Why Terra Blockchain was not a Failure?

One of the top 10 crypto currencies a week ago, a stable coin, Luna’s market cap dropped from over $40 billion to just $500 million dollars within the first 24 hours of the market crash. This dramatic fall of terra (Luna) has wreaked destruction in the lives of investors. It got to the point where investors feared they would become homeless after the mayhem ends. 

What’s more? It was dubbed as a “stable coin”. Stable coins are pegged to a commodity/currency or algorithmically developed stable coin to keep their price relatively stable. Now the question arises, “How do we maintain UST’s price?”.

UST is an algorithmic stable coin developed by Terra Form Lab and its price is pegged to US dollars (a fiat currency). Luna is Terra’s governance token and it plays an important role in maintaining Terras stablecoins value by reducing market volatility. Since, UST does not rely on a reserve of assets to maintain their peg, instead it makes use of an algorithm that establishes a balance between UST and Luna. 

The terra ecosystem has two kinds of tokens:

1. A large family of terra stablecoins
2. LUNA

Luna is the governance token of this chain. It is used for mining rewards, volatility absorptions and transaction fees. The protocol runs on the Delegated Proof of Stake(DPoS) mechanism. In DPoS, miners mine Terra Stable coins by staking LUNA. Stablecoins of Terra are pegged to some of the most powerful fiat currencies of the world. 

This bundle of currency includes USD, EUR, JPY, GBP, KRW, CNY etc. If another currency is to be added to the bundle, it is done via community voting. 

To understand this phenomenon, let's take an example of UST, which is another name for TerraUSD, a cryptocurrency stablecoin. These coins are usually pegged, either literally or artificially, to the United States Dollar. 

Terra’s mechanism allows users to trade between Luna and UST. For example, if UST token is trading at 1.02 US dollar, users can trade 1 US dollar worth of Luna for 1 UST, while the market burns 1 USD of Luna and mints 1 UST. Now, users can sell their 1 UST for 1.02 US dollar and earn a profit of 0.02 US dollar. This mechanism increases USTs’ demand but also reduces its supply, hence UST eventually returns to its pegged value. 

If 1 UST is trading at 0.98 US dollar users can then trade 1 UST for 1 US dollar of Luna, market burns 1 UST and mints 1 US dollar of Luna. By selling 1 US dollar of Luna, the user has earned a profit of 0.02 US dollar. In this case, supply of UST increases but the demand for it decreases which brings the price of UST back to its pegged value.   

Now what happened here is that USTs were being sold and dumped faster than the capacity of liquidity pools. It means that the liquidity pool did not have necessary assets to carry these mass level transactions, thus the coin devalued and the result was displayed before the entire world. 

This market was never stable to begin with but this 99% drop left investors with nowhere to go. But is it really a failure? Most experts would say so. But if we overlook this massive loss of money, we will observe how it was a successful experiment and learn alot from it. What we have learned is that we need to develop:

1. A Stable Ecosystem
2. A financial doomsday model

Ecosystem Development: 

Two things that define a blockchain is its ecosystem and community. To make a blockchain less volatile, we need a hefty community and powerful ecosystem. Terra Labs did an excellent job of creating a strong ecosystem. Their ecosystem was focused on attracting external projects on the terra blockchain. This blockchain had 114 projects in total. Here is a picture representing apps in their DeFi Ecosystem.

But their ecosystem collapsed nonetheless. This shows that there is no limit to how strong an ecosystem should be to make a blockchain sustainable.

Develop a Financial Doomsday Model:

People took to social media and networking channels to share their experience. An investor who lost over $15,000 after HODLing it when it was trading above $100 the previous month said on reddit, a popular networking channel, "I got greedy hoping to get more money so I can at least afford a downpayment for a house for my family. I guess no house and savings then,". Another redditor said, "I lost all my life savings. Had bought Luna at $85, not sure what to do,”

There are many similar scenarios where crypto investors lose life-time worth of savings in similar crashes. What we need here is a doomsday financial model. It will be a fail safe plan in case of such contingencies where the investor community doesn’t go homeless in case of a market crash.

For stablecoins, the reserves should not only be algorithmic. There should be reserves in the form of assets and commercial papers (a short term debt issued by companies). This is because Algo stablecoins are vulnerable to extreme market conditions and run on their reserves.

Final Thoughts:

What we learn from this development is that DeFi is still in experimental stages. Also, we need to introduce better incentives where investors feel secure when HODLing. Moreover, algorithmic stable coins can be made less volatile by having secondary assets.

In the end, we can safely conclude that this can be termed as a successful experiment as it provided us with very valuable insight into the crypto market. The Terra blockchain may rise again but the story of these recent events is forever etched into the history of the crypto market world.

Note: This Article is researched by RNS Solutions’ R&D Lab and is proofread by Dr. Shakil Muhammad, CEO RNS Solutions and a top blockchain expert.