A Framework To Value Terra Luna
Introduction
Over the last 25 years we have seen the growth of some of the greatest companies in history. Companies such as Amazon and Tesla had great product market fit by internally solving problems that turned their biggest expenses into a revenue stream. This eventually resulted in vertical integration.
What did Amazon and Tesla have in common?
They both understood that creating and acquiring features would be a powerful model that can compound future growth.
A vast majority of companies know how to quickly add to their valuations but don’t know how to actually create any extra value. Let me explain.
The cyclical nature of many startups begins when they first raise capital. They use that capital to artificially accelerate internal business metrics through short term solutions. Using their unsustainable, new and improved business metrics they raise more money. And the cycle restarts. This is how many startups go from a $1 million company to a $1 billion back down to zero in a couple years.
Amazon and Tesla were both examples of expert capital allocators that solved problems, not just for the market, but for themselves. They understood that acquiring features is the fast way to become vertically integrated.
TESLA
Think about all the steps needed to make a car. First, someone needs to gather up all the raw materials (steel, rubber, titanium, etc) and get them to the manufacturer. The manufacturer (or a bunch of different manufacturers) makes the battery, the steering wheel, the seat cushions… and then someone puts them all together to make the final car. The car then goes through distributors and retailers, before being sold to ordinary consumers like you and me.
Vertical integration is the process of acquiring and controlling different parts of the same production chain. Tesla makes their own batteries, electronics, parts, software and even the car seats. This allows them to build highly customized and superior components.
In 2016, Tesla CEO Elon Musk said that Tesla would be increasing vertical integration in order to “have the ability to produce almost any part of the car at will” and “alleviate risk with suppliers … if 2% of suppliers aren’t ready, we can’t make the car.”
The move to manufacture and distribute technologies through in-house solutions, allowed Tesla to export most of their technologies to other companies such as Apple, Panasonic and Toyota. This ability to supply fortune 500 companies with crucial technologies has resulted in a substantial revenue stream.
Tesla acquired features that lead to vertical integration !
AMAZON
In addition to Tesla, Amazon had the same Kaizen philosophy.
Year end 2005, Amazon had approx. 8.5 billion in sales and 2 billion in profit. The two biggest costs affected their margins were product and shipping.
So what did they do ?
They started Amazon Kindle, Amazon Basics, Amazon Fire, Amazon Echo. Amazon’s margins climbed as a result.
On the operating side,
Amazon was spending 6% of revenue on fulfilment, so they started a fulfilment business.
Amazon was spending 5% of revenue on technology, so they started AWS
Amazon was spending 2% on marketing, so they started Amazon Prime
Amazon was spending 2% on payment processing, so they started Amazon payments.
Amazon acquired features that lead to vertical integration… and a complete monopoly!
These companies didn’t prioritise fast and unsustainable expansion, but first decided to look within the company for ways to create features that add value.
ADJUSTING THE PHILOSOPHY TO CRYPTO PROJECTS
The survival of a project relies on whether they can be part of crypto’s adoption curve. The fight for meaningful adoption creates massive demand for new use-cases, and therefore developers. General purpose blockchains that are just creating the tools to build applications, rely on developers to accrue not only value but adoption for them. This doesn’t go well for projects when the rate of adoption far exceeds the rate of new developers.
They will get left behind !!
Terra is a promising project that is re-engineering the way we should think about the structure of Defi. The Terra blockchain is a Proof-of-Stake blockchain that is building on some of the shortcomings of Ethereum. The difference between Terra and many general purpose blockchains is their ability to develop useful applications (features) in-house, just like Amazon did in the early 2000s.
Terra Luna has not only created the tools for other developers, but for themselves. Anchor Protocol, Terraswap, Mirror protocol and Ozone Insurance are all examples of Terraform lab’s efforts to internally bring value to the Terra Luna ecosystem. Their main focus is to build meaningful applications around the native stablecoin UST.
Terra is creating/acquiring features that’s making them vertically integrated!
- On and off ramps
- Savings protocols
- DeFi
- Insurance
- etc
In addition, UST is one of the only applications to get real meaningful adoption. When I say meaningful adoption, I mean everyday people are using it without understand Defi, blockchain, cryptocurrencies, etc. This project is called Chai.
