Messri Report: Terra Becomes the Best-Performing Ecosystem of 2022, UST Becomes the Key to Ecosystem Expansion

Original: Messari

Key Insights:

• LUNA's price return in the first 2.5 months of 2022 outperformed the total of other smart contract ecosystem tokens by a ratio of 7:1.
• Terra's TVL market share in the emerging smart contract ecosystem grew by 54% in 90 days, now accounting for one-third of the TVL in emerging ecosystems.
• Most of the TVL growth came from debt protocols, as Anchor saw a $5 billion increase in TVL within 30 days. These deposits were largely made to chase Anchor's 20% yield, as debt grew only one-third relative to deposits.
• 51% of Terra's TVL comes from debt protocols, 8% from DEX, and 36% from staking protocols. Other emerging ecosystems have about one-third of their TVL from debt protocols, with less than half from DEX.
• Recently launched new structural important protocols (DEX and money markets) are key sources for future growth.
• The main risk lies in the cancellation of Anchor UST deposits, which could lead to an oversupply of UST in the market outside the protocol.
• The key opportunity lies in the native stablecoin that can be used to drive ecosystem growth at any time, as most smart contract ecosystems are constrained by stablecoins—Terra's ecosystem has minimized this constraint.

LUNA's Outstanding Performance

By orchestrating a $11 million token price bet on Twitter, it is safe to say that Terra has captured the attention of the crypto community. Attention, of course, follows price.

LUNA (the native asset of the Terra ecosystem) has detached itself from the typical price fluctuations of general smart contract platforms and has firmly rooted itself on the moon. In the past 30 days (as of March 14), smart contract tokens excluding LUNA and those with a circulating market cap (CMC) over $10 billion have dropped by 12%, while LUNA's price has risen by over 76% during the same period.

So what happened?

Two core reasons drove the revaluation of the asset.

1. Risk Reassessment: Adding BTC as a reserve asset: The establishment of the Luna Foundation Guard (LFG) was to protect the UST peg. As an entity, LFG used LUNA to purchase over $2.2 billion in BTC (by destroying LUNA for UST, then using UST to buy BTC). Additionally, there are 8 million LUNA (about $800 million) earmarked for future BTC purchases. Thus, the risk of a downward spiral scenario in the algorithmic design of UST has significantly decreased, leading to a revaluation of LUNA's asset price.
2. Increased Usage and Strong Fundamentals: As the broader market experienced price and yield declines, Anchor's 20% stable yield attracted a large influx of new users and capital. As new UST is minted, LUNA supply is burned, leading to upward price pressure and significant growth in commonly referenced metrics like TVL.

With the reduction of volatility risk, the main factors for sustained success shift to the fundamental adoption of the network and related applications, as well as UST in a broader sense.

The best way to estimate UST demand is to first break down the relative growth rates of the entire ecosystem, then the increasingly refined breakdown of TVL, followed by the DeFi sector, and finally the protocols. By understanding UST demand, one can accurately assess the bullish and bearish cases for Terra.

TVL Growth and Comparison

Since early 2022, the TVL of top smart contract ecosystems has declined, roughly reflecting changes in the market prices of native assets. Fantom and Terra are the only two ecosystems with TVL growth in the past 90 days.

Terra's TVL growth (+49%) is primarily due to the significant rise in LUNA's price and the continued expansion of UST supply. Consequently, the composition of TVL share in the emerging smart contract ecosystem has changed, with Terra now being the largest ecosystem outside of Ethereum.

More impressive than Terra's 49% growth in TVL over 90 days is its 54% growth in TVL market share among emerging ecosystems. This market share now accounts for nearly one-third of the top emerging ecosystems. Strong relative performance has shifted Terra from CMC to the TVL band where emerging ecosystems reside.

When plotting the CMC and TVL of emerging ecosystems against Ethereum data, it becomes clear which ecosystems are gaining or losing ground, regardless of overall market changes.

Generally, moving up and to the right is good, indicating that the ecosystem is more valuable relative to market leaders. The outlier on the left suggests that investors are pricing in TVL growth. Meanwhile, the outlier on the right signals that investors are skeptical about the sustainability of TVL or, more optimistically, indicates that investors are slow to appreciate the appreciation of different mechanisms.

In the past 90 days, Terra has clearly moved far to the right of the outlier. Even with Terra's 30-day price increase of 76%, its CMC has failed to keep pace with its relative TVL growth, suggesting that investors are either intentionally discounting the growth of TVL or inadvertently failing to grasp its competitive positioning. When comparing Terra to another well-known protocol, Avalanche, it becomes clear why Terra is undervalued based on TVL.

