The Lean Block

Posted on Apr 05, 2022Read on Mirror.xyz

The quest to decentralize major world currencies - How did it start?

How do you know that you have made it to the top? It’s when the government comes after you and serves you with a subpoena. It happened with all the big tech CEOs like Mark Zuckerberg, Sundar Pichai, Jack Dorsey, and Tim Cook. And it happened with Do Kwon, the co-founder of the Terra blockchain.

On September 20th of last year, Kwon was a guest speaker at a crypto conference in New York. Just as he was about to go on stage, he was approached by someone representing the US Securities and Exchange Commission (SEC) and was served with a subpoena for a certain financial application built on top of the Terra blockchain that the SEC didn’t like. His response? Suing SEC back on the grounds of an improper serving of the subpoena and citing that the decentralized nature of crypto projects, where the project is controlled by the public, means it can’t be regulated by the archaic regulatory frameworks currently in place.

Regardless of which camp you support in this debate, it has to be admitted that Terra is big enough to warrant the SEC’s attention, which is also a testament to its widespread adoption and success. But, how was Terra able to succeed in this crowded market of blockchains? What was their unique value proposition? How were they able to drive adoption early in the project? This post evaluates the go-to-market strategy of Terra to answer all these questions, and many more.

But first, below are some quick primers on a couple of topics that will be used in this post. If you already know all about stablecoins and the basics of Terra protocol, feel free to skip ahead.

What are stablecoins?

The allure of crypto is strong. The internet is strife with stories of people making life-changing money by investing in it. But as every crypto enthusiast/trader will tell you, it’s not a fun ride. Even the blue-chip assets like Bitcoin and Ethereum are highly volatile which makes it difficult to park your funds in them. Further, this volatility makes them bad means of payment. Who would know this better than the guy who bought two pizzas with 10,000 Bitcoins in 2010, which would be worth $400 million today. Ouch!

The need for a non-volatile crypto-native asset where you can park your funds, and even use it for payments, is what gave rise to stablecoins. Stablecoins are cryptocurrencies that are designed to be pegged to a real-life currency (referred to as fiat currencies). So the price of a stablecoin pegged to USD will always be $1. But how are these artificially created currencies able to ensure that their price is always $1? There are primarily two ways of doing this.

One way is to back them with fiat money. So, if I create 1 million USD pegged stablecoins on a blockchain, I would need to get actual 1 million dollars and put them in a bank. That way, if anyone wants to cash out their stablecoins, they can easily exchange them with the money that I have in the bank. This trust that every stablecoin is backed with an actual $1 is what maintains the price of the stablecoin.

Another way is to create *algorithmic *stablecoins. These stablecoins are not backed by fiat money sitting in a bank. Instead, most of them are programmed to leverage the demand-supply market forces to keep its price stable. That means if a stablecoin starts trading above $1, then the supply of those coins is increased. An increase in supply leads to a reduction in price, pulling it back to $1. Similarly, if it starts trading below $1, then the supply is reduced. A reduction in supply leads to an increase in price, taking the price back to $1.

What does it have to do with Terra?

Terra is a blockchain (similar to Bitcoin or Ethereum) whose primary offering is a suite of algorithmic stablecoins pegged to many of the world’s prominent currencies like the US Dollar, the British Pound, Korean Republic Won, etc. And they have a unique mechanism to leverage the demand-supply forces mentioned above. It’s easier to understand their stability mechanism if we think of it in two parts.

Part One. Just like Bitcoin blockchain has Bitcoin, Ethereum has Ether, Terra has its own native cryptocurrency called Luna (this is NOT a stablecoin). Based on how Terra blockchain is used, its native cryptocurrency Luna has many demand drivers.

  • First, any transaction performed on Terra is charged a small fee, which can be paid in Luna. So, people will buy Luna to use the Terra ecosystem.
  • Second, this fee is shared with anyone who buys and holds Luna. So people will keep holding Luna as an investment to get a share from the transaction fees.
  • Third, holders of Luna also get to vote on proposals requesting a change to Terra. So stakeholders like developers are incentivized to hold Luna to have a say in how the Terra ecosystem evolves.

Together, these factors provide value to Luna and incentivize people to buy Luna which results in an increase in its price (which touched $100 recently).

Part Two. Knowing that there is a continuous demand for Luna, this very cryptocurrency is used to maintain the price of a stablecoin on Terra. Let’s take USD pegged stablecoin, called UST, for example. Its price always needs to be $1, and let’s assume that the current price of Luna is $100.

