What is Terra and how does it work

By May 12, 2022DeFi
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Terra is a decentralized and open-source blockchain designed to create algorithmic stablecoins. It was founded by Terraform Labs (Do Kwon e Daniel Shin) in 2018.

Unlike other realities, such as USDT or DAI, this type of coin does not have any assets to cover the value: an algorithm takes care of it.

Besides stablecoins, the other pillar of the Terra chain is LUNA, the native coin that plays different roles.

Terra is different from other ecosystems. What it offers is not the “usual” scalable blockchain but a real alternative to traditional payments.

Terra is a decentralized and open-source chain built using Cosmos SDK, the leading framework for blockchain development.

This solution allows programmers to create without having to start from scratch, benefiting from a ready-to-use environment. Furthermore, the chains based on Cosmos SDK can easily communicate with each other, giving life to projects that add further value to the ecosystems themselves.

The consensus algorithm is Proof-of-Stake and uses the Tendermint consensus. In short, the environment is scalable, secure and transactions are fast.

As in other proof-of-stake realities, validators play a crucial role in the Terra working system.

They must approve the transactions, guaranteeing their correctness and security. Each validator proposes the blocks, votes on their validity, and adds them to confirmations.

Furthermore, this position assigns significant responsibilities and powers in terms of governance.

The rewards for this are the fees produced during transactions.

A validator must have certain technical requirements (computing power, internet bandwidth above a certain speed…) which make this position not accessible to everyone.

But you can delegate LUNA to a validator of your choice.

As we delegate, we will receive a share of the fees coming from the transactions (subtracted from a variable percentage commission destined to the validator).

How does the Terra chain work?

Stablecoins are the core element of this ecosystem.

These cryptocurrencies have a fixed price, anchored (pegged) to something else. For example, 1 TerraUSD is worth exactly as much as 1 US dollar.

The stablecoins are cryptocurrencies, but without the volatility that characterizes those not pegged to any asset. If we think about integrating the blockchain into payment systems, stable currencies represent an essential point.

How does Terra Protocol work?

Terra Protocol is designed to ensure a constant value of stablecoins over time. To do this, it focuses on maintaining the balance between supply and demand.

The relationship between stablecoin and LUNA is the fundamental aspect that makes it possible for the entire protocol to work.

Imagine the entire ecosystem as two pools, the first containing TERRA stablecoin ($UST, for example) and the other LUNA.

Based on the supply-demand ratio of stablecoins, these “pools” decrease or increase the liquidity contained in them.

Let’s take an example: in an expansion phase, the price of UST rises relative to the peg. This is due to high demand coupled with low supply.

In this case, the protocol incentives users to burn LUNA and UST. For every dollar of LUNA burned, one UST comes into life.

By doing so, LUNA’s “pool” drops in liquidity, while the other rises.

UST’s supply grows, bringing the price back to the correct value. LUNA, on the other hand, is more valuable as there is less availability.

Instead, the contraction phase drags the price of UST below the peg. In this situation, we find low demand and excessive supply.

The procedure will be exactly the opposite. Users will be incentivized to burn UST and mint LUNA, bringing the price back to the correct level.

In this case, LUNA will see its value decrease: the available quantity will be higher than before.

So, LUNA is the indispensable counterpart for the functioning of the protocol.

However, the development team has found a way to reward investors: thanks to the supply that changes according to needs, the value of this coin grows with the increase in demand for stablecoin Terra.

The role of refereeing in the Terra Protocol

In the TERRA ecosystem, the market allows you to exchange $ 1 of LUNA for $ 1 of UST at any time (we wrote UST but the concept is valid for each stable Earth currency).

Therefore, in situations where the peg of one of the stablecoins should deviate from the usual level, users are encouraged to carry out an arbitrage operation.

For example, with USTs worth $ 0.98, it is convenient to buy the asset.

Then, using the Terra Station “market swap”, it is possible to exchange the USTs just bought with LUNA, at the exchange rate of 1 UST = 1 $ of LUNA.

By doing so, the difference between 1 and 0.98 (2 US cents) represents the user’s profit.

Exchanging UST with LUNA means burning one for the other, following the mechanism described above.

The UST supply decreases and the peg returns to the correct value of 1 dollar per piece.

The same is also true in the situation where UST exceeds $ 1.

Exchange LUNA for UST on Terra Station at the exchange rate of 1 $ LUNA = 1 UST, then sell them at a price above the dollar and take the profit.

After several operations, UST returns to the correct value as the offer has been increasing.

Thanks to the interdependence between LUNA and the Terra stablecoins, there is an excellent degree of stability.

The best part is that the greater the demand for stablecoins, the greater the need to operate with LUNA. The intrinsic value tends to grow.

It does not matter which coin is burned: the capital remains within the ecosystem.

Terra was the protagonist until two days ago: the second chain on Defi Llama, behind Ethereum.

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