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Terra and Cosmos, Architects of a Decentralized Financial System

Terra and Cosmos, Architects of a Decentralized Financial System

  • Terra, along with its LUNA cryptocurrency, is based on the Cosmos SDK system; with the creation of stablecoins, it quickly became the second-largest ecosystem in decentralized finance, although it recently collapsed dramatically.
  • Updated on 17 May 2022.
Portada Cosmos y Terra

Cryptocurrencies encompass many protocols and applications that build the new decentralized financial system. In this context, two essential blockchains are Terra, which seeks to revolutionize stablecoins, and Cosmos, the creator of other blockchains.



Terra creates stable decentralized currencies

Terra is a blockchain that specializes in creating stable coins such as UST, EUT, and KWT, among others. Stable coins are tokens linked to other currencies or assets. In the first quarter of the year, Terra established itself among the top five blockchains by market capitalization, thanks to its mechanism for creating stable coins, particularly UST, a currency pegged to the value of the U.S. dollar. 

UST is an algorithmic stable coin that works under a series of smart contracts, maintaining the link with the dollar. It has an innovative mechanism of «burning» Terra’s native token called LUNA to generate UST. That is, every time USTs are created, in the backend, the blockchain «burns» an equivalent amount of LUNA. 

This mechanism results in two fundamental principles for the blockchain. First, when a quantity of LUNA is burned, its total supply is reduced. As a result, its price goes up, as there is a reduction in tokens. Second, burning a quantity of LUNA keeps the UST peg stable concerning the dollar. 

Terra UST

Q1’22: Terra gained confidence, and LUNA increased in value

With its innovative mechanisms, Terra established itself during the first quarter of 2022 as the leading blockchain issuer of stable decentralized algorithmic stable coins. Demand for UST grew exponentially, which increased the price of LUNA. By the end of March, UST had a market capitalization of $14 billion, making it the fourth-strongest stable coin.

On the other hand, LUNA surpassed its all-time high twice in the first quarter of the year, with prices at $100 at the end of December and $104 in March.

La demanda de UST creció en gran medida gracias a la plataforma de finanzas descentralizadas Anchor Protocol. Esta es una de las más de cien aplicaciones de DeFi construidas en esta blockchain.

UST demand primarily grew thanks to the Anchor Protocol decentralized finance platform. It is one of more than a hundred DeFi applications built on this blockchain.

Terra issues UST, a stable algorithmic currency

There was a lot of skepticism about the UST stable coin from its inception, as the blockchain issued a token linked to a real-world currency without fiat reserves. It was to avoid the creation of a centralized, stable coin like USDC and USDT.

On the contrary, Terra issued UST under specific computational mechanisms, making it a stable decentralized currency. That is, UST was backed by smart contracts and also by LUNA, the blockchain’s native currency

To keep the value of UST pegged to the dollar, TerraForm Labs, Terra’s creator, has a non-profit organization called Luna Foundation Guard. LFG is charged with supporting the Terra ecosystem by creating a decentralized global economy with the fundamental task of linking UST to the U.S. dollar. 

LFG announced in the last week of February the acquisition of $1 billion in bitcoin, thereby establishing a reserve of UST denominated in BTC. To perform this, it burned an equivalent amount of LUNA.

A blockchain world interconnected with Cosmos

Cosmos is a blockchain ecosystem that positions itself as one of the architects of the decentralized financial system. It can create other blockchains that can interoperate, which is crucial for the ecosystem. 

Luna, Binance Smart Chain, Thorchain, and Kava are among the blockchains built using three mechanisms.

Cosmos the internet of blockchains
  1. Cosmos SDK: This system allows the creation of customized blockchains that can communicate natively with other blockchains.
  2. Tendermint Core BFT Consensus: Blockchains are built using the proof-of-stake consensus mechanism with this consensus engine. 
  3. Interblockchain Communication Protocol: IBC is the system that allows communication with different blockchains generated with Cosmos SDK or with other blockchains.

How do Terra and Cosmos interact?

Terra is a blockchain built with the Cosmos SDK development system. The Cosmos SDK system is used to build blockchains that employ proof-of-stake mechanisms. The advantage of this system is that Terra was not made from scratch but relatively leveraged Cosmos tools to customize its own decentralized and secure blockchain.

Terra chose that system for building its blockchain thanks to specific Cosmos mechanisms, such as the IBC protocol. By using it, Terra can communicate with any blockchain created with the Cosmos SDK system and with blockchains that use proof-of-stake as their consensus mechanisms, such as Solana and Polkadot. Another advantage of the Cosmos system is that blockchains generated on it can quickly scale.

Blockchain and cryptocurrencies

Anchor Protocol: savings with a 20% annual rate of return

Anchor is a decentralized lending and savings protocol built on Terra’s blockchain. It offered a low volatility yield of 20% on deposits of UST, the primary stablecoin in Terra’s ecosystem. The platform also allowed users to borrow UST at low-interest rates fluctuating between 0.5% and 3%.