Suppose the price of UST in the open market becomes $1.5. To bring its price back down, the supply of UST needs to be increased. So Terra protocol incentivizes people to create more UST as below.

  • Terra protocol allows people to destroy 1 Luna (worth $100 at that point) to receive 100 UST in exchange.
  • Since the price of that much UST is $150 at that point, they will immediately sell that UST in the open market to make a $50 profit. Ka-ching… Instant profit!
  • And when enough people do this, the increase in UST supply eventually brings the price down.

Similarly, suppose the price of UST in the open market becomes $0.5. To bring its price back up, the supply of UST needs to be decreased. So Terra protocol incentivizes people to destroy their UST as below.

  • First people will buy UST in the open market at a reduced price and get 100 UST for $50.
  • Terra protocol allows people to destroy 100 UST to receive 1 Luna in exchange (which is worth $100 at that point). So basically, they were able to get $100 worth of Luna for just $50. Ka-ching… Instant profit again!
  • And when enough people do this, the decrease in UST supply eventually brings the price back up.

If you are more of a visual learner, here is a great tweet explaining this.

https://twitter.com/shivsakhuja/status/1471231107026731009?s=20&t=3sMyBA7dIWiOyZLi1yTZtA

If the mumbo-jumbo above seems too convoluted, just remember - the cryptocurrency Luna is provided value based on the usage of the blockchain, and this Luna is used to maintain the price of the stablecoin. The price volatility of UST is transferred to Luna, which is not really a matter of concern because Luna has other ways to accrue value as stated earlier. So in the long run, if demand for UST grows, so will the price of Luna. And it’s worth noting that people write programs to automatically do all of the above in real-time so the price of the stablecoin generally returns to its original peg pretty quickly.

One last point to note. I lied when I said Luna is destroyed in exchange for UST in the above process. Well, most of it gets destroyed, but a small part gets transferred to a ‘Treasury’ which gets used to help the blockchain grow. We will see later how this treasury was really used.

Now that we hopefully understand what Terra is and how its algorithm works, it should be noted that Terra is not the only game in the town. There are a lot of different stablecoin projects, each with its unique approach to price stability and its own value prop. So, how was Terra able to enter this crowded market, and what was their go-to-market strategy? To find out, we break down Terra’s go-to-market strategy as below.

  • Terra’s Positioning
  • Getting the First 1000 Users
  • Metrics - Was Terra’s Launch a Success?

Terra’s Positioning

The core problem that Terra set out to solve was to create a ‘truly decentralized stablecoin that can be widely used’. The identification of this problem was informed by analysis of other stablecoin projects at the time, primarily -  Tether, Circle, Gemini, Paxos, and Dai. All these other stablecoins had some or the other problem(s) that could prohibit the long-term growth and/or widespread adoption that Terra was aiming for.

Stablecoins offered by Tether, Circle, Gemini, and Paxos are completely centralized. These stablecoins are backed by an equivalent amount of US dollars in a bank account. This makes them open to censorship by institutions and the government and goes against the very ethos of web3. Further, for some of these stablecoins, especially Tether, there have been reports that contrary to their claims, they actually don’t have equivalent dollars in the bank to back their stablecoins. Given the opaque nature of traditional banking services, it’s difficult to find the truth in such cases.

Then there are algorithmic stablecoins, Dai being the most popular, where people are required to provide other cryptocurrencies (like Bitcoin, Ethereum, etc.) as collateral to take out a loan in the form of stablecoins. If the value of the collateral goes down a certain threshold, there is automatic liquidation of the collateral aka the collateral gets automatically sold. With the volatility often experienced by cryptocurrencies, there is a very real risk of this happening which discourages people and businesses to take out loans in Dai. After all, who wants to lose their assets due to short-term volatility when those assets can be worth much more in the future.

Irrespective of the design of the stablecoin, one common problem plaguing them all was that they are all generally pegged to US dollar only. This decreases the appeal of those stablecoins in other countries as it subjects users in those countries to the volatility in the international exchange rate which they will incur when converting the stablecoin back into their home currency.

Having identified these key problems, Terra set out to come up with a better solution, only to run into another problem that would significantly impact the design of their solution!

hhis issue wich blockchain to build this stablecoin on. Ethereum was the only viable candidate because it was sufficiently decentralized and was the only battle-tested chain at the time. However, there are certain **limitations of building on Ethereum **-  high transaction costs due to the lack of scalability of Ethereum at the time, dependence on Ethereum’s own development cycles, and limited interoperability across different chains. These limitations could be prohibitive to Terra’s long-term growth.

