate in voting and receive a reward for correctly voting on the median price. Basically, this process allows Terra Protocol to bring external (exogenous) price data into the blockchain in a decentralized fashion and the Terra algorithm uses this data to set a target price.
Open market arbitrage incentives: Once the system has a target price, the algorithm compares the price of UST in the system to this target and adjusts its monetary policy accordingly. Basics of demand and supply apply to the UST stablecoin as well. When there is a lot of demand but limited supply of UST, UST becomes more valuable than $1 (e.g., $1.05). To re-peg, the Protocol creates more units of UST and promises that any user that deposits $1 of Luna will receive 1 UST (which is worth $1.05 at that moment.) A user who does that can profit $0.05 by selling 1 UST for $1.05 in the open market. On the flipside, if the demand to UST is too low compared to its supply, UST becomes less valuable than $1 (e.g., $0.95.) To re-peg, the algorithm creates more Luna and promises $1 worth of Luna to any user deposits 1 UST. A user who does that can profit $0.05 by selling $1 worth of Luna in the open market. So the arbitrage incentive lies in the fact that Terra Protocol’s market module always promises the following: regardless of Terra and Luna’s price in secondary markets, if a user deposits 1 UST to the protocol, they will always receive $1 worth of Luna, and vice versa.
Stable staking rewards: In their original whitepaper, Terra Protocol states that “The Protocol is best off when it consistently rewards those who protect it.” So who protects Terra? A group of super users called validators.
By taking part in the consensus mechanism, validators add new blocks containing transactions to the Terra Blockchain. This is important because only via the addition of new blocks, the transactions that users conduct using UST can actually be confirmed and finalized on the blockchain. Basically, no validators, no UST. By taking part in the consensus mechanism, these validators incur expenses such as equipment and time-related costs.
Additionally, validators and delegators (i.e., Users that stake their Luna tokens to validators) incur the costs of a shrinking Terra economy because, when demand to UST falls, the Protocol creates more Luna to absorb UST’s volatility (pulling Luna’s price down.) So validators need to be properly incentivized to protect the Terra economy, both in expansion and contraction phases.
This brings us to the need for stable staking rewards. The rewards validators receive by adding blocks to the Terra blockchain are based on transaction fees contained in each block. And transaction fees are variable. During contraction, transaction fees are usually increased (fewer transactions but higher fee), and during expansion, transaction fees are usually decreased (more transactions at lower fee). By aiming to reward validators both in good and bad times, Terra economy retains its protectors and is able to weather UST’s volatility.
Luna Burn: Similar to the goal of stable staking rewards, Luna burn mechanism ensures that the users and validators that believe and protect the Terra ecosystem are rewarded. As discussed above, when the Terra economy is contracting, the Protocol creates Luna to buy UST off the market, increasing Luna’s supply. In the short-term, this negatively impacts Luna holders (i.e., validators, delegators, and users) because it lowers Luna’s price and eats into their wealth. To offset the impact of Luna creation in contraction, during the expansion phase, the Protocol buys and burns Luna, decreasing Luna’s supply and increasing its price.
Luna Foundation Guard (LFG): In January 2022, the Terra Protocol announced the formation of Luna Foundation Guard. LFG is meant to be a center of excellence for the Terra Protocol with two mandates: 1- preserving the stability of Terra stablecoins, 2- fostering the Terra economy to maintain Terra’s mainstream adoption. Specifically for the first mandate, LFG raised $1 billion in bitcoin via the sale of Luna. LFG’s bitcoin reserve will be leveraged in monetary policy whereby when UST is below peg, this reserve will be used to buy UST off the market (instead of solely relying on Luna creation to do so). While critics argue that the use of bitcoin reserves have made Terra similar to crypto-backed stablecoins, the intended purpose of the bitcoin reserve will only be to protect downside cycles to preserve Terra’s stability. Terra’s Do Kwon recently stated that every time the Terra Protocol grows my minting more UST, a certain % of the profit from minting will be used to buy even more bitcoin, growing LFG’s reserves.
DESIGN PRINCIPLE — DECENTRALIZATION
While reviewing Terra Protocol’s decentralization, we want to understand if there is a single point of failure within the system and how transparent its monetary policy is to the users.
- Decentralized governance: Similar to MakerDAO, Terra Protocol is governed by a decentralized group of community members that hold the Luna token. Community members submit, vote, and implement proposals to improve the Terra Protocol. This ensures that Terra stablecoins are managed not by a central authority.
- Immutable monetary policy: The system’s willingness to respect the target exchange rate irrespective of the market conditions keeps the market exchange rate of Terra at a tight band. This exchange rate is encoded in the blockchain and can not be adjusted or customized for a single party, ensuring that users from around the world can trust and use Terra stablecoins.
