Love ya from the Terra to the Luna

When Satoshi Nakamoto designed Bitcoin and launched it to the world, she was contesting to the havocs of the financial crisis in 2008. Bitcoin’s whitepaper is a juicy reading from engineering, economic and mathematical perspective. However, the philosophy behind a decentralized currency able to empower individuals was the driver that pushed me to delve into blockchain and cryptocurrencies.

The next inspiring reading that pushed me to start delving into DeFi was Terra Money. Little by little, I am becoming a Lunatic-fanatic. Why? I think Terra is the convergence of blockchain, cryptocurrency and DeFi at the service of a global need: financial inclusion.

Terra’s main goal is the readiness of price-stable cryptocurrencies for mass adoption making a difference with other protocols: expanding access and use of financial decentralized applications, building the financial infrastructure suitable for efficient payment systems, fast and cheap transactions, cross-border payments, savings, lending, insurance and beyond.

What a dream ! suitable, seamless, cheap and fast financial services are precisely the needs of billions of financially underserved populations.

A dream without policy is demagogy, and this is another astounding feature of Terra Money because the protocol was conceived as an economic system where technology and economic policy merged. Based on algorithmic monetary policy and, in its origin, an algorithmic expansionary fiscal policy (Keynesian lovers: “jet a coup d’oeil”) developers seeking to reach mass adoption and utilization of DeFi can find their match here.

The economic model in Terra deserves opening a Cavernet Sauvignon or a Highlands organic expresso. Wait for you to get it and continue reading.

Let’s start with the monetary policy in Terra:

Money is supposed to function as a store of value, a unit of account and a medium of exchange. Only then, we can buy, trade, save and invest comfortably. Money requires to keep stable purchasing power, conversely, volatile or inflationary currencies become a headache, specially to consumers. Also, volatile currencies are poor to denominate prices and affect its usage as a medium of exchange because it stops people to be fairly and predictably compensated for goods and services due to changes in value during the payment process. In Terra Money, the goal is to mint stablecoins that can be used as money within a pure algorithmic solution.

Emulating the gravitational pull relationship between the Earth and the Moon, Terra Money is a decentralized Proof-of-Stake open source blockchain of algorithmic stablecoins (Terra stablecoins ) and native token Luna. The protocol presents a dual-coin mechanism to absorb the volatility and keep the peg of the stablecoins.

Terra’s Monetary Policy:

Terra has a multi-fiat peg policy and a dual-coin mechanism consisting of Luna (the native token) absorbing the volatility of Terra stablecoins. To do so, an elastic monetary supply adjusts to keep the peg -contracting and expanding- according to changes in demand for money.

The idea is intuitive: when the price of a stablecoin, for instance UST pegged to the US dollar, falls below the peg (1:1), Luna is auctioned in exchange for the UST, that is, the system mints Luna and burns (destroys) UST. This process will contract the supply of UST, increasing its price until reaching the peg again. In this operation, there is a risk-free profit by arbitraging the difference in price since the system always exchanges at price of $1.00. Example: if UST falls to 0.90, by trading UST for 1 USD worth of Luna from the system, an arbitrageur makes a 0.10 risk-free profit compared to the 0.9 USD worth she could get in the open market. Conversely, when the price of UST is above the peg, the supply increases by minting UST and burning (destroying) Luna, reducing UST price until reaching the peg. Arbitrageurs also make risk-free profits for example, if UST increases to 1.10, arbitrageurs can trade 1 USD worth of Luna to the system to get 1.1 USD worth of UST.

Nonetheless, the devil is in the details:

The volatility of Luna is absorbed by Terra’s miners who stake Luna to mine Terra, as such, the staking power can be equated to the hash power in a Proof-of-Work blockchain. Therefore, in the short-term when supply is contracting (i.e., miners buy back Terra), Luna miners are diluting their mining power, i.e., Luna stakes are worth a smaller portion of total available mining power. To compensate miners for that, mining rewards are increased in the long-term.

In the original design, there were two sources to reward miners:

1. Fees: rewards for validating transactions in Terra fluctuating between 0.1% — 1.0% to keep transactionality cheap compared to TradFi payment systems and,
2. Seigniorage: smart contracts operate like a “central bank” with the mandate to issue a currency that will trade at $1.00. Thus, seigniorage is a source of revenue calculated by the value of minting stablecoins minus the costs of minting them. When demand for Terra increases, the system mints UST or other stablecoins in Terra and burns Luna.

More than that, the system has to ensure that the rewards to miners are sustainable, stable and predictable, only then the system can absorb short-term volatility and create long-term incentives to keep the miners in Terra Economy. It is intuitively simple but reaching the objective is quite more complex.