Armed with this info and a determination to create a better solution, Terra decided it’s time for the world to get a new stablecoin with the below differentiating features:

  • Avoid centralization by creating an algorithmic stablecoin on a public blockchain.
  • Avoid automatic liquidation of collateral by employing a novel price stability mechanism (discussed in the previous section) that doesn’t need collateral.
  • Not just the US dollar, but create multiple stablecoins pegged to the world’s major currencies like the British Pound, Korean Republic Won, and even SDR.
  • Avoid limitations plaguing Ethereum by building their own blockchain on top of which, these stablecoins will be created.

Now, just because you have a unique product with differentiated features from the incumbents, it doesn’t mean it gets welcomed by the world on a red carpet. It is crucial to identify who your actual users will be and articulate the actual value for those users. Terra’s stablecoin has primarily two sets of users:

  1. Consumers who use stablecoins to buy/invest.
  2. Developers who create applications on top of Terra blockchain that use the stablecoin.

The value prop from Terra to these two user sets is:

  1. Consumers get to avoid going through traditional banks. They may want to do this either because they are not eligible due to their economic strata or they want to avoid the 2-3% transaction fees that banks and credit cards typically charge or they just want to avoid dealing with the frustratingly prohibitive red tape that plagues today’s banking systems.
  2. Developers get access to an ecosystem of consumers eager for new applications which allow for high adoption of the applications that they build.

It should be noted that these two user sets feed off of each other. As consumers start using Terra’s stablecoins, it incentivizes developers to create more applications on the Terra blockchain, knowing that the consumers are already there. And as more applications get created, it makes Terra more attractive to the consumers, thereby driving up the adoption of stablecoins even further.

BUT… this seemingly virtuous cycle is what makes it hard to kick the product off the ground at first. After all, why would consumers use stablecoins if there are not many useful applications already present? And why would the developers build those applications if the ecosystem doesn’t have consumers to use them? The classic chicken and egg problem. Solving this problem is the initial struggle of getting your first 1000 users to kickstart the product.

Getting the First 1000 Users

Having identified their two key user segments - consumers and developers - Terra needed to figure out how to get them on board. Conventional wisdom says, first recruit the suppliers in a system. Uber first convinced limo companies to register, Etsy first recruited sellers by going to crafts fairs, and Doordash first persuaded restaurants to join. So, you would think, Terra would first find ways to incentivize developers to build applications that can then start pulling in the consumers. But, they decided to go after the consumers first.

They did this by partnering with a mobile payment service called Chai. Chai is a Venmo-like app, which allowed people to easily make payments to stores. It already had ~10 million users and partnerships with many major local banks to facilitate payments. Further, they partnered with many big e-commerce platforms in southeast Asia which were collectively generating $25 billion in annual transaction volumes through 45 million users. This is how it all worked:

  • Consumers will install the Chai app on their phone and fund their account by transferring money from their bank account.
  • In the backend, Chai will use Terra to convert that money into stablecoins. When the users pay for a product/service, they would transfer the stablecoins to the merchant’s account.
  • When the merchant wants to cash out, Chai will give them cash for the stablecoins they have.

All the interaction with the blockchain was in the backend and the whole thing worked seamlessly for users. But why would the merchants and consumers want to use the Chai app in the first place? Merchants signed up because the alternative was using Visa/Mastercard, which charged 2-3% fees. Since Chai was running on Terra, there were no middlemen and hence no such fees. And consumers were incentivized because they were able to get good discounts by using Chai. These discounts were funded using the money collected in the Terra ‘Treasury’ that I mentioned earlier. Below is that excerpt again to refresh your memory.

One last point to note. I lied when I said Terra destroys Luna in exchange for UST in the above process. Well, they did destroy most of it, but a small part was transferred to a ‘Treasury’ which was used to help the blockchain grow. We will see later how this treasury was really used.

Note: They eventually stopped funding the treasury using this method. It was just an early mechanism to help kickstart the network.

In my humble opinion, it was a masterstroke! Cutting out the middlemen to incentivize merchants. And utilizing the money generated by the protocol itself to fund discounts for consumers. This got them their first 1000 consumers (more like 300,000, as we will see in the metrics section).

