I won’t lie but I have been somewhat smitten by Terra these past few months. It has been making hard-hitting news and there is no escape from it. Perhaps it was my calling to go down this rabbit hole. It did not take me long to figure out the incredible support that Terra has in the form of a community that calls itself LUNA-tics. Honestly, it’s quite hard to not be a chain maximalist when you have such a community to show you the way.
Terra is a protocol for stable currencies with LUNA as the native token. LUNA has been one of the biggest gainers with a 2000% increase since the start of the year. With billions of dollars in TVL and tens of thousands of new users knocking on your doors, waiting to be LUNA-tics, it is making Tsunami waves.
One of the biggest factors that deter blockchain from mainstream retail adoption is price volatility. The recent crypto flash crash wiped out $400 billion dollars in market value on the day of El Salvador’s bitcoin adoption. El Salvador got lucky in buying the dip but for the rest of the mainstream world, such fluctuations are barriers that will keep pushing the growth and adoption away. The exact reason for the flash crash is like peeling the onion but one of the reasons that could be attributed is lack of liquidity, unlike a conventional market. The supply-demand mismatch has always been a concern especially when it comes to stablecoins. Stablecurrencies like DAI have traded at a premium to the Dollar in the past.
Terra is a blockchain payment project developed by Terraform Labs aimed at creating an ecosystem of stable cryptocurrencies. Terra uses a Delegated Proof-of-Stake (DPoS) consensus model, built using the Cosmos Network’s Tendermint Consensus protocol. Terra has quite a few algorithmic stablecoins pegged to different currencies and UST is one such algorithmic stablecoin that is pegged to US Dollar. These coins are backed by LUNA tokens. LUNA is the governance token that is used for staking by the validators as well as the rewards. UST is a scalable, yield-bearing coin intended to bring a scalable solution for DeFi improving on the existing scalability issues faced by other stablecoins.
Tendermint Consensus Protocol & DPoS
One of the most fundamental requirements of any distributed system is consensus, an agreement on a state of network. Different blockchains use different consensus models. Terra uses the Tendermint BFT Consensus protocol of the Cosmos Network. Terra core is built on top of Tendermint BFT using the Cosmos SDK and this essentially becomes the framework for the app development. More on the Cosmos Tendermint BFT.
Terra uses a Delegated Proof-of-Stake (DPoS) which is similar to PoS, whereby stakeholders can stake their assets in order to delegate validators which helps in improving scalability. The top 130 validators (based on the amount of bonded LUNA) make up the validating set. A slashing mechanism (where a portion of validator funds are slashed and a temporary ban is imposed on the said validator) guarantees honest behavior. This is activated in three main cases: double signing (validators signing more than one block at the same height), downtime (validator inactivity for a prolonged period of time), and an excessive number of missed oracle votes (validators failing to meet the minimum number of periodic votes on LUNA’s exchange rate). Rewards are paid both to validators (known as delegates), as well as the delegators. (More on LUNA below)
StableCoins, Seigniorage and Price Mechanism
Terra stablecoins are algorithmic, unlike other stable coins which are backed by collateral reserves. These algo-stable coins are aimed at solving the existing barriers by providing a seamless cross-chain payment service with minimal charges bridging the gaps of the blockchain world. The network maintains price stability by adjusting the supply based on demand through an embedded market maker. The cost of minting is equal to the face value of the stablecoins minted. In order to mint 1 UST, only $1 worth of the reserve asset ($LUNA) is burned. This monetary policy is infinitely scalable that can help DeFi apps and protocols achieve their full potential without restrictions.
For the sake of example, Let’s consider the cost of UST< $1, you exchange UST for LUNA and mint LUNA thus burning UST. When UST is burned, supply reduces and the cost of UST goes up. When UST>$1, you exchange LUNA for UST and then sell that UST at a premium to the dollar. The supply increases and the cost of UST reduces bringing the peg back to $1. This is exactly how the pricing mechanism works through an elastic algorithmic system where internally UST is always valued at $1 but the outside markets determine the value of LUNA and UST.
Seigniorage is the difference between the value of money and the cost to produce it. Terra protocol is defined by Seigniorage.
