An Analytical Look Into the Interdependent World of Terra
Terra provides a decentralised algorithmic stablecoin. To ensure their coin has long term viability, Terra built an entire ecosystem around the stablecoin. The ecosystem currently consists of a payment app (Chai), a savings protocol (Anchor), a synthetic stock market (Mirror) and a bunch more. An insurance protocol (Ozone) is planned to launch soon. Each utilizes Terra’s stablecoin, increasing its demand, which is important — as we will find out later.
Chai — Terra Use Case
Chai is a South Korean e-wallet application that allows its users to pay with Korean Won (KRW). Transactions are processed in the background via Terra’s blockchain and transaction fees are paid to the Terra network (instead of VISA or Mastercard). Settlement time, from vendor to customer wallet, is much faster than with bank accounts, and transaction fees are significantly lower. Chai in numbers:
2.5 million users;
~60K daily active users and a transaction volume in June 2021;
~ 42 million USD (orders of magnitude smaller than VISA & Mastercard, but much more real-world use than many other crypto projects).
I will walk through the tokenomics of Terra, Mirror and Anchor in detail and show that they are quite complex. One might wonder why separate tokens and protocols were used, complicating the design compared to an all-in-one solution. Do Kwon, one of the Terra founders, explains this nicely:
Do Kwon, founder of Terra on decentralisation
To get a more basic intro to tokenomics check out my BanklessDAO post on Bitcoin & Ethereum.
Terra has recently gone through an update to Columbus-5, this article reflects the current Columbus-5 version of the network. You can read here about what changed.
Terra / Luna Tokenomics Breakdown
Terra & Luna tokenomics
Terra (UST) represents the stablecoin. Luna represents the reserve or governance token — used to hold Terra to its peg. The stablecoin is not only used in the Terra ecosystem; bridges have been built to enable usage in other ecosystems like Solana.
The tokenomics due to the inbuilt stablecoin are a bit more complex than those of Bitcoin and Ethereum, but the details below should help explain how it works.
Genesis supply of LUNA
The stability reserve is used to manage the network’s early stability and intervene with injection of Luna where required. If demand increases rapidly, the Terra team can burn Luna from the reserve to supply more Terra (more on this later).
Terra can be pegged to many different fiat currencies. TerraUSD (UST), pegged to the US Dollar, has the biggest market cap and transaction volume. TerraKRW (KRT), pegged to the Korean Won, is used in the Chai payment app. For the purposes of this analysis, we’ll be focusing on UST to explain the mechanics, but the pegged currency is interchangeable with any other Terra stablecoin.
Whenever there is high demand for UST, the protocol market maker offers an arbitrage opportunity through minting Terra. The demand will lead to an increase in the price of UST in the market and it will lose its peg to US Dollar. Arbitrageurs can now trade in Luna for Terra 1:1, allowing them to sell the newly minted UST for a profit at the above-peg market price. Luna on the other hand is burned.
This goes on until sufficient supply has been introduced to bring UST back to its peg.
Compared to the expansion just described, the contraction works the opposite way, allowing arbitrageurs to buy cheap UST on the market and swap it 1:1 for Luna. UST gets burned in the process. This reduces the supply of UST until the peg is back in place.
Contraction can introduce a lot of LUNA and cause its price to drop. The aim of the Terra protocol is to grow via economic, real-world use. Holders believing in this will have to endure short term volatility for long term growth of the ecosystem, adoption of UST, and the increasing scarcity, and thus value, of Luna. If you want to go down the economic rabbit hole of these price dynamics, check out why there is no top floor to the LUNA price elevator.
Validators participate in determining the exchange rate to the fiat currency that Terra is pegged to. An accurate vote is rewarded, inaccurate votes are penalised. Since Columbus-5 the rewards are derived from fees on swaps between different Terra currencies (i.e. UST to KWT).
Transaction fees consist of gas fees and taxes. Gas fees are set by validators, to avoid spamming on the network. Taxes are set by the protocol and can be altered by votes up to a maximum of 1%.
Validators run a full node and sign transactions into a block. They are rewarded with fees from transactions, there is no inflation minting coins as reward for staking. Only the 130 validators with the largest stake are active and thus earn the reward from transaction fees. Not complying with safety and liveness rules, can result in penalties to the staked amount.
Luna holders can delegate their Luna to a validator to earn rewards (~10% / year) without the responsibilities of becoming a validator themselves, contributing to the total amount staked by the validator. Validators will take a commission on the reward and pass on the remaining amount to delegators.
The treasury receives Luna from seigniorage and can use it as fiscal stimulus supporting apps in the Terra ecosystem. Specific use of the treasury funds is subject to proposal and voting of validators. The idea is to generate economic growth by supporting apps in the economy.
Mirror Tokenomics Breakdown
Mirror protocol tokenomic
The Mirror protocol aims to bring synthetic assets, known as Mirrored Assets (mAssets), to the Terra ecosystem. These replicate real-world stocks, allowing people outside the US to invest in US stocks and profit from price action, even without regular access to the US stock market. The protocol is built around the usage of UST but has its own token, MIR which is mainly used for governance.
mAssets track the price of real world stocks listed on the NASDAQ and are backed by collateral. Users who want to mint a whitelisted mAsset, need to back the equivalent of the current asset’s price plus a certain percentage of overcollateralization.
mAssets can then be held or traded on Terraswap. This continues even beyond stock market trading hours. In cases where the mAsset prices deviates from the replicated assets price too far, arbitrage is used to incentivise users to bring prices back.
