What is Terra (LUNA)?

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Robert has reported for a variety of international publications including the Associated Press, The Guardian, Vice, and Decrypt. Current areas of interest include the political economy of technology, cryptocurrencies, and privacy. Robert has a Bachelor of Science from UCL, and a Master's degree from the University of Oxford's Internet Institute.

Terra was a blockchain platform that powered a network of decentralized stablecoins. Its currency, also known as LUNA, operates as a kind of decentralised reserve.

The creation of entrepreneurs Daniel Shin and Do Kwon, Terra was started in 2018. Its governance and staking coin, LUNA, launched in 2019. After that, LUNA shot up in value. As of April 2022, it was the 6th most popular cryptocurrency with a market cap of nearly $37 billion.

Shin and Kwon had wanted to create cryptocurrencies that were stable against the world’s major currencies. It started with the Terra Alliance, a consortium of 15 large Asian e-commerce companies that have about 45 million users among them, according to crypto metrics site Messari.

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Terra’s main product was its algorithmic stablecoin, TerraUSD, a cryptocurrency that used complicated mathematics to maintain its peg to the US dollar. It innovated on other so-called stablecoins like USDC and Tether, which are backed by reserves of cash, the whereabouts of which are frequently called into question by regulators.

However, in May 2022, Terra lost its peg to the US dollar, and the value of Luna crashed by 99% in just two days. The Terra network went through a hard fork, launching Terra 2.0, and previous Luna tokens were renamed Luna Classic (LUNC). However, as of August 2022, the coins had not recovered their previous value.

Understanding the stablecoin economy

To understand Terra, it is helpful to understand the stablecoin market. Stablecoins can be useful for crypto traders who want to invest in cryptocurrencies while also pegging the value of their investments to fiat currencies, such as the US dollar, a historically stable currency controlled by the Federal Reserve.

Stablecoins make it possible to hold a store of value in the crypto economy that is generally unrelated to the rest of the crypto market’s whiplash ups and downs. If bitcoin crashes, a US dollar stablecoin should, in theory, always be worth $1. They are also useful when investing in long-term crypto funds, like liquidity pools that pay out annual percentage yields. It’s a lot easier to work out how much money you will earn when you are paid out in coins that are always equal to $1.

Broadly speaking, there are two types of stablecoins. The first is reserve-backed stablecoins. There are lots of these, but the two most popular are Tether (USDT), which had a market cap of $82.5 billion as of April 2022, and USD Coin (USDC), which had a market cap of $51 billion as of April 2022. Whenever someone gives Tether or Centre, the consortium that maintains USDC, a dollar, the companies will store that money and issue them a crypto dollar in return. Other reserve-backed coins are pegged to the value of another cryptocurrency. Wrapped Bitcoin is one example. It’s a coin that tracks the price of Bitcoin and is backed by reserves of Bitcoin, and it had a market cap of nearly $12 billion in April 2022.

There are several issues with this approach. Regulators may decide that these companies should be subject to extensive regulation (as Federal Reserve Chair Jerome Powell advised in September 2021) or ban them outright; the companies may lie about their reserves (a charge the New York Attorney lobbed at Tether); and the companies may reinvest funds in risky products without telling consumers. Tether in particular has been criticised for withholding details about the commercial paper in which it invests some of its reserves.

The second kind is a decentralized, or algorithmic stablecoin. This is what TerraUSD was. Algorithmic stablecoins use, as the name implies, algorithmic mechanisms to maintain their pegs rather than a centralized body. There are many flavours of algorithmic stablecoins. Some are overcollateralized with reserves of other cryptocurrencies, some are partially collateralized with centralized stablecoins, and some are not collateralized whatsoever.

Uncollateralized cryptocurrencies use different techniques to maintain a peg to another currency. Some burn or mint coins in users’ wallets to alter the value of each individual coin (this is known as a rebase), others reward users who have staked money in the protocol. Other examples of algorithmic stablecoins include Frax, Ampleforth, DAI, and sUSD.

These algorithmic coins also have their own difficulties. The most obvious is that some algorithmic stablecoins simply do not work. Empty Set Dollar was worth $0.009 in April 2022, and Basis was worth $0.011 — far from their desired price of $1.

The other problem is that some algorithmic stablecoins are not entirely decentralized, and still rely on collateralization from centralized stablecoins, such as USDC, which means they are subject to the problems mentioned above. DAI became partially backed by USDC after a ‘Black Swan’ event in March 2020, around the time that the coronavirus pandemic sent global markets tumbling. As of this writing, Frax is about 80% backed by reserve-backed stablecoins, down from 100% when it launched in December 2020.

Why Terra was different

So, where does Terra fit into this? Terra (LUNA) powered a bunch of algorithmic stablecoins. If the price of TerraUSD falls below $1, Terra’s algorithm was supposed to draw from a pool of LUNA to mint more UST and boost the price. Correspondingly, if TerraUSD rose above $1, the pool would burn LUNA — destroying it permanently from circulation — to depress the price of the token.

Like a couple of other algorithmic stablecoin projects (such as Ampleforth), Terra’s model relied on arbitrage. If TerraUSD is low, it is rational for an arbitrageur to buy lots of it, which will increase the demand and hopefully pump up the price to $1. When it’s above $1, arbitrageurs will sell it. Since there’s no joy in buying a dollar-pegged stablecoin for more than a dollar, it should fall in value.

While other coins use a token like LUNA to maintain the peg of a single token, LUNA maintained the peg of several different Terra-based stablecoins, and the supply of LUNA expanded or contracted quite dramatically, as was seen in the 2022 crash.

UST was dependent on the success of LUNA tokens to maintain its peg, so when the market determined LUNA was worthless, it became difficult to burn LUNA tokens to maintain UST’s peg to $1. This is not unique to Terra.

TerraUSD launched in 2020, but others preceded it, including TerraKRW, a stablecoin pegged to the Korean won, and TerraMNT, a stablecoin pegged to Mongolia’s currency, the tugrik. There are also stablecoins pegged to the Chinese yuan, Japanese yen, British pound, and the euro.

What can you do with LUNC and Terra Stablecoins?

LUNC is a fungible token that you can buy and sell on crypto exchanges. You can stake it to support its stablecoin projects, like TerraUSD, and its proof-of-stake validator network. LUNC is also a governance token.

Last Updated August 31, 2022

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