The Terra Stablecoin
In Facebook’s announcement of its Libra blockchain project, the company highlighted that the cost of digital payments is prohibitive for many people and businesses around the world. Facebook is not alone in trying to address this issue of costly payment processing. In South Korea, over USD20 billion is transacted annually on ecommerce sites that operate on razor thin margins. These transactions are expensive to process, with sites paying up to 3% in transaction fees to traditional payment processing companies. With over USD0.5 billion in annual fees, it is no wonder that ecommerce companies in Korea and other parts of Asia are looking for a cheaper solution. One such solution is the Terra network, a price-stable cryptocurrency aimed at mass adoption. In many ways, Terra has created an Asian-centric version of what Facebook is trying to accomplish with Libra. This month we will evaluate how the Terra stability mechanism works and how Terra plans to go mainstream, starting with ecommerce platforms in Korea.
Digital assets and cryptocurrencies enable low cost digital transactions to take place. However, speculative demand for Bitcoin leads to wild volatility, making it impractical for use in applications like ecommerce. Vendors are unlikely to want to receive payment in a currency whose value could rapidly decline before the transaction is settled. One solution for ecommerce platforms is to use stablecoins that benefit from extremely low transaction fees and maintain their prices relative to a fiat peg. This is the goal of Terra. By dramatically lowering payment processing fees, it aims to become the default payment option for ecommerce platforms around the world.
Terra is a payment network that has been built using the Cosmos SDK, with the network running on top of the Tendermint consensus engine. As with other proof of stake networks, Terra has its own miners who play a key role in maintaining the network. In order to be a miner on Terra, the miner needs to stake a token called Luna. The amount of Luna staked directly corresponds to how often the miner will be elected as a block producer and the amount of fees the miner will accrue, paid in the stablecoin Terra. Miners have a crucial role in ensuring price stability, as they act as price oracles, stating exchange rates for different currency pairs. Malicious miners are slashed (some of their Luna holding is taken away as a punishment) for providing inaccurate price data, while honest miners are rewarded for providing accurate data, with accuracy being a function of average submissions.
From a technical perspective, the critical mechanism built into Terra is that it achieves price stability. In fiat monetary systems used by countries, the money supply is manipulated by central banks and governments through mechanisms such as interest rates and the issuance of bonds. In Terra, an elastic money supply has been built into the network to maintain price stability. When price levels are falling below the target, the network works to reduce the money supply, pushing prices back up to the peg. Vice versa, when price levels are rising, the network expands the money supply which pushes prices back down to the peg.
A key property of Luna is that it can always be bought or sold for Terra at the peg price. The network agrees to be the counter-party for anyone looking to swap Terra and Luna at Terra’s target exchange rate. This provides an incentive for traders to continually trade the arbitrage between the peg price and the real-time market price. If we assume the Terra pegged price to be USD1 and the market price to be USD1.1, then traders will look to swap Luna for Terra through the protocol at the USD1 price and then immediately sell on the market at USD1.1. This will deflate the market price until the arbitrage opportunity no longer exists. Likewise, when the market price is USD0.9, traders will buy Terra off the market and then sell to the protocol at the peg price of USD1. In both examples, traders can make 10% returns by trading arbitrage on the network. By doing so, they move the market price of Terra back to the peg price.
Price stability is a key feature of the network, but Terra is one of many stablecoins. What makes Terra unique is its focus on adoption. When the supply of Terra expands to maintain the price peg the protocol uses some of the newly minted Terra to fund discounts on ecommerce websites, driving users towards Terra as a payment method.
For example, let us assume that a new ecommerce player opts to use Terra, which leads to an additional USD100m in transaction volumes. To meet the increased transaction volumes and demand, the Terra protocol must mint new Terra of USD10m. This new Terra can be rewarded to ecommerce users in the form of discounts, with shoppers using Terra for their payment being given better prices. This provides a strong incentive to use Terra over other payment options.
While discounts are a good way to incentivise usage, the team behind Terra realised that it would be tough to convince users to try a payment method denominated in a currency different from the local currency. As a result, Terra will create multiple stablecoins, each pegged 1:1 to a local currency. These stablecoins will have shared liquidity, with the system supporting atomic sways between Terra currencies at their market exchange rates. For example, TerraUSD can be swapped for TerraKRW (Korean won) instantly at the effective USD/KRW exchange rate. As the number of supported currencies increases, this atomic swap functionality can be applied to new use cases such as cross border transactions and international trade settlements.
The Terra mainnet launched in April and is gaining adoption. Last month Chai, a Korean mobile payment service, partnered with Terra and it is now one of the most heavily used blockchain applications in existence. Chai offers the ability to pay with Terra on ecommerce platforms like TMON, one of the largest players in South Korea. In just over a month, Chai has handled 379k Terra transactions for 240k users, with single day transaction volumes of almost USD1m. As a result of its success with Terra, Chai is expanding its Terra integrations and has announced partnerships with Idus (a popular online marketplace in Korea) and the crypto credit platform Nexos.
CMCC invested in Terra in January 2019 and we remain excited by the product and team. The founder of Terra, Daniel Shin, is an accomplished tech entrepreneur, having previously built and exited an ecommerce company to KKR. Terra has signed up an impressive set of companies willing to try out their stablecoin solution, including some of the largest food delivery, e-commerce and ticketing companies in Korea and Asia. They have also established a banking partner that is facilitating the swift conversion from Korean won to Terra. We are watching the continued roll out of Terra closely and believe that it has the potential to become one of the first mass-market blockchain payment solutions.