Chai is a South Korean payment processor, incubated by Terraform labs, which has 2.4 million users and 108,727 daily transactions and growing.
By using UST, Chai has seen massive growth in South Korea showing no plan to stop anytime soon.
Chai’s merchant-centric approach has lead to its integration into numerous online payment networks. These include eCommerce giant TMON and Yanolja, the no.1 hospitality app that processed billions in transactions in 2020. In addition, offline payments have been integrated by a partnership with BC Card. Chai’s physical offline exposure has allowed them to partner with the likes of CU, Korea’s largest convenience store chain with approximately 19,000 locations. CU benefits so much by Terra’s payment network that they personally put up banners, at no charge to Chai, asking customers to use Chai as their main form of payment. The benefit comes from a 1.13% fee and an instant settlement period, compared to the industry average 3% and a 2–3 day period before funds are accessible. This is a game changer, allowing users to pay basically anywhere with Terra’s payment network, for low fees and instant settlement.
For example, taxi drivers in South Korea can’t afford to pay a 3% fee and wait 2–3 days for funds. These taxi drivers have very small margins, so they need that money ASAP to feed their family and buy fuel for the next days work. Truely game changing!
Do Kwon explains one of the ways Chai can achieve these innovations. “In the payment stack their are a set of intermediaries that take the settlement from the payment company and then sends that wire transaction to all the merchants. They are called the Value Add Network (VAN) and the ironic thing is they really add zero value to payment networks. The VAN is an anachronism from a time when you didn’t have digitised banking so people had to do a lot of manual transfer checking and things like that.”
UST STABLECOIN ECONOMICS
Every Terra Luna project centres around the UST stablecoin. It’s essential that a Defi protocol has an efficient decentralised stablecoin as it’s the most important part of any robust Defi ecosystem.
“The stablecoin is the most important product in crypto, uniquely serving the currency function of cryptocurrencies.” — Do Kwon, CEO of Terraform Labs
A critical piece of Terra’s ecosystem is Luna, the staking token in Terra’s PoS blockchain.
The concepts behind Terra’s stability has always been the same: adjust its supply in accordance to changes in demand to keep its price stable at 1 dollar (dollar = any currency). The protocol does this in a decentralised and algorithmic way. More precisely:
- When the price of Terra rises the protocol needs to expand the supply
- When its price falls the protocol needs to reduce its supply
Reducing or increasing Terra’s supply simply means buying or selling Terra at its target price respectively. The protocol uses the value of Luna to facilitate these exchanges, essentially making Luna a market maker for Terra:
- To mint 1 Terra, burn 1 dollar worth of Luna
- By selling 1 Terra, the protocol earns 1 dollar of Luna.
So as demand for UST increases, so does the burning of Luna tokens supply.
Most L1s try to sell their technology. They sell the throughput, the speed, the security, the decentralisation, etc. However, Terra, despite having all of those things, sells one thing… and that’s UST. Terra’s focus on UST means that LUNA actually doesn’t have a price ceiling.
Put simply, $100 of Luna = $100 UST. Whether that $100 of LUNA is 1 LUNA or 0.00001 LUNA.
Typically demand decreases for an investable asset as price increases. But for Luna the demand is for UST which has no price change. Demand can stay constant whether Luna is $1 or $10,000.
In addition, Luna is the asset that incentivises stakeholders and acts as a collateralised asset that stabilises the Terra economy. Luna holders who stake to secure the network are rewarded with fees from all transactions (the “Terra tax”). This ‘Terra tax’ is the incentive that rewards Luna holders if they chose to stake Luna and secure the network. Importantly, the tax is paid in fiat by all the consumers and businesses who draw value from the network. This is in contrast to the inflation-funded rewards used by most PoS networks. Luna pays real value to those who serve to secure the network.
UST IS EXPERIENCING A DIFFERENT TYPE OF TRACTION
The velocity of money is a metric that measures the rate at which money is exchanged from one entity to another. The velocity of different stablecoins can indicate what people are using the specific stablecoin for.
