The Terra blockchain and its native token, LUNA, have recently experienced unparalleled growth due to UST’s rapidly growing adoption. In 2021 alone, LUNA experienced a +14,000% change in market capitalization, and UST’s supply surpassed $10 billion.
Terra’s Columbus-5 upgrade, implemented earlier last fall, is mainly responsible for UST’s recent supply growth. Columbus-5 was initiated with the primary goal of simplifying the economic design of Terra and improving the value capture of LUNA holders based on UST’s growth. The upgrade has largely achieved this by decreasing the liquid supply of LUNA through increased burning and staking and increasing the supply of UST by expanding its cross-chain prevalence. Increased cross-chain distribution of UST has also improved the security of the asset by removing the risk of dependence on a small number of protocols. Before delving into the specific details of Columbus-5, it is essential to establish background on Terra.
Terra Basics
Terra is a Proof-of-Stake (PoS) protocol that creates decentralized, algorithmic stablecoins. While Terra can create stablecoins that track any fiat currency, UST has been its primary use case. Terra maintains UST’s peg of USD through an elastic monetary policy enabled by its dual, UST-LUNA token model. When the value of a unit of UST is above the USD peg, users are incentivized to burn LUNA and mint UST. When the value of a unit of UST is below the USD peg, users are incentivized to burn UST and mint LUNA. During times of UST contraction, LUNA valuation decreases, and during times of expansion, it increases. LUNA is the variable counterpart to UST. By modulating supply, LUNA’s valuation increases as the demand for UST increases.
LUNA holders secure the network by bonding their LUNA to a network validator. Bonded LUNA accrues staking rewards that come from three sources: gas, market stability fees, and swap fees. Users can stake their LUNA to a network validator through Anchor Protocol in exchange for bLUNA, a tokenized representation of bonded LUNA that can be traded freely or used as collateral on other protocols in the Terra network. Unbonding LUNA may take up to 21 days, during which rewards are not accrued.
Columbus-5 Upgrade
Economic Changes
Seigniorage occurs when LUNA is exchanged to mint new UST. Prior to TIP43 and Columbus-5, whenever UST was minted, the Terra Protocol would burn a portion of earned LUNA, and the rest would be diverted to fund various community projects. Due to the rapid pace of seignorage generation, Terra’s community pool and oracle reward pool became overfunded. In an effort to fix this and maximize value accrual for LUNA holders, Columbus-5 implemented the burning of all community pool funds and routed 100% of all future seignorage to be burned. Roughly 89 million LUNA was burned from the community pool. $1 billion worth of burned LUNA converted to UST was used to bootstrap Ozone, an algorithmic, claims-based insurance protocol on Terra. Ozone would later be taken over by Risk Harbor, an automated risk management protocol for DeFi.
Increased burning has led LUNA to become a radically deflationary asset and has improved its value capture based on UST’s growth. While community projects may no longer receive funding from seigniorage, other community-led programs have surfaced to fund new projects.
Economically, increases in UST demand simultaneously result in the expansion of the LUNA demand curve and contraction of the LUNA supply curve. Given that the demand curve for LUNA is more inelastic at lower supply levels, increased demand for UST at lower levels of LUNA supply has an exponentially greater impact on LUNA price. As LUNA supply decreases, the actual amount of LUNA needed to be burned to mint UST also decreases. If UST adoption continues to grow over time, it is possible that LUNA supply will become essentially fixed at some low level in the future. Burning 100% of seigniorage will dramatically accelerate the reduction of total LUNA supply over time.
Oracle Developments
Validator oracle votes are critical in maintaining UST issuance at correct prices. Before Columbus-5, oracle votes had the potential to be pushed out of the mempool during periods of high network demand. This precise situation occurred during the May 2021 market crash when a flood of other transactions boxed oracle votes out of blocks. Following Columbus-5, oracle votes will receive priority in the mempool so that they are never forced out of blocks during periods of network traffic surges.
Before 100% of seigniorage was burned, a portion of it was allocated to validators to encourage accurate oracle voting. To compensate validators for the loss of seigniorage rewards, Columbus-5 dividends swap fees to validators that would have otherwise been burned. This change has resulted in higher yields for staking LUNA and has dramatically increased the amount of LUNA staked.
Cross-Chain Advancements: Inter-Blockchain Communication (IBC)
Terra is a Cosmos SDK blockchain utilizing Tendermint consensus. All blockchains built on the Cosmos SDK come natively with IBC, a standardized communication protocol for IBC compatible blockchains. Columbus-5 activated IBC functionality on Terra, enabling the seamless transfer of assets and data between Terra and other IBC-enabled chains such as the Cosmos Hub, Secret Network, Akash, Thorchain, and many more. Prior to Terra’s IBC integration, the IBC lacked a highly liquid stablecoin. Enabling IBC has enabled UST liquidity to flood into other IBC-enabled chains, and as hypothesized, UST has since become the dominant stablecoin pair on Cosmos’ most liquid DEX, Osmosis. As the Cosmos ecosystem continues to grow, UST’s growth stands to benefit immensely.
Increased demand for UST on other connected blockchains will continue to grow UST’s network effects and improve UST liquidity distribution. While UST’s cross-chain prevalence is improving, much outstanding UST supply remains heavily concentrated in a small number of protocols, such as Anchor. As UST’s cross-chain distribution grows, downward reflexivity to its peg and risk associated with its dependence on a small number of protocols is reduced.
