The Economics of Terra & Luna

Using Seigniorage to Build Monetary Systems on the Blockchain

In today’s post, we will talk about:

• Seigniorage and What It Is

• The Terra Ecosystem and Its Economics

• The Interplay Between Terra and Luna

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Seigniorage is the difference between the face value of money and the cost of producing it. For example, if it takes the government $0.05 to mint a new $1 bill, the 95 cents here is considered to be the seigniorage. In other words, it becomes revenue for the government issuing the currency.

Seigniorage can take place naturally as well, even without the influence of any government or money printing. Imagine an economic system where there are only two types of currencies - gold and silver. If a silver coin is worth $1 while the gold coin is worth $20, people would only transact and exchange for goods in silver and hoard the more valuable gold.

Ultimately, gold would be taken out of circulation and an effective seigniorage would take place on the value of gold. This phenomenon, which was originally observed by Sir Thomas Gresham while working as a financier for the Royal Exchange in London, ultimately became Gresham’s Law in economics.

Since one of the many purposes of crypto is to create “sound money”, it is not surprising that projects are implementing seigniorage as a part of their tokenomics. But perhaps the most interesting implementation of it so far has been Terra and the ecosystem around it.

So what exactly is Terra?

According to it’s founder Do Kwon, Terra’s mission is to create “the most useful dollar possible”. To become useful money is a big ambition for any project, especially when considering what it takes to get there. For money to be useful, it primarily needs to meet two thresholds:

1. It needs to be a good medium of exchange

2. It needs to be a good store of value

Soure: YahooFinance

Even Bitcoin, which was created as an alternative currency to fiat, is only able to really fulfill one of these aspects. It is a good store of value due to the scarcity baked into its code, but its not so great as a medium of exchange. Transactions take too long, fees can be too high, and its far too volatile. Breaking it down is also incredibly difficult.

For example, if a store listed it’s prices in Bitcoin, you would have to first go on a web browser or app to check the price of Bitcoin, and then your calculator to see what 0.000022 Bitcoin is worth. Bringing us back to Gresham’s Law, it is also probably not something you want to exchange with. If you think Bitcoin’s price is going to go up in the future, how willing would you be to give it up now for your coffee in the morning?

On the other end of the spectrum are the cryptocurrencies which can be great mediums of exchange, but often fall short as a store of value. Stablecoins pegged to currencies are a great example of this. USDC may be an easy way to transact because 5 USDC is worth $5. You don’t need your phone or your calculator to use it. But the fact that it is pegged to the U.S dollar would mean that you would be feeling the impact of inflation just the same as someone holding USD. Not so great as a store of value.

Fiat Backed Stablecoins (Source: Wes Levitt)

The Terra protocol provides a dual-sided solution that addresses both concerns with becoming useful money. First, Terra offers a stablecoin that is pegged to fiat currencies such as the U.S Dollar or Korean Won. All of these currencies track 1:1 with their respective fiat system, meaning that TerraUSD (UST) reflects exactly $1 worth of value. The ecosystem offers shared liquidity across the many different currencies, meaning that TerraUSD and TerraKRW (KRT) can be swapped instantly at the market rate for KRW/USD.

While other stablecoins are backed and collateralized by fiat or on-chain assets, Terra’s backing of its stablecoin comes from its sister token - Luna. The purpose of Luna is to act as a staking and governance protocol for UST. Luna is not a stablecoin and the price is subject to volatility, much like most major cryptocurrencies.

Since Terra runs on a Proof-of-Stake (PoS) blockchain network, miners need to stake Luna in order to earn rewards from activity and usage of UST. Holding the Luna token means you have the ability to connect to a network validator in the ecosystem. When UST is used to settle transactions, the fees from the transaction are distributed amongst these validators.

Luna also serves the purpose of acting as a price stabilizer for the stablecoin Terra. This interplay between the two tokens creates an interesting model for a monetary and fiscal system on the blockchain - the Terra ecosystem.

How Does All of This Work?

The Terra ecosystem is designed so that 1 UST can be exchanged for exactly $1 of Luna. As the demand for UST goes up due to increase in usability of Terra, the price of UST follows and goes above $1. Luna holders can spot this arbitrage opportunity, and exchange $1 worth of Luna to earn UST that is currently valued above a dollar. This takes out supply from UST until it eventually returns back to its stable price of $1.

Source: Terra

As an example, let us imagine the total supply of UST to be exactly 100 with a stable price of $1.00. As more transactions take place using UST, there is higher demand for this stablecoin amongst users and merchants. Increased demand is reflected in the price, and UST price de-pegs from the dollar and becomes $1.05. You are a savvy investor who holds $100 of Luna and know that the algorithm allows you to exchange $1.00 of Luna for exactly 1 UST.

There is clearly is an arbitrage opportunity here. You exchange $100 worth of Luna for 100 UST, which is now valued at $105 and walk away with a $5 profit.

In the process, you have done 2 important things:

1. You have added 100 new UST into the total pool which helps stabilize the price of UST back to $1.00

2. You have taken $100 worth of Luna out of circulation, making Luna more scarce. The system burns a portion of the Luna, and the remaining is seigniorage which returns to the Treasury. The result is Luna becoming more of a deflationary asset as the usage of UST goes up

Source: Terra

On the flipside, let’s imagine that the demand for UST is decreasing in a contractionary environment. Lower demand is reflected in the price, and it momentarily de-pegs to $0.95. Since UST can be exchanged for $1 of Luna, you exchange your 100 UST into $100 of Luna, pocketing the $5 difference as profit.

In the process, you have done the exact opposite as above:

1. You have taken out 100 UST out of the pool, which impacts the supply and stabilizes the price back to $1.00

2. You have minted new Luna, which adds to the supply and decreases the price of Luna.

So far, this model has obviously worked. TerraUSD is one of the largest stablecoins in the world, with adoption growing exponentially all over the world. As of this writing, about $31.3 billion is locked up within the Terra ecosystem. This has also spurred new innovation in the space, starting from payment processors, such as Chai, to protocols such as Anchor and Mirror.

Source: DefiLlama

Beyond just seigniorage and trust, the algorithmic stablecoin of Terra also offers many regulatory advantages. USDC and Tether are minted by centralized organizations and are backed by collateral which are often not very transparent. Terra, on the other hand, is minted by individuals who use the ecosystem. Since Luna is backing Terra, the collateralization behind it is also perfectly transparent.

Source: CoinTelegraph

More recently, LFG (Luna Foundation Guard) approved a proposal to back the Terra stablecoin using roughly $10 billion worth of reserves in Bitcoin, with other decentralized assets to be added in the future. Beyond that, there is so much going on in this ecosystem that it is not possible to cover in just one post.

Source: LFG Twitter

Regardless, I think it is safe to say that this won’t be the last time you or I hear about Terra and Luna.