- Terra’s LUNA aims to help you maintain a ratio of 1USD:1USD-pegged stablecoin
- A mechanism is used to balance supply and demand of LUNA and Terra stablecoins
- There could be a scenario which would trigger a Terra death spiral
If you are a crypto investor who has an eye on public chains, Terra must be one project at the top of your list. LUNA, the native token of Terra, achieved a 100X increase in 2021. The highest TVL on Terra also surpassed $20B at one point, exceeding BSC.
Currently, the TVL on Terra is around $16B, ranking 2nd among all the chains. Differing from other public chain projects, Terra is a distributed blockchain protocol specially designed for algorithmic stablecoins and used for payment solutions.
You probably already know that you can trade LUNA on major exchanges like Binance, Huobi and Kucoin. You can also participate in Anchor Protocol, which offers yields on Terra stablecoin deposits via lending and borrowing. Anchor is a money market in the Terra ecosystem.
What Problem is Terra Solving?
Traditional stablecoins like USDT, USDC or BUSD are issued by centralized institutions. Although they are pegged to USD as 1:1, the actual value relies on the credit of the issuing company. Sometimes, due to a supply and demand imbalance, there will be price deviation on these stablecoins’ prices. This means that you may need to pay 1.01 USD for 1 USDT. If businesses want to employ blockchain stablecoins into viable payment solutions, the stablecoins should be pegged to fiat currencies with a real stable value.
Terra is here to make sure you only pay 1 USD for 1 USD-pegged stablecoin (TerraUSD). It is worth mentioning that Terra is now offering TerraUSD (UST), TerraMNT (MNT), TerraKRW (KRT), and TerraSDR (SDT), which are pegged to different fiat currencies. To make it simple, UST will be used in the following example.
How does Terra Create A 1:1 Ratio?
The key factor for a price deviation is the supply and demand imbalance. Terra creates a mechanism to rebalance the supply and demand automatically. There are two kinds of crypto on Terra: LUNA, and Terra-issued stablecoins pegged to different currencies. As mentioned, LUNA is the native governance token of Terra.
In the Terra protocol, 1 USD worth of LUNA is always equivalent to 1 UST. Take a look at the following scenarios,
if you need to pay 1.01USD for UST, which means UST demand > supply:
You can mint 1 UST using LUNA (only costs 1 USD) and the corresponding amount of LUNA will be destroyed. Then, you can sell the UST on the market for 1.01USD, helping to increase supply for UST AND earning the premium.
if you need to pay 0.99 USD for UST, which means UST demand < supply:
You can mint 1 USD worth of LUNA using 1 UST. This means you spend 0.99 USD for 1 USD value of LUNA. In this case, demand for UST increases.
In both cases, users are incentivized to take profit from arbitrage, helping to rebalance supply and demand.
LUNA’s Meteoric Rise
Obviously, LUNA and Terra stablecoins influence one another. With Terra stablecoins being applied into more use cases, their demand will increase and LUNA will have to be destroyed to provide the stablecoins supply. This in turn reduces the supply of LUNA which has a positive effect on the market value. In the past few months, the speedy development of DeFi projects like Anchor Protocol and Mirror Protocol, which are based on UST, have also helped push the market value of LUNA up.
UST Decoupling and Terra Death Spiral?
Screenshot of total deposits and borrow on Anchor Protocol
Currently, most UST issued are used in Anchor Protocol. The high staking interest in Anchor drives demand for UST, which in turn burns LUNA and reduces LUNA supply. However, Anchor's loan interest is low. This means that Anchor pays out the staking interest using its reserve fund, and it might not be sustainable in the long run.
To keep Anchor competitive, Anchor needs to either decrease the staking interest or issue more loans. However, decreasing the staking rate may trigger UST investors to convert their UST back to LUNA in Anchor. If LUNA supply increases drastically, its price will drop. To add on, if LUNA price drops to collateral price level (the asset price when locked by borrowers), investors would be less likely to borrow and would likely want their assets back. In this case, the prices of UST and LUNA will have a higher spread i.e. UST decoupling.
If and when UST can be applied in more use cases, this situation is extremely unlikely to occur.
The views expressed in this article are the author's alone and do not necessarily represent the views of ApolloX.
Risk Reminder: Crypto trading carries a risk. All trading activities are done at your discretion and at your own risk. The information here should not be regarded as financial or investment advice from ApolloX. ApolloX will not be liable for any loss that might arise from your use of any financial product.
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