The Terra protocol provides stability to stablecoins via algorithmic correction of the emission on demand fluctuation.
For example, growing demands for any Terra stablecoin results in an increase in transaction volume, as well as in stablecoin price growth. Because of this, the Terra protocol must implement some kind of counterweight that makes sure the stablecoin price is accurate to that of the fiat currency it’s based on. In this case, the total emission of the Terra stablecoin must increase to compensate for the increased demand. This is called expansion.
In the opposite situation, where the demand for the Terra stablecoin drops, lowering the transaction activity and, consequentially, lowering the price. In this case the emission must be lowered to maintain the correlation between the stablecoin and the market price of the fiat currency. This is called contraction.
As mentioned earlier, the stability of Terra stablecoin prices requires a certain amount of demand to stay afloat under pressure. Worst case scenario is that the system will stop functioning if the LUNA capital, which serves as the foundation for the stablecoins, will become lower than the capital of said stablecoins. Price stability in the Terra protocol is held up by the stability of validation demands, because it’s the validators who pay to suppress LUNA price volatility. So it’s extremely important to provide some attractive conditions so that the validators are still interested in staking LUNA under any amount of market pressure, pumps or dumps, since staking is a long-term investment. Validation rewards also have an inherent instability to them, since they’re directly tied to the amount of transactions: the more transactions, the more transaction fees.
With inconsistent validation rewards oracles wouldn’t want to continue staking, because it’s hard to determine if it will be profitable, accounting for the fact that staking also comes with the price of locking LUNA on your account for some time. This kind of indecisiveness must be eliminated by providing a stable reward for delegation, which is independent of the current state of Terra. That way, in addition to the Terra price stabilization mechanism, a LUNA demand stabilization mechanism exists as well, which helps support the long term wellbeing of Terra at the cost of validation reward correction (changing transaction fees and LUNA burning speed) to counteract the volatility coming from macroeconomic tendencies in the Terra economy. It’s much more convenient for validators to take on the responsibilities of staking if there is a stable and predictable profitability instead of an unstable profit that sometimes can even turn into expenses, meanwhile a stable increasing reward will, in time, compensate them for the long term investment in the Terra network.
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