Other Developments
Wormhole V2
While IBC connects Terra to application-specific blockchains on Cosmos, Wormhole connects Terra to disparate shared state machine blockchains such as Solana and Ethereum. While many current cross-chain bridges sacrifice a degree of decentralization in favor of convenience, Wormhole claims to retain the benefits of both. Wormhole operates as a decentralized oracle network that relays messages between chains, relying on the consensus of the connected chains to accept state changes between them. At the time of writing, $755 million UST has been bridged to other Wormhole integrated blockchains.
More recently, Wormhole suffered the largest recorded DeFi exploit in which over $326 million of ETH was stolen from the bridge. Jump Capital has since replenished all stolen funds, making all Wormhole users whole. Despite this setback, Wormhole remains one of the largest cross-chain bridges with over $2 billion locked.
Growth of Terra’s Ecosystem
Many new projects have launched on Terra following Columbus-5, bringing in new use cases and utility to the blockchain. Recent project launches, such as Astroport, have rapidly bootstrapped liquidity and have propelled Terra to the second-largest blockchain to Ethereum with $14 billion TVL, nearly 7% of the TVL across all chains. Beyond new projects, increased risk management through Ozone will also likely grow the TVL of existing projects on Terra. As of the new year, Ozone launched with protection for Anchor specifically and will be launching integrations with Mirror and Orion soon.
Incentive Programs
To further UST adoption on other blockchains, LUNA holders passed a governance decision in November 2021 to deploy $3 million of community pool UST (converted to LUNA) to various protocols’ liquidity pools across major L1s. More recently, LUNA holders voted to implement an additional liquidity mining program to deploy $2 million of LUNA to various protocols on Solana, Oasis, and NEAR.
Despite recent growth in decentralized stablecoins, centralized stablecoins still dominate overall stablecoin liquidity. Because of this, Terra has aligned their interests with decentralized stablecoins MIM and FRAX to bolster decentralized stablecoins’ share of the stablecoin market. Because the majority of stablecoin liquidity on Ethereum resides on Curve, LUNA holders recently voted to deploy a large amount of capital to incentivize deep UST liquidity on Curve. These incentives entail the deployment of $12 million in LUNA for Convex incentives, $250 million in UST to farm CVX/CRV via Curve’s USTw-3CRV pool, and $2 million in LUNA for Tokemak incentives.
Competition
DAI and Centralized Stablecoins
While DAI is technically a decentralized stablecoin, it is primarily collateralized by USDC, making it quite centralized relative to UST. Until UST surpassed it on November 18th, DAI was the largest decentralized stablecoin by market capitalization. UST’s supply is now 17% larger than DAI as it continues to grow at a rate faster than its more centralized peers. As shown by UST’s recent period of rapid growth, incentive programs can dramatically accelerate adoption. Although UST is far from eclipsing USDC or USDT, the combination of recent regulatory concerns around centralized stablecoins combined with UST, MIM, and FRAX’s collaboration to boost decentralized stablecoin liquidity on Curve may have the potential to change this narrative more quickly than others may realize.
MIM
At this point, MIM is more of a companion than a competitor; however, it is still the second-largest truly decentralized stablecoin to UST. While many kinds of yield-bearing assets collateralize MIM, UST predominantly collateralizes it through its Degenbox strategy. It contributes to a significant amount of deposits on Terra’s Anchor protocol. Abracadabra, like Terra, has also put forth considerable capital to incentivize the growth of UST and MIM on Curve by committing millions of dollars of SPELL emissions to Votium UST-MIM incentives.
MIM and Abracadabra are also part of a much larger ecosystem of projects led by developer Daniele Sestagalli known as “Frog Nation” (SPELL, TIME, ICE, and SUSHI). In addition to Abracadabra, Wonderland has also contributed to UST adoption by deploying its most recent $48 million UST yield farming strategy. Although decentralized stablecoins like MIM may become long-term competitors to UST if their supplies begin to outpace centralized stablecoins like USDC and USDT, for the time being, their growth is symbiotic.
Looking Ahead
As of January 14th, 2022 Terra will reduce its tax rate to 0. LUNA stakers currently earn rewards through a combination of on-chain swap fees and network tax income. The tax rate is currently a deterrent for developers with capital constraints wishing to deploy contracts on-chain. Terra seeks to inspire more new developers to build on the blockchain and further promote innovation by reducing the tax rate.
Other recently passed proposals involve the continued effort to bring UST liquidity outside the Terra ecosystem, further cementing it as a cross-chain stablecoin. This entails allocating:
$60 million UST to seed MarketXYZ, Themis, and Rari Fuse pools.
$1.7 million UST to enable bonds and incentives for OlympusDAO and InvictusDAO.
$18 million UST to increase Votium incentives.
$50 million to farm TOKE.
$1.4 million in incentives to leading protocols on Avalanche, Fantom, and Moonbeam.
$15 million to bootstrap liquidity on ZigZag Exchange which will onboard UST to zkSync and StarkNet.
While most of Terra’s recent governance proposals have been aimed at improving UST’s cross-chain dominance, Terra’s latest proposal was marketing-focused. Following the approval of $40 million of community pool funds to be used for a sports partnership, Do Kwon announced that Terra would be partnering with the Washington Nationals. As part of the agreement, UST will become an accepted payment method at Nationals Park.
Conclusion
Terra’s Columbus-5 Upgrade has propelled UST to the largest decentralized stablecoin and has created immense value for LUNA holders. The upgrade has set the path for UST adoption to continue to grow on other IBC-enabled blockchains and major L1s alike. LUNA supply will also experience greater contractions going forward following Columbus-5’s improved burning and staking mechanisms. More recently, Terra participants have set forth aggressive initiatives that attempt to further UST’s supply growth by increasing its cross-chain prevalence and real-life use cases. If these initiatives prove to be successful, LUNA holders will accrue immense value as a direct result of the changes implemented in Columbus-5.
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