When arbitragers buy UST with LUNA in expansion and sell that at a price higher than $1, more UST is minted increasing the supply while simultaneously reducing the LUNA in circulation. A portion of LUNA that is returned to the system is burned and the rest is stored by the Treasury for use in funding and development support. The value of LUNA recovered by the network, calculated as newly minted Terra minus the cost of issuance (which is 0), reflects the profit gained. This is known as seigniorage. The opposite happens in a contraction when the price of UST is lesser than $1, UST is burned and LUNA is minted.
This price mechanism is however defined by a threshold amount of demand to maintain the peg. Miners are consistently incentivized to stake LUNA, despite the price fluctuations. Terra achieves this by implementing a demand stability mechanism, which calculates miner rewards by altering transaction fees (affects total rewards) and LUNA burn rate (affects the supply of LUNA). As a result, mining rewards remain stable regardless of Terra’s market conditions.
What is LUNA?
LUNA is the backbone of the Terra ecosystem. It is the native token that is used for staking by the validators to secure the network, governance, and collateralization for the price-stability of the stablecoins. LUNA is the tool of value for the network through the staking mechanism. And since LUNA holders are exposing themselves to price volatility risks, they are incentivized through staking rewards. As of 09 Sep 2021, 36.9% of LUNA holders are staking the tokens and the return is 3.3835% annually (data as per Flipside Crypto). The staking rewards come from transaction fees (or gas), taxes on transactions, and seigniorage rewards.
LUNA can exist in three forms — Unbonded (freely transacted as a regular token), Bonded (locked in the system for staking), and Unbonding (unstaking or undelegating and the period lasts for 21 days when it can neither be staked nor traded). To incentivize LUNA holders to invest long-term in the network, staking rewards are granted first to validators, and then to delegators. Rewards are proportional to the size of stake and comprise gas fees, taxes, and seigniorage. As Terra’s flagship currency, TerraSDR (SDT) is the currency used for rewards and fees.
Gas fees are essentially compute fees, and tax fees are a small percentage calculated on top and capped at 1 SDT. Seigniorage rewards are distributed when validators take part in voting on LUNA’s exchange rate for oracles. LUNA is also used as a governance token. Similar to other protocols, this means that LUNA token holders can create and vote on proposals — ranging from software upgrades to how funds from the community pool are spent.
Imagine if the blockchain could connect seamlessly with other blockchains transferring data and value, Imagine if the blockchain nodes could sync in minutes than days, Imagine if the blockchain could be upgraded in minutes than hours, Imagine if the transaction speeds could be increased up to 100x, and Imagine if the technical risks on the blockchain could be mitigated through Insurance policies. Imagine if we could transport ourselves to different dimensions of the universe through a portal gun. Does it all sound too good to be true?
Maybe yes, maybe not. The only way of knowing for sure is to wait for the Columbus 5 upgrade to happen. Maybe the only thing restricting is our imagination. I wonder why Columbus though. Maybe because he found America but that was accidental. Wasn’t it?
Taking a dive into Columbus 5 Mainnet Upgrade
These few months have/will be a witness to some important upgrades in the blockchain world whether it was the London HardFork or the Alonzo HardFork or Terra’s Columbus 5 Upgrade.
Columbus-5 is the new system that will inherit Columbus-4. If I would want to define Columbus 5 upgrade through my poetic calling, “I would call it a breeze of fresh air that will fill you with a new life”. But for now, let’s try understanding it from a little more technical perspective.
Seigniorage burning — Columbus 5 upgrade will see a major change in terms of Seigniorage. When LUNA is burned to mint new Terra stablecoins, Seigniorage is created. Presently, only a portion of LUNA is burned with the minting of UST. The remaining goes to the community pool and the oracle reward pools. With the upgrade, the entire Seigniorage will be burned. The amount of extra burn will be significant that will push more adoption of UST and further increase the price of LUNA.
Stargate Upgrade — Stargate Upgrade is the largest Cosmos upgrade to date. This will enable higher transaction throughput, cross-chain transactions, accelerate UI development, amongst other developments. Let’s understand these -
I. IBC enablement — IBC is Inter-Blockchain Communication Protocol that enables Cosmos SDK-based sovereign blockchains or zones to communicate with each other and is set to launch with the Stargate update. It will help to achieve interoperability of the Cosmos Network. IBC will enable value transfer across sovereign chains that enable IBC. With more and more zones enabling IBC (Osmosis) or having announced intentions of enabling IBC (Gravity DEX, Secret Network), it will allow Terra to benefit in the form of increased UST adoption on different chains.
