How Terra Stablecoin Works: Code-Controlled Cash

Terra has carved a niche in the cryptocurrency world with its unique approach to stablecoins. Unlike stablecoins tethered to real-world assets like cash or gold, Terra’s brainchild, TerraUSD (UST), relies on an intelligent algorithm to maintain its peg of $1. But how exactly does this algorithmic magic trick work? Let’s delve into the fascinating world of Terra stablecoins.

Here’s a simplified breakdown of how it works:

• Two tokens: Terra has two main tokens: UST (the stablecoin) and LUNA. UST aims to stay pegged to $1, while LUNA’s supply fluctuates.
  

• Maintaining the peg: Smart contracts automate the process. When UST trades above $1, users are incentivized to burn (permanently remove) UST from circulation by exchanging it for LUNA at a discounted rate. This increases LUNA’s supply and reduces UST’s, pushing its price back down to $1.
  

• The opposite effect: If UST falls below $1, users can buy UST at a discount with LUNA. This burns LUNA, reducing its supply and increasing UST’s demand, driving the price back up to $1.

• LUNA’s role: LUNA acts as a shock absorber, expanding or contracting its supply to meet demand for UST.

The Symbiotic Dance of UST and LUNA

Imagine a seesaw with UST on one side and LUNA on the other. The goal is to keep UST balanced at $1. Terra achieves this through a fascinating interplay of supply and demand, governed by smart contracts – self-executing code on the blockchain.

UST Above $1: Profitable Burning: 

When UST’s price climbs above $1, an arbitrage opportunity arises. Users are incentivized to burn UST from circulation in exchange for LUNA at a discounted rate. This burning essentially removes UST from the market, reducing its overall supply. Think of it as taking weights off the UST side of the seesaw.

• Why is burning profitable? Because for every UST burned, users receive a slightly greater value in LUNA (since UST is trading above $1). This price difference creates a profit margin for arbitrageurs, the traders who exploit these discrepancies.

UST Below $1: Discounted Minting:

Conversely, if UST falls below $1, another arbitrage opportunity emerges. This time, users can buy UST at a discount using LUNA. When they do this, the system automatically mints new UST tokens. This increases the total supply of UST, adding weight to its side of the seesaw.

• Why buy discounted UST? Because users anticipate the price to rise back to $1, allowing them to sell their UST for a profit.

LUNA: The Dynamic Shock Absorber

LUNA plays a crucial role in this process. As UST is burned or minted, LUNA’s supply automatically adjusts in the opposite direction. When UST is burned (reducing its supply), more LUNA is minted to compensate. Conversely, when a new UST is minted (increasing its supply), LUNA is burned to maintain the balance.

The Importance of Incentives

This entire mechanism hinges on the economic incentives it provides to arbitrageurs. They are the invisible hands constantly adjusting the supply of UST and LUNA to maintain the peg. The potential for profit keeps them actively participating in the system, ensuring UST stays close to $1.

Elastic Money Supply: A Balancing Act

Terra maintains a dynamic money supply for its stablecoins. This means the total amount of UST in circulation constantly adjusts based on market forces. Here’s the gist:

• Minting New UST: When demand for UST surges, the system mints new UST tokens to meet that demand. This increases the overall supply but should theoretically be offset by burning LUNA to maintain the peg.
• Burning UST for Stability: Conversely, if UST’s price dips, the system burns existing UST tokens, reducing the total supply and countering downward pressure on the price.

Real-World Applications: Beyond the Hype

Terra stablecoins aren’t just a theoretical concept. They’re making waves in the real world:

• Streamlined Payments: Imagine paying for your online shopping with UST – fast, secure, and borderless. Terra stablecoins are being integrated into payment systems, offering a convenient alternative to traditional methods.
• DeFi Powerhouse: Terra is a hub for decentralized finance (DeFi) protocols. These protocols leverage UST’s stability to offer lending, borrowing, and other financial services within the blockchain ecosystem.

Limitations to Consider

It’s important to remember that this system is complex and relies heavily on market forces. While it works well in theory, unexpected events or sudden loss of confidence in UST can disrupt the balance. For instance, if a large number of users lose faith in UST and try to sell it all at once, the burning of UST might not be enough to keep its price at $1.

Conclusion

Despite these hurdles, Terra’s future looks bright. The project is constantly evolving, with developers working on improvements and new features. With continued innovation and a focus on building a robust ecosystem, Terra stablecoins have the potential to revolutionize the way we interact with digital currencies.

Frequently Asked Questions

• How much LUNC is consumed every day? LUNC has burned at an incredibly inconsistent average rate, varying from 95.8 million to over 181 million per day. Recent rises in the LUNC burn rate have resulted in the burning of over 749 billion LUNC.

• Is investing in Terra Luna Classic a wise move? LUNC investors are optimistic about the future despite the recent crypto winter. Terra Classic has recovered from a bear market and shown significant growth over the last 12 months. Forecasts point to a possible peak of $0.00031 in the upcoming year, pointing to a rising trend.

• With old Luna, what can I do? Following the collapse, the Terra community decided to airdrop fresh LUNA tokens to a large number of holders of UST tokens and old LUNA tokens, as well as to start a new LUNA chain called LUNA 2.0.