Having figured out the consumers, it was time to focus on the developers. Onboarding so many consumers and kicking off the stablecoin economy was a good signal for developers to take notice. They were then further incentivized to build on Terra using a well-established playbook. First, Terra was updated to support arbitrary smart contracts - which means that any developer can code and deploy an application on top of Terra. Then, they announced grants for developers for building on Terra. And last, they seeded the ecosystem with some of their own applications like Station - which is a wallet that can be used to interface with Terra backend, Anchor - which is an application to get ~20% annual return on your deposits, and more. Given that blockchain applications are open and composable, it meant that new developers could easily integrate with these applications and use them in their own applications if they would like to. All of this got them their first 1000 developers.

Metrics - Was Terra’s Launch a Success?

Let’s first look at the ‘consumers’ user segment. In the first three months (June - August 2019) after launching the partnership with Chai:

  • Terra had 300,000 unique users who did 1.2 million transactions. PayPal in comparison has 400 million active users and does ~3 billion transactions in a three-month period. I know it's not fair to compare a well-established giant like PayPal to a three-month-old project, but it provides some perspective to see that Terra’s volumes right after launch indicate they did well in acquiring the initial consumers.
  • Around half the consumers did around 2-10 transactions in that three-month period. This means at least half the users found enough value to shop again using Chai. The industry standard for great retention in consumer transactional products (like Airbnb, Lyft) is also 50%. While three months is a very short period, 50% of repeat consumers for Terra is a good early indication for retention.

Now, let’s look at the ‘developers’ user segment.

  • As can be seen from the graphs compiled by The Generalist, the developer activity on Terra has steadily increased since the announcement of the grants in May 2020.

  • The number of applications on Terra has also increased to more than 200 since then. While this may seem minuscule compared to giants like Ethereum and Binance, Terra’s Total Value Locked (TVL) is $25 billion, which means Terra applications are collectively processing $25 billion of assets currently. This is humungous and puts Terra as one of the top 4 chains in terms of TVL.

So, was Terra’s launch a success? A resounding Yes! As they say, a good beginning is half the battle won. Terra has since grown immensely with a thriving ecosystem of 200+ applications and UST being the largest decentralized stablecoin being used. But one should never rest on their laurels! So, what’s next for them?

What’s next for Terra?

Terra’s future is heavily dependent on finding ways to increase the adoption of its stablecoins. One of the ways they did this was by creating an application called Anchor. This is a lending and borrowing protocol where lenders deposit UST to a pool, and borrowers can take a loan from that pool. The interest paid by borrowers goes to lenders. While not groundbreaking, it is able to pay a stable ~20% APY return to the lenders, which is huge compared to most of their competitors (and traditional banks). Further, the majority of the other financial applications built on Terra utilize the Anchor protocol to provide this savings rate to their customers as well. Now, this rate of return is not sustainable. Although Anchor has some unique mechanisms to help pay this high return, the main reason for such returns is that it is a big marketing play. Terra is burning money to offer such high yields to drive up adoption. This is critical because so many of the other Terra applications are using Anchor, and when the yields go down, there is a risk of users leaving those other applications as well. However, paying upfront to acquire users is a proven strategy. Uber did this by promising guaranteed hourly rates to initial drivers regardless of the trips they made, and Twitch/Youtube did this by promising a certain amount of money to famous content creators regardless of the revenue they bring in. Now Terra is doing this in the hopes to retain those customers by providing enough value through other applications that they continue to stay even when Anchor returns go down. They just need to make sure that the ecosystem is ready for when that time comes.

While their primary product is stablecoin and the financial ecosystem around it, there is no reason for Terra to remain pigeonholed in it. Uber started with limos and expanded to taxis and uber eats, DoorDash started in the bay area suburbs and expanded to the rest of the US, and Amazon started with books and expanded to - well, conquering the world! Now that Terra has a fully functioning blockchain, they can expand to other use cases like digital assets like NFTs, games, social, and much more. Many applications have already started doing this and it bodes well for the Terra ecosystem.

As more and more users come on board through these applications, Terra needs to go back to its roots and replicate what it did with Chai. As previously mentioned, it’s a simple payments app in Southeast Asia that abstracts away all the complications of using blockchain. Terra needs to find ways to encourage projects to replicate this experience for all the use cases and geographies. That is the only way to mass adoption because let’s face it, using blockchain apps today is not the easiest.

And finally, there is the ever-present threat of regulations. Countries throughout the world are still figuring out how to regulate the crypto space. And like all other crypto projects, Terra needs to monitor this, especially since Kwon is already in the crosshairs of the US SEC!

References and Additional Readings