Avalanche has more daily active users, higher DEX TVL, trading volume, and outstanding debt. So why is its market cap and overall TVL nearly half that of Terra?

About $2 billion of Avalanche's DEX TVL is in stablecoin swap protocols, serving a small trading volume and a completely different stablecoin market. Since UST is a single native stablecoin, Terra does not require this excess capital for similar asset swaps or to maintain peg stability.

Thus, from the perspective of the entire ecosystem, its DEX capital can be utilized more effectively. Not to mention, LUNA as the currency asset backing UST gains additional value.

Much of the undervaluation reasoning is attributed to debt protocol statistics. Avalanche's debt utilization rates in Aave and Benqi are relatively healthy, with utilization slightly below 50% (outstanding debt/deposits). In comparison to Aave and other money markets on EVM chains, Terra's main debt protocol, Anchor, is unique.

The utilization rate is about 20% of total deposits, meaning more capital appears in the TVL statistics, thus not being effectively used as interest-bearing debt. Anchor's underutilization is due to the fixed deposit of 20% APY paid to UST deposits.

With insufficient interest or staking income (the collateral in Anchor earns staking rewards paid to depositors), the deposit APY is paid from the protocol's reserves, which is often an unsustainable model for debt protocols.

However, from the perspective of the entire ecosystem, what may seem unsustainable from a single protocol's viewpoint could lead to the overall network's success. To understand the entire Terra ecosystem, let’s break down capital by DeFi sector and protocol type.

Protocol Type Chart

Debt protocols account for about half of the total TVL across the network, growing nearly 96% in 90 days, making it the fastest-growing DeFi sector in TVL. Anchor's high-yield deposit rates and lagging borrowing volume are clearly the main drivers.

In addition to being the second-largest sector in TVL, liquid staking protocols are also the second-fastest-growing sector, growing over 81% in the past 90 days with the launch of Stader. Thus, liquid staking TVL exceeds one-third of the network's TVL.

In contrast, both Ethereum and Solana have prominent liquid staking protocols, accounting for 10-20% of their respective network TVL, indicating that the Terra ecosystem has a relatively higher adoption rate in this area. One significant reason for this is that Anchor specifically uses liquid staking derivatives as collateral, unlike protocols like Aave on Ethereum, which accept native assets and staking derivatives.

Due to the oversized TVL share of debt and liquid staking protocols, there is certainly a sector that is underrepresented. DEX on other networks accounts for 20-40% of TVL, while Terra's DEX accounts for less than 10%.

However, as mentioned earlier, having a single stablecoin in the ecosystem eliminates a large portion of on-chain DEX TVL typically dedicated to stable asset swaps. Additionally, Terra's DEX liquidity has maintained strong growth during this period, reaching 55%.

Let’s dive deeper into another layer to examine the protocols driving growth within each sector.

Debt Protocols

Anchor

As mentioned earlier, Anchor is the largest protocol on Terra, playing a key role not only within the ecosystem but also in the narrative questioning the ecosystem.

While debt on the platform grew by 57%, Anchor's total deposits nearly doubled in 90 days. These deposits are either UST in its Earn product or collateral used for debt.

UST deposits earn a fixed rate, maintaining a 20% annual yield, and serve as the supply for issued debt. The collateral assets (bLUNA and bETH) are liquid staking derivatives, with the staking yields directly used for the protocol's reserves (and ultimately flowing to UST depositors). Debt can only be taken against the collateralized assets.

The protocol's revenue comes from the staking yields of the collateral assets and the interest paid by borrowers. Relative to these two sources, the disproportionate growth of UST deposits (+187%) creates an unstable system, as the APY for depositors remains unchanged regardless of the income generated through debt or staking.

The difference between revenue and interest payable on deposits is covered by the protocol's reserves, which, after LFG injected the latest $450 million in February, is now close to $1 billion.

At the current deposit levels, the reserves alone can fund about 2-3 months of deposit interest or about 6 months of expected borrower interest and staking yields. To continue funding deposit rates, these reserves need to be continuously replenished from external parties.

Of course, everyone close to the project is aware of this. Recent proposals have suggested adjusting the tokenomics and adding new collateral assets (more staking income), but none of the solutions are a panacea. Maintaining deposit rates requires too much additional income.

For Anchor, the biggest question is not how it will make its system sustainable. Inorganic incentives will have to be reduced at some point, which is quite simple.

