LUNA has already made headlines with its massive surge in 2021, but it represents something entirely more fundamental to Terra’s stability.
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In an interview, Do Kwon, co-founder and CEO of Terraform Labs, said that Terra’s ecosystem is built with several use cases in mind such as savings, payments, investments, and schools. another opportunity to take advantage of its stablecoin assets. The Market Insights newsletter previously covered Terra’s ecosystem growth in 2021 and how it reached hundreds of decentralized applications from just two early last year.
And it’s all based on Terra’s stablecoins and the protocol’s ability to maintain the stability of their pegs. The key ingredient to that stability, however, is its primary staking asset, LUNA. On the surface, investors know LUNA for its rapid price appreciation in 2021, but according to the project’s white paper, owning and holding LUNA is meant to represent something entirely fundamental. more critical to the stability of the entire network.
LUNA is mining power
Terra is a Tendermint-based blockchain maintained by validators that follow Tendermint’s authorized proof-of-stake algorithm and vote on new blocks. Validators run programs called full nodes and are required to stake a certain number of LUNA tokens to be included in the active validators list, which currently includes 130 validators. Active validators earn revenue through the transaction fees associated with each block.
Those who don’t want to set up full nodes but want to get a share of the validator’s revenue are called delegators. Authorizers are basically people who delegate their LUNA tokens to validators to increase the weight of the staked LUNA. Essentially, LUNA represents the mining power in the Terra network, and the more its economy grows, the more LUNA producers earn in fees.
LUNA is a volatile absorber
Another important role of LUNA is maintaining its stable price peg. As mentioned, Terra stablecoins follow an algorithmic market module, which means that the protocol adjusts the supply automatically based on the state of the market. The protocol can achieve this through open market arbitrage incentives.
Let’s do a scenario where 1 TerraUSD (UST) trades above the $1 close. In this case, LUNA owners can swap $1 worth of LUNA using Terra Station’s market swap feature and sell it for 1 UST. The user can then sell this amount for the equivalent dollar value and profit from the difference. In this regard, the protocol effectively reduces the supply of LUNA and increases the supply of UST which, in large enough volume, could eventually drag it down to $1.
On the other hand, when the price of UST falls below the $1 peg, the protocol incentivizes users to burn UST in exchange for LUNA. This expands the supply of LUNA and reduces the UST, bringing its value back to $1. As a result, the price volatility of UST is absorbed through the mining and burning of LUNA tokens. So far, the market has been able to respect the latch even as it rallies as high as 30% from $1. Over the course of a year, the UST has deviated from the average anchor by about 4%.
Stable mining demand
With these considerations in mind, it is understandable how important the role of LUNAs is in the Terra ecosystem and equally important in maintaining stable mining demand. However, Terra is designed in such a way that the fees generated from blocks increase with the expansion of its ecosystem and vice versa.
Furthermore, the supply of LUNA also shrinks as the Terra network grows as its supply is reduced from UST mining. As a result, mining rewards will be unpredictable, which may discourage users from staking LUNA as it would make profits difficult to determine.
Achieve stable mining rewards
The solution of the protocol is to make mining rewards more predictable regardless of whether Terra is in a contraction or expansion phase. It uses stable leverage in the form of transaction fees and “seigniorage” (or the amount of LUNA burned) to achieve this.
For example, when mining rewards are decreasing, indicating that Terra’s economy is in recession, the protocol will increase LUNA’s write speed and increase fees. This makes LUNA makers less inclined to forgo LUNA staking altogether.
Prior to the Columbus-5 upgrade last year, seigniorage was directed to a community group to drive more adoption during the expansion. All seigniorages are now burned, simplifying Terra’s economic design where mining 1 UST means burning $1 worth of LUNA. All fees also translate into staking rewards for LUNA, making staking more appealing as a long-term commitment.
Terra’s creation of decentralized money with stable and reliable value has encouraged further innovation on its platform. Cointelegraph Research’s upcoming report will take a deeper look at Terra’s ecosystem, design, community, and more. Keep stable!
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