Compensating validators for dilution
To incentivise validators to weather the storm, Terra introduces long-term validator incentives in the form of inflationary rewards (currently ~10%). Effectively Terra is inviting potential validators to ride out the J-curve with them and collect beans in the process. At a high-level, the idea makes sense; the negative multiplier effect should hold only until the network effect is reached. Once that is achieved, then the loop should turn from adverse to virtuous, and value would start to trickle back into Luna tokens.
A hidden viral loop in the token economics
Things get interesting when the boundaries between merchant/user of the Terra blockchain and validator start to blur. There is no provision in the model to explicitly prohibit merchants from also become holders of Luna and validators in Terra's consensus. In fact, it seems that Terra implicitly optimizes for that. Of course, not all merchants will wear investor hats, but potentially the more savvy (and dare I say the more influential) will recognise that since they are already long the platform as early adopters, they can leverage up on the upside by staking Luna, while reducing their unit costs and hedging the downside, by collecting ledger fees.
Now were that the case, merchant validators are even more incentivized to evangelize Terra; the more merchants on the platform, the more ledger fees they would collect, the more their unit economics would improve and the quicker the platform would get to the critical inflexion point, after which the Luna economics turn positive.
As positive as this might be though, so long as local governments remain skeptical of cryptoassets, it is unlikely that this viral loop will be activated.
Demand for txs = value appreciation for Luna
By now, it should be clear that Terra has been architected in such a way, that makes demand for transactions the critical variable in its value model. So far, the team has implemented 1 stable pair - the Korean Won (KRW), with plans to expand in a multitude of currencies that include the USD and the IMF's SDR.
From a strategic standpoint, the decision to start with the KRW seems smart for a couple of reasons; (i) Korea is one of the most technologically advanced countries globally, with the 2nd highest % of Information and Communication Technology as a proportion of GDP, and 2nd highest % of R&D spend among OECD countries.
Not only does that improve the adoption potential for Terra, but also (ii) given the relatively insular nature of Korean currency markets (see: Kimchi premium), it provides for a "natural" incubator by protecting Terra from external competition. That allows Terra to iterate fast and capture market share in the Korean and ASEAN markets, leveraging local networks, while ironing out the model and improving its potential for further expansion.
Further, the team has explicitly targeted e-commerce as the first market they will be focusing on, a burgeoning industry that has been experiencing anywhere between 5% and 65% CAGR in the region, over recent years. One of Terra’s core strategies is to build an alliance of e-commerce sites and operate as a payment platform for them. The Terra stablecoin may also be offered as an incentive for those making purchases on these sites - a strategy that is serviceable due to the cost efficiency that Terra's blockchain back-end achieves.
In order to bolster their go-to-market capabilities, Terra launched CHAI, a consumer facing e-commerce application for everyday purchases (to illustrate, a large proportion of purchases are reportedly for rice) that works with Terra's blockchain as the back-end payment rails. According to reports from Terra, CHAI has seen 250k sign-ups since launching a few months ago, with $1.3M volume processed.
A quick look at the Terra block explorer points to an approximate equivalent $1.5k as the current daily transaction volume - a figure that pales in comparison to legacy internet native competitors. To illustrate, appox. $200M daily volume processed by Adyen, a Dutch competitor of Stripe that recently underwent an IPO at an $18B valuation. Be that as it may, in the short few months the platform has been live, volume has been growing linearly, showing a healthy - albeit pre-exponential - growth pattern.
While somewhat protected from global markets competitors, Terra faces strong domestic competition from Kakao/Klaytn (who has also a stake in Terra), Toss and other legacy payment solution providers.
Should one be a buyer of Luna at this point?
Terra has secured $32M from Polychain, Arrington XRP and Binance Labs - among others, in a sale that concluded in September 2018. Various ICO listing sites point to the ICO price per Luna token, standing at $0.80. Given the pre-sale patterns we have seen over the years, we could speculate that the price that early investors came in is closer to to $0.2. Anecdotal information we have collected, point to Luna tokens changing hands OTC pre-Mainnet for as much as $2.4 per Luna, which would have put early investors at over a 10x return at that point.
Currrently, the token is trading at $0.43, having listed at approx. $1.7 per token; that's a 75% drawdown, that puts the early investors in the 2x gain region - likely with more realised already, and less of an incentive to sell down on the remainder of their positions.
Arguably, one could pick a worse moment to start building a position, although the lack of liquidity might prove to be an issue, depending on the intended position size.
My take on Terra's valuation
To further put some context on current price levels, I went ahead and built a DCF model to value Terra. The premise is that a DCF model applies really well to valuing Luna tokens, as staking Luna is a claim to a stream of future cash flows (tx fees).
Model assumptions
I benchmarked the 3 industries that are most relevant to Terra (shown below), projected their growth in tx volumes according to 3rd party estimates over 10 years, estimated how much share blockchain based solutions are poised to capture over those 10 years (different S-curves) and made an assumption on the proportion of the blockchain quadrant Terra is likely to represent in each industry.
The main assumptions that govern the model beyond the ones mentioned above, are:
a 0.35% tx fee - adjusted downwards from the average {0.1% to 1%} to reflect the cost of running a validator
a 40% discount rate - industry standard for VC
an 80% main use case contribution level - assuming that most of the value transacted on Terra will come from the 3 industries benchmarked
a 25% staking rate - reflecting the current state of Luna staking / total supply
a 2% annual growth rate after the 10 years modelled to capture the terminal value
You can access the model and try your own assumptions here.