Rather, the question is how it can scale back incentives without immediately releasing too much UST into the market. Nearly two-thirds of UST exists in Anchor or its reserves, so even a slight change in Anchor demand can lead to massive changes in external supply. In short, there is currently not enough UST demand outside of Anchor to absorb the large outflows of funds from Anchor.

The excess UST supply from Anchor needs to be absorbed by sources of demand beyond LUNA redemptions, which is where recently launched and upcoming protocols come into play.

Mars

Mars recently launched in March after its Lockdrop and Liquidity Bootstrap Auction (LBA). Structurally, the protocol functions more like a traditional money market similar to Compound, rather than Anchor's unique model.

However, unlike money markets similar to Compound, Mars offers contract-to-contract (C2C) lending, meaning whitelisted protocols can borrow from Mars without depositing collateral in the money market (referred to as Red Bank).

Instead, the collateral is located in external smart contracts with established credit limits. Although this feature was initially only available for leveraged yield farming, once the framework is established, there will be more unique use cases.

DEX Protocols

TerraSwap has long been the leading DEX on Terra, but the situation has changed since Astroport launched in December. After its launch, Astroport almost immediately took control of most DEX liquidity.

Astroport continues to dominate marginal DEX liquidity flow, now accounting for over 75% of all DEX liquidity on Terra. This rapid growth is not zero-sum; overall DEX liquidity has increased during this period. This growth indicates that while Astroport has indeed absorbed considerable liquidity, it has also attracted new capital.

For the top trading pairs in the ecosystem (LUNA-UST and bLUNA-LUNA), a more imbalanced story unfolds. After trading went live in late December, Astroport captured nearly 70% of the trading volume for these pairs, and now it holds nearly 90% of the trading volume share.

Overall, trading volume on Terra is currently quite concentrated in two main pairs: LUNA-UST and bLUNA-LUNA. As of early March, Astroport has consistently ranked among the top five DEX in cryptocurrency, almost entirely from these two pairs. While concentration is certainly a risk, it also presents an opportunity.

As the ecosystem builds out, trading volume shares of DeFi tokens like ANC and ASTRO are increasing, and other trading pairs may follow suit. Astroport has shown strong adoption in several major markets, and it has significant potential as more ecosystem tokens come online.

Astroport can support both constant product pools (Uniswap V2 style) and stableswap invariant pools (Curve style), allowing it to capture all potential market share for swapping DEX. On the other hand, EVM ecosystems tend to offer multiple products for both types of markets.

In terms of tokenomics, Astroport has a fee-sharing model (xASTRO) as well as a popular voting lock mechanism (vxASTRO), which further increases fee shares and brings additional governance control and fee boosts.

Staking Protocols

Liquid staking plays a relatively important role in the Terra ecosystem. Due to deep integration, the TVL share of staking protocols is higher than in other ecosystems. Other ecosystems have adopted liquid staking retroactively, while Terra's largest protocol has incorporated it natively into its protocol design.

Lido and Stader are the two main protocols offering liquid staking derivatives on Terra. Lido is the larger of the two and has been operational longer. It powers over $5 billion in bLuna and bETH in Anchor. Additionally, more LUNA is stored in Lido, supporting stLUNA assets in the ecosystem.

Stader's scale is about one-tenth of Lido's on Terra, with over $700 million in TVL. Its staking derivative is LunaX, currently lacking the major integrations that Lido has established (i.e., Anchor). However, it is seeking integration with other lending protocols like Edge. Stader has also launched a product called "degen vaults," which is a packaging strategy utilizing its LunaX derivative token.

Derivative Protocols

There are relatively few derivatives and synthetics on Terra. Mirror is a synthetic protocol that allows users to access traditional assets like Apple stock. It was initially a cornerstone of the ecosystem but later saw a decline in popularity. Its TVL share dropped from 35% in August to below 3%. However, the sector is growing, primarily thanks to Prism.

Prism is a recently launched protocol that reconstructs assets into yield components and principal components. When the staking yield value of LUNA is separated from its core utility value (principal), it can achieve a mature and efficient financial ecosystem. For example, principal tokens can be sold to hedge against price fluctuations in LUNA, while yields remain captured in yield tokens.

Similarly, variable future yields can be sold in the form of yield tokens at a fixed upfront price. This form of trading rate derivatives represents a massive market in traditional markets (according to Prism's data, valued at over $500 trillion).

In general, derivatives remain a growth area for Terra, especially if PoS chains develop large markets for their ongoing yields.

UST Adoption

Terra's ultimate success hinges on the adoption of UST, both within the evolving Terra ecosystem and into widely used DEX on other chains. UST is the clear decentralized stablecoin leader across several categories: it has the largest supply (over $15 billion in circulating supply); it is the fastest-growing in circulating supply (growing 30% in the past 30 days); and it has the fastest-growing usage across various DeFi metrics.