First, increasing rewards depend on the growth of the Terra Ecosystem and the network effects that come along with utilization. The fiscal stimulus was designed to walk in that direction and will be described in the Fiscal Policy. Secondly, predictable and stable rewards for miners in the long-term mean that miners are compensated consistently under all economic conditions: in the goods and the bads. To do so, the protocol algorithmically adjusts unit mining rewards according to changing market conditions.

The profit or loss from mining 1 Luna at any moment in time (t) is calculated as :

Profit or loss = ((Fees + seigniorage) / Luna supply)- Unit mining costs

The first term refers to Unit Mining Rewards. For simplicity, unit mining costs are low and equalized to zero. Therefore the stability and predictability of rewards depend on fees and the rate of Luna burn, moving in opposite directions:

• When Terra economy grows, fees increase and Luna supply shrinks (Luna is burnt from seigniorage)
• When Terra economy shrinks, fees decrease and Luna supply expands because more Luna are issued to buy back Terra.

Therefore the algorithm oppose the movements to stabilize mining rewards:

• If Unit Mining Rewards are increasing, the algorithm decreases fees and decreases Luna burn.
• If Unit Mining Rewards are decreasing, the algorithm increases fees and increases Luna burn.

In the original Whitepaper, part of the seigniorage (Luna “burn”) was not really a destruction of Luna, but a recirculation of resources into Terra’s Treasury, used as fiscal stimulus to expand the ecosystem, therefore the rate of Luna burn was only a portion of the total seigniorage. With recent changes in to the protocol (Columbus-5) effective as of September 30, 2021, all Luna is now burnt.

Terra’s Expansionary Fiscal Policy

Terra included an expansionary fiscal policy as a driver of Terra’s GDP growth just like National governments use public expenditure expecting higher economic growth in the future due to its multiplier effects in consumption or investment. Likewise, algorithmic stable coins like Terra rely on holder’s beliefs that the assets will appreciate in the future, thus the need for growth by new entrants into Terra’s ecosystem.

To stimulate growth of financial applications using Terra as underlying currency, the protocol created a Treasury that subsidized new dApps by allocating resources derived from seigniorage, where elegibility conditions were the economic activity and the use of funds. The mechanism to apply for Treasury’s funding operated as follows:

1. A dApp applied for an account with the Treasury providing metadata of the project, wallet address, auditing and governance procedures.
2. Within voting intervals, Luna validators voted to accept or reject new dApp applications. To accept a proposal, the net number of votes (Yea minus Nay) needed to exceed one third of total validator power.

Validators in Terra voted for acceptance of new dApps and exercised vigilance on whether dApps were behaving honestly and making legitimate use of the allocated resources. Validators also could suggest a blacklist of dApps if the funds were not used as committed and submit it to voting.

To inform their vote, validators used the resulting ‘weight’ assigned to eligibility conditions:

(1) funding efficiency
(2) size of the microeconomy

The ‘weight’ was calculated for each period of time (t) with the moving averages of two terms: Wt=(1-λ) TVt+ λ (∆TVt)/F(t-1). It looks more complicated than it really is:

The first term [(1-λ) TVt] is the average transaction volume as a proxy indicator of the size of the micro-economy of the dApp. Larger transaction volume reflects bigger economies and viceversa. The second term ponders funding efficiency by dividing the trend in transaction volume by recent past funding. If transaction volume is following a positive trend per unit of funding it reflects a dApp with efficient use of funds and the opposite if the trend was negative. Lambda is the parameter to determine the relative importance of the size of the economy and funding efficiency. If lambda is 50%, then both (size and efficiency) had the same relative importance. A higher lambda means that efficiency is relatively more important than the size of the economies and viceversa. The parameter lambda was calibrated to fund proposals with the highest net impact on the economy.

Blockchain and cryptocurrencies are reshaping finance and we are just at the inception of this revolution. Nonetheless, beyond first movers and new protocols focusing in the blockchain trilemma, I think the so-called ‘killer protocols’ that will gain the acceptance from the masses, at the same time giving sustainability and the desired network effects to the protocol, are precisely those capable of understanding and incorporating the logic behind the consumer’s decision making.

Terra’s whitepaper was a personal delightful encounter with a protocol that combines technology and economics seeking to respond to one of the biggest problems in our so advanced “Metaverse” era: billions of individuals that live in the absolute exclusion of reliable, customized and open financial services.

In the second part of Terra Money, check more about Luna Tokenomics and governance in Terra protocol.