The LUNA Cryptocurrency and How Terra Works
December 27, 2021
In May 2022, a collapse of the Terra’s ecosystem occurred, negatively impacting both TerraUSD and LUNA. This article was written before the event, so before reading it, we encourage you to learn more about the situation and stay updated. In general, Young Platform articles are intended for informational purposes only and do not constitute financial advice.
The LUNA cryptocurrency is based on Terra, a blockchain built using Cosmos technology and aimed at facilitating decentralised payments of all kinds and anywhere on the globe.
To do so, it does not content itself with providing a fast blockchain with low transaction fees, but also develops a system to create stablecoins anchored to any fiat currency without the need for reserves.
Lending and yield farming protocols are also part of the core system, but its ecosystem is even broader and will in time offer solutions for all DeFi services.
The LUNA cryptocurrency at the heart of Terra
At the heart of the blockchain and the entire Terra ecosystem is the cryptocurrency LUNA.
LUNA is used as collateral to participate in the Terra network as transaction validators or to vote on governance proposals.
For this purpose LUNA is staked, as in any Proof-of-Stake blockchain.
Terra Station is the wallet created by the Terra team and supports the staking of all Terra native assets.
Given the staking system, LUNA can exist in 3 states, called “phases” by Terra’s witty developers.
- LUNA is Unbonded when not staked, so it is fully tradable in the market and provides no rewards.
- LUNA is Bonded when it is staked, meaning it is locked in the protocol in order to generate rewards. It cannot be traded in this phase.
- LUNA is Unbonding when it is in the process of being removed from staking. This process lasts 21 days. During these days the LUNA in question can neither be exchanged nor generate rewards.
The second major function of LUNA is to amortise the volatility of Terra stablecoins.
How does LUNA keep the price of Terra’s stablecoins from swinging?
Let’s take the example of the stablecoin pegged to the US dollar, Terra USD (UST).
UST is an algorithmic b, like all stablecoins on Terra.
This means that its value is not based on the value of an underlying asset – such as fiat currencies, crypto, or other assets – but is determined by an algorithm.
In fact, the price of UST is pegged to that of the dollar, but its supply is tied to that of LUNA. Mind you, there is no reserve or collateral of LUNA backing UST, so we can’t call it a collateralised or cryptocurrency-backed stablecoin, because LUNA is not an underlying asset, but merely a term in the equation that allows it to absorb UST’s volatility.
How the LUNA cryptocurrency stabilises UST
The price of UST varies according to supply and demand, like any currency. To avoid it from distancing from the dollar price, Terra has adopted a seigniorage model based on the two tokens, UST (or Terra’s other stablecoin) and LUNA.
The seigniorage model generally allows the price of a currency to be manipulated by controlling its supply. In this case, the supply of one coin depends on the supply of the other.
It is thus possible to stabilise the price of UST through the conversion of the cryptocurrency LUNA.
When the price of UST exceeds $1, the protocol converts $1 of LUNA into $1 UST in order to increase its supply and thus lower its price. As a result, the price of LUNA goes up because it becomes scarcer.
This process is not a real conversion. What actually happens is that the “converted” coins of LUNA are burned, i.e. removed from the total supply and at the same time new USTs are minted.
Conversely, when the price of USTs falls below $1, the protocol sells 1 UST in exchange for $1 of LUNA. As a result, UST becomes scarcer and therefore more valuable, approaching $1.
Terra was created to facilitate global transactions by allowing any fiat currency to have a stablecoin. Currently, the world of stablecoins is dollar-centric and therefore not integrated with the financial services of each country.
Having a stablecoin pegged to the Korean Won, for example, facilitates trade between the US and Korea. Thus we have TerraKRW (KRT), which through the CHAI app is accepted in many Korean shops.
Memepay does the same in Mongolia with the Terra MNT stablecoin. These are payment Dapps that have partnered with Terra and are now based on its blockchain.
Terra is the centre of a large system of decentralised protocols and applications (Dapp) that offer various DeFi solutions.
Terra’s core protocols are Mirror, Terraswap, Anchor and Ozone. These are respectively Dapps that give access to synthetic assets, decentralised trading, loans and insurance.
Mirror and synthetic assets
Synthetic assets are generally a kind of derivative financial product. More precisely, they are a combination of two financial instruments that allow exposure to an asset without owning it.
Mirror is a protocol that allows the creation of synthetic assets that mimic the performance of traditional and off-chain, i.e. non-blockchain-based, financial instruments.
The protocol is of course based on smart contracts and is available on both Ethereum and Terra.
These types of synthetic assets are called Mirrored Assets and are referred to on the Dapp as mAssets. So if you want to invest in Tesla shares via Mirror, click on “mTSLA”.
To create a new mAsset all you need to do is open a position on Mirror and deposit collateral.
Mirror allows you to generate loans and do advanced trading with these assets. In addition, by opening a leveraged position you get APY rewards until you close it.
The trading functionality is provided by Terraswap, a decentralised exchange based on liquidity pools, a bit like Uniswap.
Mirror Protocol is governed by the community through the MIR token, given by the protocol as a reward for actions by participants that promote the security of the system.
Anchor: Lending and Staking
This protocol has several sections. The Bond section allows you to staking the LUNA cryptocurrency and get bLUNA tokens (Bonded LUNA) which include periodic rewards. When staking, you can choose which validator to trust.
On Earn, on the other hand, you can lock stablecoins like UST to receive APY in aUST.
Annualised Percentage Yield (APY) is the actual rate of return on an investment in one year. It’s not only used in the investment industry, but also in DeFi and particularly in yield farming features and liquidity supply programmes.
The Borrow section is dedicated to generating loans in Terra-supported tokens by depositing collateral, which can also be bLUNA, for example. As an incentive for borrowing you receive an APR in ANC, the Anchor governance token.
It stands for Annual Percentage Rate, and it indicates the percentage of interest you will get in a year, without considering compound interest. You may hear of APR in DeFi and particularly in yield farming features and incentive programmes linked to liquidity supply.
In the Governance section, ANC is either staked or deposited in the ANC-UST liquidity pool together with UST.
The Columbus-5 Update
Columbus-5 is the name of the latest update to the Terra blockchain, active since 9th September 2021, which has led to substantial changes to its component protocols.
For example, Columbus-5 introduced Ozone, Terra’s insurance protocol that provides protection from risks arising from any technical problems within the ecosystem.
On this occasion, the protocol was also upgraded to Stargate, the latest version of Cosmos. Stargate provides all blockchains developed with its SDK (application development package) with functionalities that allow cooperation with other blockchains.
As a consequence, hundreds of new Dapps have arrived and are arriving on Terra.
Speaking of interoperability between blockchains, the update also led to the launch of the bridge connecting Terra to Solana, which facilitates their collaboration and lowers transaction costs between one blockchain and another.