UST's growth continues to expand both within and outside the Terra ecosystem. Since adopting UST in October, Osmosis's second-largest token has been UST, which is also the largest stablecoin on DEX to date.

Recently, the ZigZag exchange on zkSync accepted a proposal requesting its market makers to remove USDC and USDT liquidity, focusing instead on listing UST trading pairs. Bitrue, the sixth-largest CEX, also announced that it would make UST the base asset for 71 trading pairs.

Looking Ahead: Bullish and Bearish

Terra has attracted a wide range of commentary, from being a new paradigm to ending in an inevitable death spiral. The key fork in the road between the two viewpoints is the assumed UST demand once Anchor subsidies are reduced. Understanding the current and potential sources of UST demand is crucial for assessing the likelihood of each argument occurring.

Bearish

The bearish case hinges on the idea that UST's adjustable model is vulnerable to collapse due to the massive inorganic demand generated for the stabilizer. Anchor's 20% deposit APY has attracted a large amount of new UST minting and Anchor deposits. Over two-thirds of existing UST is used to farm Anchor's 20% APY, which is unsustainable in its current form. The bearish argument is that deposit subsidies will inevitably decrease or cease altogether, leading to UST outflows.

Given the relative scale of UST in Anchor, there is no other existing UST market large enough to absorb the outflows. Therefore, the natural trend is to either swap for other stablecoins or redeem LUNA. If there are sufficient UST outflows and redemptions, LUNA will face significant downward price pressure.

As LUNA's price drops, it indicates a decline in confidence in redeemable assets, prompting UST holders to redeem out of concern for future value depreciation. The subsequent sale of redeemed LUNA further encourages the next UST holder to follow suit, ultimately leading to a death spiral. This phenomenon is known as reflexivity, and when it moves downward, it is the demon of all algorithmic stablecoin designs.

Bullish

The bullish argument claims that given the rapid growth of the Terra DeFi ecosystem and the widespread adoption of UST by exchanges and other Layer-1s, there will be sufficient demand to absorb Anchor's outflows.

Overall, Terra's DeFi ecosystem is still quite young. The two most popular applications have launched in the past few months, serving as fundamental primitives that lay the groundwork for more applications. DEX on other chains account for about 20-40% of TVL, but Astroport currently only has 5% and is growing rapidly, with about a 50% increase in the past 30 days.

Mars is certainly also poised to grow in a similar manner. If we assume these two protocols grow to the same relative size on other Layer-1s, it would require about $3-6 billion in additional TVL. And this is before considering other sources of demand or assuming general ecosystem growth.

Another byproduct faced by all young protocols is a large allocation of undeveloped liquidity incentives. Incentives from other protocols can gradually release Anchor UST reserves over time, avoiding supply shocks.

For example, Astroport recently achieved a 20% APR (excluding incentives) on its LUNA-UST pair, along with an additional 10% LP incentive (total APR of 30%). Similar yields exist in DEX and will continue to attract the employed portion of Anchor deposits, which poses the greatest risk of supply shock.

Given these two factors, there is sufficient organic growth demand and new inorganic incentives to safely reduce the $8 billion Anchor UST deposits to sustainable levels.

Considering the growth stage and trajectory of the protocol, equal additional UST demand should be generated to absorb Anchor outflows as a baseline scenario. The home run case generates greater demand than what is needed to absorb Anchor outflows across multiple ecosystems.

More generally, this approach of first incentivizing stable supply and then building protocols is a unique and effective way to develop Layer-1 ecosystems. Most emerging and mature ecosystems are constrained by stablecoin supply—this constraint does not exist in the Terra ecosystem.

Terra actually has a large supply of stablecoins ready to provide liquidity and has a scalable model to inject new stablecoins without regulatory bottlenecks. In the long run, as the Terra ecosystem and cryptocurrency as a whole continue to grow, this could prove to be a powerful differentiating feature.

Final Thoughts

Despite the scrutiny, it is undeniable that the Terra ecosystem is experiencing significant growth. The rapid growth of UST enables Terra to uniquely expand its ecosystem. With much of Terra's DeFi ecosystem recently or soon to be launched, timeliness may create sufficient demand to alleviate Anchor's inflated deposit levels.

Looking ahead, the Terra ecosystem will be significantly influenced by discussions around the Anchor community's deposit rates, the adoption growth of Astroport, Mars, and other DeFi applications, and how UST is adopted in external ecosystems.