If two chains are sovereign, how can tokens from one be transferred to another?
Chain A locks the tokens and relays proof to Chain B. Once verified, Chain B mints its own representative tokens (sort of like vouchers), which can later be destroyed to unlock the original tokens on Chain A. So the value that tokens represent can be transferred across chains, but the token itself cannot.
It will also help to connect non-tendermint blockchains like BTC and ETH through the peg-zones thus connecting the different silos of the blockchain world.
II. Protobuf Migration — Protobuf as a name seems so lackluster given the kind of magic it will do with the incredible changes. Stargate upgrade implementation will make a transition from Amino to Protobuf that will see significant improvements to performance, compatibility, interoperability, operability, and developer ease-of-use. Protobuf is expected to clear the biggest bottleneck in Cosmos network to make the applications way faster, reliable, easy to create with much lower gas costs. The blockchain performance will see an improvement of 10x to 100x in throughput that will enable Cosmos to handle the increasing volume of cross-chain transactions. Protobuf will introduce a standard for composability that will enable developers to develop reliable front-end UI that works with other UI.
III. State Sync — Tendermint makes new blocks at 6 or 7 seconds per block which is great for blockchain performance. However, it takes days for participants to synchronize a new node and is a challenge for a validator operator that needs to replace a failed validator. The current practice is downloading a public snapshot, which makes syncing much faster, but it’s a security risk for the validator and the network. State Sync solves this issue that will enable new nodes to sync in minutes than days.
IV. Chain Upgrade Module During the Cosmoshub-2 and Cosmoshub-3 upgrade there was an hour of disruption. This issue will be solved by changing to a new auto-upgrade system powered by Regen Network, which reduces the coordination complexity, human error, etc. This will enable validators to upgrade the chain software asynchronously in minutes rather than an hour or more.
Wormhole Launch — Wormhole will be launched with the Columbus-5 upgrade. Wormhole is a bridge that connects Terra to Solana. As of now, only the ERC-20 version of UST can be ported to Solana which creates friction and with Wormhole, UST can be bridged directly to Solana. This will help in the increased adoption of UST by Solana projects leading to further integration and collaboration between the two ecosystems and enable a large deflationary pressure on LUNA’s supply. Saber and Mercurial (stableswap projects on Solana) already have UST pools and multiple other projects are also hinting at future collaborations. The coming together of these two ecosystems would mean unimaginable possibilities with varied use cases and integrations.
Ozone Insurance v2.1 — Ozone is a Defi protocol from Terraform Labs. It’s an insurance mutual protocol that facilitates levered coverage of technical failure risks in the Terra DeFi ecosystem. This will see the lock-up of a considerable amount of UST to safeguard the ecosystem and thus driving more adoption of UST and the growth of Terra. Ozone over time can be expected to be the cheapest and more reliable than most of the other available policies on Terra.
Other Upgrades — Columbus 5 upgrade will see various other upgrades listed below -
- Swap fees as dividends instead of burns — to increase staking rewards (will only result in ~2% less burn happening, while staking yield will increase above 10%).
- Optimize gas efficiency of oracle voting — achieved through seigniorage burning.
- Charge gas fees for log size — to prevent spamming of local storage.
- Separate mint/burn swap base pools in the Market Module — to reduce arbitrage opportunities by simulation of a virtual AMM.
Portal Gun Access — Anyone staking UST or LUNA will have access to a portal gun that can transport you to different realms of the universe, just like Rick’s. Maybe not exactly that but with IBC, it can surely take you to different realms of chain metaverse. Just not Rick’s portal gun though.
Columbus-5 Mainnet upgrade of the Terra ecosystem will be the most important upgrade on the Terra blockchain. It will be a precursor for Terra to gain mass adoption like never before. From simplifying the treasury model logic, Stargate upgrade, and ease of swaps, it is expected to see an onslaught of projects. Infact, there are projects waiting for this upgrade before they jump on the wagon. I only see a path that will push the demand for stablecoins into different ecosystems besides Terra. Will that make the world LUNA-tic, let’s wait till 30th September to find out. I guess a significant part if not sooner, then later.