The collateral is paid into a collateralized debt position (CDP) which tracks the backing rate and liquidates the position should asset prices rise too high without receiving further backing. Backing is possible in MIR, UST, mAssets, ANC and LUNA.
Mirror utilizes inbuilt oracles, that are incentivised to report the real price of assets or penalised for failing to do so.
A governance mechanism decides which mAssets are whitelisted for minting.
Staking is in place to allow participation in governance. Stakers can vote and receive MIR rewards (APR) for staking.
MIR staking is funded by a 1.5% protocol fee. The fee is charged on every withdrawal from a CDP.
The contract collector collects the 1.5% fee in UST and sells it on Terraswap to buy MIR, creating demand for MIR, and balancing out the supply from staking rewards.
Another form of staking involves liquidity tokens which are minted for every currency pair. A liquidity provider will receive LP tokens to indicate the percentage of contribution to the liquidity pool of a currency pair. These tokens can be staked to receive MIR. On top of the regular commission for liquidity providers, this incentivises LPs even more (farming).
The staking rewards for liquidity providers is funded by the genesis supply (image below), which is distributed among multiple parties and paid out over 4 years:
Distribution of MIR tokens
Like the real stock market, Mirror allows shorting of assets. The way the CDP is structured is already a short position. Say an mAsset, that has been minted by posting 200% collateral, rises in price. The collateral ratio of 200% will have to be maintained by posting more collateral — similar to shorting assets in the stock market. If the collateral ratio is not maintained the position will be liquidated and auctioned off.
Anchor Tokenomics Breakdown
Tokenomics Anchor savings protocol
If Mirror is the stock market, Anchor is more on the fixed income side, offering a fixed return of 19% annually on deposits of UST or other Terra stablecoins. Not many other protocols offer fixed returns, so let’s have a look at where these returns come from.
Depositing Terra stablecoins like UST or KRT will gain a fixed interest of 19% per year. The stablecoins are pooled by currency and aTerra tokens are awarded to indicate the share of the pool and claim interest on the deposit.
The protocol aims to keep the deposit interest rate within a range of around 19% and achieves this by subsidising it from the yield reserve and incentivising borrowers to deposit more bonded assets (bAssets) when required.
Borrowers receive Anchor’s governance token ANC as a reward for borrowing, often paying back the interest due for a loan. This is due to the project’s genesis supply issuing ANC tokens to ramp up the ecosystem. In later stages, this will be supplied by the yield reserve when necessary.
The yield reserve collects excess yields in the form of Terra stablecoins and converts them into ANC tokens in exchange for Terra stablecoins on Terraswap. This creates demand and balances out the supply generated from rewarding ANC tokens to stakers, liquidity providers and borrowers. The yield reserve only converts and supplies the ecosystem when required, collecting yields when supply is high and distributing them to stimulate rates when required.
Borrowers can borrow Terra stablecoins by paying interest and depositing collateral. Collateral is posted in the form of bAssets, which are staked assets in a proof of stake protocol. Currently only Luna is supported, but other staked assets are planned.
bAssets are overcollateralized to ensure liquidity. bAssets are staked assets so they generate a staking reward. This reward is kept by the Anchor protocol and paid into the yield reserve or distributed as staking rewards, making up a large income stream for the protocol. Anchor collects staking rewards from all of the overcollateralized bAssets. While it will only lend a certain amount to a borrower, it will receive rewards for > 200% of that amount from staking.
The ratio of overcollateralization is watched by liquidators and if ratios are not maintained by posting more collateral, positions will be partially or fully liquidated. In this case 1% of the collateral is paid to the yield reserve.
The yield reserve is also responsible for paying out staking rewards to stakers of ANC. As of writing APR is 7.88%, and will allow stakers to also participate in protocol governance.
Similar to the Mirror protocol, Anchor needs liquidity of its token ANC on Terraswap. Liquidity providers of the ANC:UST currency pair will, as of writing, receive an APR of ~77%, subsidised by the genesis supply.
The total genesis supply (see image below) is 1 billion distributed over the first 4 years. Most of the supply goes towards incentivising borrowers:
Supply schedule ANC token
Oracle feeders ensure prices of bAssets are kept up to date to track the collateral ratio.
Terra, with all its different protocols, is one of the most interesting projects I’ve encountered. Basing the whole ecosystem around a stablecoin is something unique and could make the stablecoins and the ecosystem immensely popular. The expansion via bridges to other chains gives Terra even more reach and fits into the paradigm of anchoring the balancing mechanism onto real-world use of the stablecoin.
While writing this article at least a handful of new Terra projects popped up on the radar, worthy of a whole new article:
Pylon, a suite of Defi savings and payment products;
Spectrum, a yield optimizer auto staking and auto compounding on various Terra protocols;
StarTerra, a gamified IDO launchpad;
Valkyrie, a rewards and referral protocol to help bootstrap launch of protocols and DAOs;
Ozone, an insurance mutual protocol, insuring against technical failure risks in the whole Terra Defi ecosystem.
The Terra Ecosystem is built on Cosmos and with that has access to the inter blockchain communication module (IBC), which allows easy integration with other blockchains and specifically, other chains built on Cosmos (such as Binance, Thorchain, Avalanche etc.). This easy integration, combined with the fact that truly decentralized stablecoins are such an important piece of the infrastructure, enables Terra to potentially move beyond the Terra Ecosystem and into other chains as well.
Florian Strauf is a technical writer exploring and visualising the tokenomics of various web3 projects.
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