The table illustrates that Terra’s stablecoins have an 82.75% lower velocity when compared to USDT (largest stablecoin by marketcap). In addition, UST demonstrates an 84.375% decrease in velocity, compared to the entire stablecoin market. However, UST has very similar velocity to the M1 money supply, which repents all US dollars used as a medium of exchange.
What makes UST different?
Blockchain based projects, such as Terra Luna, have created ecosystem that that limit friction to, essentially, nothing. This is a great foundational element that is supporting much faster adoption and more flexible transactions, when compared to traditional finance.
The total stablecoin market experienced a 6.4 monthly velcoity that was driven, mainly, through trading. Evidently, traders favoured stablecoins like USDC and USDT when going in an out of the digital asset market. Although trading will still be a significant use case in the future, it will not be as dominant in comparison to savings as it is now.
As cryptocurrencies experience mass adoption by more traditional users the biggest use case for DeFi services will be savings protocols such as Anchor and lending/borrowing protocols such as AAVE and Compound. Locking funds into savings protocols will inherently decrease the velocity of stablecoins to levels closer to that of the M1 money supply.
Anchor Protocol, Terra’s savings protocol, offers an interest rate of 20% that is driving down UST’s velocity. It is in Terra’s interest to keep the velocity low, as more stablecoin supply can be minted and thus more LUNA burned. As such, it can be expected that the Terra blockchain has position themselves to dominate the savings sector, rather than the trading market.
CONSTRUCTING A FRAMEWORK TO VALUE THE LUNA TOKEN
The Luna token is an asset that gains most of its non-speculative value from the demand for UST and the transaction fees that ensue. An increase of useful applications built around UST will inherently increase the demand/burning of Luna. The valuation methodology is to look at Terra as simply a decentralised payment network.
Distinguishing between Centralised and Decentralised payment processors
- Traditional equities need to be profitable to distribute cash flow. In contrast, Luna has no current expenses, no balance sheet, no assets and never plans to. I don’t need to extrapolate expenses, liability growth, etc. The value of Luna is simply determined by its tax rewards and the multiple you are willing to pay for future rewards.
- The burning of Luna is a dynamic that’s never seen in traditional markets.
- The cash flows (tax rewards) are constantly distributed to a different number of stakers. This changers stakers equity in the tax rewards.
Despite this, the valuation model is very simple
- The market capitalisation is determined by current tax rewards (Tax rate x volume) multiplied by the multiple the market is willing to pay for future rewards.
- The value of 1 Luna is the market cap divided by the number of Luna tokens receiving cash flow (staked Luna).
Value of 1 staked Luna = (Annualized Transaction Volume) x (Tax Rate) x (Rewards Multiple) / (Staked Luna)
Transaction Volume
The following graph illustrates Terra’s transaction volume over the last year. It’s evident that the ecosystem has experienced significant growth, reporting 18.1 Billion in annualised transaction volume. This growth is expected to continue has more applications are built and Chai gains more market share in a number of different regions.
Tax Rate
Every transaction on Terra is subject to 0.479% fees which is capped at $1.4 (1 SDT). The tax rate has been increased numerous times with the focus of benefiting the network and its participants. The Columbus-3 hard fork increased the tax rate to just shy of 0.5%, representing an approximate 10x increase relative to the tax rate in September-October 2019. The increased fees pose no risk to Terra’s usage, as many payment processors demand a 2.5–3% cut.
Rewards Multiple
The markets accepted rewards multiple can be derived from the P/E ratio of many public companies in the same niche.
Visa (Small growth potential) — 60
Mastercard (Small Growth potential) — 60
Paypal(Medium growth potential) — 70
Based on the P/E ratio of the established business above, I am going to assume a sufficient rewards multiple of 100. This is relative to the possible growth of Terra Luna and their track record of building real world businesses that are bringing exponential growth to the exosystem.
Staked Luna
According to Terra Station there is 379,076,383 luna staked. This is nearly 40% of all Luna’s supply.
PUTTING IT ALL TOGETHER TO FIND LUNA’S VALUE UNDER THESE PARAMETER
This report is not going to take into account possible fundamental changes such as projections for increased adoption, increased demand for Terra and so on. This is such a new project that trying to predict future fundamental changes is nearly impossible. The model will give a ‘fair’ value for the Luna token based on current metrics.