- Permissionless money: Terra is not backed by fiat currencies or centralized stablecoins so there is no centralized collateral that can be censored by regulators.
DESIGN PRINCIPLE — CAPITAL EFFICIENCY
Unlike overcollateralized crypto-backed stablecoins, Terra Protocol doesn’t require users to provide any collateral to redeem UST. Not relying on any other cryptocurrencies allows the system to scale as user demand grows.
KEY METRICS
These metrics can be regarded as the high-level vital signs of the Terra Protocol and the UST stablecoin. Flipsidecrypto has a dedicated site on metrics associated with Terra that does a great job on reporting on KPIs — here I’ve handpicked the metrics/graphs that are most aligned with our discussion:
- UST Peg Variance: Shows how well TerraUSD kept its price around the peg. We have already established that, as an algo-stablecoin, UST’s price is more volatile than other centralized-stablecoins and hence the zig-zags in the graph. There are two things to note here however. First, if you look at the y-axis of the below graph, price varies in small denominations. Second, a more granular and actionable analysis would be looking at % percentage of time Terra is above or below peg. I’ll keep that for later
- Cumulative Total Users on Terra: Shows how much the Terra economy grew over time. Remember network effects play a key role in any currency’s adoption. So the more people use Terra, the more value each new participant gets from joining the Terra network.
- LUNA Staked Supply: Shows confidence in the Terra Protocol. Remember staking is essentially locking your assets to contribute in the consensus process of the Terra blockchain and receiving rewards in return. The risk with staking is that staked assets are locked for a duration of time. This means that stakers take the risk of losing their wealth in staked Luna if Luna experiences a sharp decrease in price. Along those lines, more staked Luna shows that people see Luna staking as a less risky process as they believe that Luna’s price is bound to perform well.
- USD Rewards Distribution: Shows how well the Terra Protocol is being protected. Remember rewards are distributed to validators as well as delegators (i.e., users that stake their Luna to validators) in return for the validators’ work. For the Terra economy to be up and running, validators need to be adding transactions to the Terra Blockchain. Without proper incentives though, validators simply will not do so. As can be seen in the blue line below, Terra Protocol does reward validators in a stable manner, ensuring that validators receive required rewards and that the Terra Protocol is operational at all times.
WHY USE OR MINT?
All of this is great, but why would you complicate your life with a seemingly risky algorithmic stablecoin?
Here, I won’t discuss why one should hold UST’s stabilizer Luna token. Although these two tokens should be mostly considered together due to their mutually beneficial relationship, our focus is stablecoins, so UST. So let’s talk about your incentives to use or mint UST:
Use (more applicable to Consumers)
- Permissionless money: if you fear that fiat-backed stables can be regulated and the crypto-backed stablecoins that are collateralized by fiat-backed stablecoins are essentially vulnerable to the same risks, Terra stablecoins are a great alternative monies for both the physical and the virtual world.
- Instant swaps with different currencies: Terra stablecoins can be converted to each other instantly at minimal fees. So users who want exposure to multiple currencies can transact and preserve their wealth in different fiat tracking Terra stablecoins.
- Transact, save, and invest: Terra ecosystem prioritizes making its stablecoins useful for all users. What that means is that, the ecosystem invests in and offers many applications for its users to leverage their Terra stablecoins. The most popular applications are Chai, Anhor, and Mirror, enabling users to conduct low-cost transactions, high-yield savings, and invest in synthetic versions of real life financial assets.
Mint (more applicable to DeFi Participants)
- Arbitrage: If UST’s price is greater than $1.00 (e.g., $1.05), a user can mint UST in return for depositing $1.00 worth of Luna to the Terra Protocol. That user can then sell the newly minted UST on the open market for $1.05, making a profit of $0.05.
- Easier to mint than buying: If a user wants to buy millions of UST to put it in a liquidity pool, it may be easier and cheaper to mint it via Terra Protocol than buying it on secondary markets like crypto-exchanges, which may have a limited supply of Terra stablecoins.
STABLECOIN PRIMER article series
Stablecoin Primer — Intro: Rower and slow cooker
Stablecoin Primer — Section 1: Path to stablecoins
Stablecoin Primer — Section 2: Stablecoin landscape
Stablecoin Primer — Section 3: Stablecoin types
Stablecoin Primer — Section 4: Stablecoin shallow dives — USDT, DAI, UST (you are here), and more
Stablecoin Primer — Section 5: Stablecoins’ future
Stablecoin Primer — Bonus section: Anything missed
Enjoy! Happy to chat further via comments, Twitter, or Linkedin
Special thanks to NEAR Team Grants for making this research possible.
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