In DeFi protocols, loans are over-collateralized; a cryptocurrency has to be locked on the platform with a value greater than the loan taken. Anchor allows users to take a loan of 85% of the guarantor’s deal with its new updates. 

Users using Anchor as a savings account were able to receive this 20% rate thanks to the interest generated by the loans and the incentives of cryptocurrencies acting as collateral. Taking a UST loan requires depositing cryptocurrencies such as bLuna and BETH. 

bLUNA y BETH

These cryptocurrencies perform staking on their respective blockchains. bLuna is a version of LUNA that generated a 9% interest, while BETH is a version of ETH that developed a 4% interest.

Taking the interest on the loans and the interest generated by the guarantor, Anchor paid depositors 20% in its stable UST currency. It made it the fourth most extensive DeFi protocol in the world.

How did Cosmos help Anchor maintain a 20% interest rate?

More cryptocurrencies were included as guarantors to keep the interest rate stable at 20%. One of the proposals was to have ATOM, the native currency of the Cosmos blockchain, in the protocol.

The blockchain would generate 14% constant interest, with ATOM as guarantor, thereby keeping the protocol liquid through the various market cycles by staking with the Cosmos currency. 

With the inclusion of bATOM, the staking version of ATOM, the platform would receive new users, which would generate greater liquidity in both Anchor and bATOM. 

Anchor Protocol and Cosmos

It has been a year since Anchor deployed on Terra’s blockchain and paid its users 20% interest on their UST deposits. Despite the platform’s stability, Anchor relied on borrowed loans to be able to pay its desirable interest rate. 

There were more deposits than loans in many cases, so there was an imbalance in liquidity. For this reason, it held a reserve in UST to offset these ups and downs. In February, $500 million was added to the account, ensuring liquidity in Anchor’s system.

The platform managed more than $15 billion at the end of March. However, the supply/demand ratio broke in May, and Terra’s funds plummeted, as did the cryptocurrencies within Anchor Protocol.



Terra Luna’s historic collapse

In a matter of days in May, Terra’s cryptocurrency (LUNA) fell 99% after peaking at $120 last month at $0.09. Likewise, its stablecoin, UST, pegged to the dollar price, is currently worth $0.12.

Graph of the fall of Terra

The crash was due to an imbalance caused by massive UST withdrawals, which destabilized the value. Terra’s algorithm started burning UST tokens in exchange for LUNA tokens to keep the UST price stable. In addition, investors quickly began to liquidate their digital assets; then, the algorithmic stabilizer could do nothing.

Future of stable currencies and interconnected blockchain system

Stable coins are necessary in the world of cryptocurrencies. Many investors do not want to expose themselves to as much volatility in market downturns, so a stable currency opens the door for traditional financial markets to merge with cryptocurrencies

Terra creator of stablecoins

Cosmos is one of the prominent builders of this new ecosystem. Each blockchain has advantages and disadvantages, and communication is vital. Cosmos has a fundamental role in creating the interconnected world, as it allows to bring together different applications and protocols of decentralized finance. 

Terra’s current situation, on the other hand, is uncertain. Unable to keep the price of its UST stablecoin stable, it lost a large share of users overnight, and with it confidence and credibility. Investors suffered unprecedented losses when Luna’s market capitalization value fell from $40 billion to $500 million. This collapse has caused uncertainty among cryptocurrency investors and in the stablecoin thesis.

Translated by Shebatt Quiñonez.

Last updated on 17 May 2022 by Sarahy Uribe.

FAQ

What is Terra cryptocurrency?

Luna is the name of Terra’s native token.

What is a Terra blockchain?

It is a blockchain specializing in creating stable currencies such as UST, EUT, and KWT. Stable currencies are linked to other currencies or assets, such as the US dollar.

What is Cosmos?

It is a blockchain ecosystem positioned as one of the architects of the decentralized financial system. It can create different blockchains that can interoperate, making it a crucial blockchain for the ecosystem.

How are Terra and Cosmos related?

Terra is a blockchain built with the Cosmos SDK development system, used to build blockchains that employ proof-of-stake mechanisms. The advantage of this system is that Terra was not made from scratch but relatively leveraged Cosmos tools to customize its own decentralized and secure blockchain.

What is Terra’s most important cryptocurrency?

UST was Terra’s most important stable currency, as it was pegged to the value of the US dollar. However, in May, it collapsed dramatically.

What is Anchor Protocol?

It is a decentralized lending and savings protocol built on Terra’s blockchain. Initially, it offered a low volatility return of 20% on deposits of UST, the primary stablecoin in Terra’s ecosystem. However, it was unsustainable and recently suffered an unprecedented disruption.

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