Value of 1 Luna = (Annualized Transaction Volume) x (Tax Rate) x (Rewards Multiple) / (Staked Luna)
The following table outlines the appropriate value of Luna based on the aforementioned metrics and parametres. This valuation is for the Luna tokens that are cash flow positive (Staked Luna). The rest of the report outlines the variables that will fluctuate Luna’s price.
VALUE LOST OR ACCRUED THROUGH OTHER VARIABLES
The preceding analysis was based on a traditional framework. When valuing a project like Terra Luna there are non-traditional variables that have to be taken into account. These variables weren’t used in the valuation above because they aren’t reliably predictable.
TOKEN BURING
The biggest value driver of the LUNA price will be the yield from burning and minting LUNA tokens as the total UST supply increases. In other words, the LUNA supply will decrease and there will be enormous buying pressure as the demand for Terra’s stablecoin increases.
The demand for UST comes from the ability for the developers on the Terra Luna blockchain to build applications that promote the buying and holding of UST. Lending, borrowing, insurance, asset purchasing and savings protocols are amongst the biggest sectors driving the demand for UST. It is worth noting that the CEO of Terraform Labs and founder of Terra, Do Kwon, expects UST to reach a $10B total supply by the end of 2021, which implies a UST supply increase of 5.6x by the end of 2021.
Do kwon plans to achieve this through a new update coming to the Terra ecosystem called Columbus-5.
Columbus-5
1. Burn all seigniorage
When UST is minted, LUNA is burned. The LUNA that is burned is called seigniorage.
Up until now, a portion of the seigniorage has gone to the overfunded community pool and has been used for oracle rewards. After Columbus-5 launches, the seigniorage will be burned that LUNA will be burned forever. It sounds risky, but it shouldn’t be. In fact, LUNA’s value should increase.
2. Upgrade to Stargate
The Stargate upgrade is one of the key elements of the Cosmos vision, allowing for effortless interoperability between Cosmos SDK blockchains and other blockchain protocols. This means that Terra, built on the Cosmos SDK, will have increased interoperability with other blockchains.
3. Integration of Ozone and Wormhole
Ozone will be the de-facto insurance protocol for projects built on the Terra blockchain. This will undoubtedly lock up a significant pool of UST and further the safety net that sits below Terra’s protocols.
Wormhole is a bridge between Terra and Solana. This will significantly reduce friction for UST moving to Solana. This will accelerate demand for UST as it integrates into Solana robust Defi ecosystem.
All these updates will, inherently, drive the demand for UST higher and accruing yield to anyone holding LUNA tokens.
AIRDROPS
Terra Luna airdrops tokens from ecosystem projects such as Mirror and Anchor protocol which acts as an additional stream of income for Luna stakers. This wasn’t incorporated into the price estimate of Luna because these airdrops are for a limited time and don’t have a constant amount nor value. In my opinion, Terraform labs has a track record in developing applications on top of Terra Luna, meaning more airdrops are likely in the future.
AMOUNT STAKED
The Luna tax rewards are evenly distribute to Luna stakers. The amount of stakers securing the network can fluctuate at anytime, changing people’s equity in the tax rewards.
In addition, the significant increases in the amount of Luna staked will most probably create a supply shock. If the amount of Luna staked is increasing, along with the demand for UST, there is an obviously bullish moment in the supply/demand dynamic.
TAX RATE
When Terra Luna first launched it’s tax rate was a meager 0.05%. Since then it has nearly 10x in value. This trend could continue and we could see more tax hikes.
In my opinion, however, this transaction tax will remain constant as it gives both a good return to stakers and allows applications such as Chai payments to be extremely competitive in the marketplace.
TERRASWAP (Hypothetical Revenue Stream)
Terraswap is an AMM type exchange like Uniswap, but with some slight modifications. Terraswap achieves billions in transaction volume and incurs 0.3% in fees. This fee goes entirely to liquidity providers. Hypothetically, Terraswap could become an additional revenue stream if, say 0.05% flows to LUNA stakers in the future.