What Is Terra? The Chaotic Algorithmic Stablecoin Protocol Explained

Stablecoins are assets pegged to the price of a single asset, typically a fiat currency such as the dollar. The first generation of stablecoins, such as Tether, maintain their price using a basket of assets including fiat reserves.

But some advocates of decentralization argue that a centralized entity maintaining a basket of real-world assets introduces a single point of failure into the system. That brings with it risks such as opacity over governance structures and whether the actual reserves held match up with what’s claimed—in turn, creating a focus for regulatory attention.

Decentralized stablecoins try to avoid these governance issues by maintaining their pegs through algorithms instead of through vast reserves of cash and debt. 

TerraUSD (UST), produced by Terraform Labs, is one such algorithmic stablecoin. (It has others pegged to different world currencies.) It aims to maintain its peg to the U.S. dollar through a network of arbitrageurs, who buy and sell Terra’s volatile cryptocurrency, LUNA (also, confusingly, known as Terra). LUNA is also a governance token, and grants holders voting power over the protocol.

In October 2023, Terraform Labs accused U.S.-based American market-making firm Citadel Securities LLC of intentionally destabilizing its TerraUSD (UST) stablecoin in May 2022, alleging that the firm was the result of a “concerted, intentional effort” rather than an algorithmic failure. Let’s examine this controversial coin.

Who created Terra?

The Terra ecosystem was created by a startup called Terraform Labs in 2018, founded by Do Kwon and Daniel Shin.

How does Terra work?

To maintain its stablecoins’ equilibrium, Terra mints and burns tokens while also incentivizing arbitrage. Here’s what that means:

Before you can buy UST, you’ll have to mint some. To do so, you’ll pay the going rate in LUNA. The protocol takes those LUNA and burns them, which constricts their supply and makes the price of LUNA go up just a bit. The same works in reverse: to mint LUNA, you’ll convert UST stablecoins. Those get burned and the price of UST goes up ever so slightly.

Why might you want to do this? In addition to using the assets for some service or utility, there’s a potential arbitrage opportunity. Arbitrageurs—traders who profit from small price discrepancies—help to keep the price of UST in check by selling LUNA for UST when the price of UST is below $1 and buying LUNA when UST is worth more than $1. If, for example, UST slips to $0.95, traders can then buy a bunch at that price but sell it for $1 of LUNA. In doing so, UST supply is reduced and, therefore, the price heads back up—at least, in theory.

This same mechanism powers Terra’s other stablecoins, including a stablecoin pegged to the South Korean won and another pegged to a basket of leading world currencies maintained by the International Monetary Fund (called Special Drawing Rights).

Terra’s whitepaper claims that the elasticity of LUNA’s supply means that the stablecoins will never fall out of kilter. Still, its success depends on arbitrageurs’ continued interest in UST. If arbitrageurs decide that UST is doomed to fail, or move their money to another project, some analysts fear that they might not arbitrage UST back to its peg of $1. Like a lot of crypto projects beholden to free markets, the community spirit is paramount. 

What else is special about Terra?

The coins are built on the Cosmos ecosystem, a blockchain framework shared by Cosmos Hub, Cronos and Thorchain. Unlike Ethereum, where all tokens are secured by proof-of-work mining from the main Ethereum chain, Cosmos protocols can be backed by independent, app-specific miners. 

Since Cosmos, and by extension Terra, is a smart contract blockchain protocol, you can use Terra coins within any of the applications built on the protocol. You can also use Terra coins across blockchains through Terraform Labs’ Mirror Protocol, which provides stocks that mirror the price of major U.S. firms. 

At the end of September 2021, Terra launched an upgrade called Columbus-5. This added functionality for the Inter Blockchain Communication (IBC) protocol, which allowed Terra to become interoperable with other blockchains. Standouts include an insurance protocol called Ozone, and support for UST from cross-blockchain bridge Wormhole V2.

The future of Terra

The future of Terra’s protocol is really a discussion about the future of the stablecoins that underpin it. Will centralized U.S. dollar stablecoins become so ingrained within the U.S. financial system (perhaps through a central bank digital currency) that decentralized alternatives fall out of fashion? 

Conversely, will decentralized stablecoins move away from U.S. dollar pegs and become backed by protocol-owned liquidity? Or will arbitrageurs tire of LUNA and crash the price of all the stablecoins within its protocols, and consign them to the graveyard along with Basis and Empty Set Dollar?

The 2022 UST crash

In May 2022, these questions were thrown into sharp relief as Terra’s native stablecoin UST lost its dollar peg amid a wider crypto market crash.

UST plummeted as low as $0.30 on May 11, essentially wiping more than $11 billion from UST’s market capitalization. At time of publication it has recovered some of its losses, but failed to regain its dollar peg, despite the efforts of the Luna Foundation Guard to deploy billions of dollars worth of Bitcoin reserves to keep UST pegged to the dollar. 

And just as UST plummeted, so too did LUNA. During the de-pegging event, the native asset dropped more than 95% in value, as the market lost confidence that its mint-and-burn mechanism could again stabilize UST.

UST’s de-pegging also attracted renewed attention from regulators. In a hearing on May 10, U.S. Treasury Secretary Janet Yellen cited UST’s collapse as yet another reason that stablecoins need to be regulated in 2022. 

The instability of Terra’s native stablecoin in May 2022 put much of the Terra ecosystem at risk. This is because it is the only native stable asset that can be used for various decentralized finance (DeFi) activities on this network, be it lending and borrowing or even making simple swaps. Without an effective stablecoin, many of these activities become extremely risk-prone.