The founder called it “the most useful dollar possible”.
It’s also got a cool name, Terra and Luna.
It seemed like a genuine project that had a bright future.
We even wrote about it in another article about
potential future crypto prices.
But recently Terra and Luna have been in the news for crashing to zero overnight.
What exactly is Terra Luna, what is it supposed to do, and how did it crash, and lose a ton of people's money?
What is Terra Luna?
Terra Luna is a project that actually has two separate tokens that work hand in hand with each other to create useful money. TerraUSD ($UST) is a stablecoin that is pegged to the United States dollar, so it should always be worth $1. Terra Luna ($LUNA) is the cryptocurrency that backs UST and helps it maintain its $1 peg.
Think of Luna as gold, and UST as silver. Gold is more valuable than silver so people want to keep it as a store of their wealth, but silver can be used for day to day transactions like to buy apples. Hungry for apples?
So, LUNA is the store of value and UST is the medium of exchange. And they can be traded for each other. Like you can spend 100 UST to get $100 worth of LUNA.
This sounded awesome to people, and LUNA took off!
Since July 2021, LUNA went from being worth $5.87 to $116.41 per token in April 2022. Its market cap increased from 2.5 billion to 41 billion.
Same with UST. Its market cap increased from 2 billion to 18.5 billion in the same amount of time. But still it was always worth around $1.
So, this project was getting a lot of attention and a lot of people were investing in its ecosystem.
Then in May 2022, suddenly the price of UST fell from $1 and the price of LUNA dropped to zero basically overnight.
How did this happen?
The Economics of Terra and Luna
First we have to learn how Terra and Luna work.
You can trade 1 UST for $1 worth of LUNA tokens. You can also do the reverse and trade $1 worth of LUNA tokens for 1 UST (remember UST is always supposed to be worth around $1).
When demand for UST goes up, its price will rise above $1. Because you can exchange $1 of LUNA for 1 UST, you now own something which is valued above what you paid for it.
A hypothetical example, let's say a lot of people are using UST right now, so the demand for the token is up. UST will then unpeg from $1 and be worth, say, $1.02 now. You have $1000 worth of LUNA that you exchange at a rate of $1 worth of LUNA for 1 UST. So now you have 1000 UST, which is now valued at $1020.00. Easy $20 profit.
Now, what happened when you exchanged LUNA for UST?
The $1000 worth of LUNA tokens (however many that is) is
burned from the circulating supply of LUNA, making it more scarce and valuable. At the same time, you created 1000 UST and added that to the circulating supply of UST.
As supply of UST increases, the price will decrease due to more tokens being available.
And the same thing goes for the other way around. If the supply of UST increases too much the price can lower to, say, $0.98 and everyone would exchange 1 UST (something worth less than $1) for $1 worth of LUNA. The profit would be $0.02 per UST exchanged. At this point the UST is burned from the circulating supply and $1 worth of LUNA tokens is created.
As the supply of UST gets low enough to meet demand, the price will rise again.
That’s how UST maintains its peg at $1.
So to reiterate, you can exchange 1 UST for $1 worth of LUNA tokens, and $1 worth of LUNA tokens for 1 UST, always, no matter what. When you exchange LUNA for UST, LUNA is burned and UST is created. When you exchange UST for LUNA, UST is burned and LUNA is created.
You’ll need to know that to understand what happened to Terra and Luna.
Why Did LUNA Drop to Zero?
In May 2022, the price of UST started to depeg dropping below its $1 value. At this point, people started to trade their UST for LUNA in order to take advantage of this price difference. This is exactly what was supposed to happen.
However, during this time there was a major crash in the crypto market causing the demand for crypto to be very low. So not many people were trying to buy LUNA compared to the people trying to sell it.
Since you could trade something that was worth less than a $1 for $1 worth of LUNA, you could just turn around, sell, and use that $1 to purchase more UST for cheap. For example, the price of UST at one point was $0.50. You could trade your one UST for $1 worth of LUNA, which you could then use to buy 2 UST at $0.50 each, which you could now trade for $2 worth LUNA. Sell, and continue the cycle.
It was a real life infinite money glitch.
As people traded their UST for LUNA the supply of LUNA increased more than the demand to buy it, which caused the price of LUNA to decrease. Since, you can trade 1 UST for $1 worth of LUNA, as the price of LUNA decreased, $1 could get you more and more LUNA.
For example, if the price of LUNA is $10 you could trade 1 UST for 0.1 LUNA. So you have added 0.1 LUNA to the supply. If the price of LUNA is $1 then you could trade 1 UST for 1 LUNA, adding 1 to the supply. If the price of LUNA is $0.1 then 1 UST gets you 10 LUNA, increasing the supply by that amount.
So as the price of LUNA dropped you were actually adding more and more LUNA to the supply, causing the price to further drop.
Now this isn't just one person adding a few LUNA coins here and there.
Before all this happened there were 18.6 billion UST tokens in circulation. After the crash, there were 11.2 billion. Remember, 1 UST gets you $1 of LUNA, so over 7 billion dollars worth of LUNA tokens were created in just a few hours, and increased the supply of LUNA by over 4 times.
And it's just a nasty cycle. More and more LUNA gets added to the supply, further dropping the price, which just adds more coins to the supply anytime some exchanges 1 UST for $1 LUNA.
At its all time high, 1 UST would get you about 0.01 LUNA. Now, 1 UST will get you something like 10,000 LUNA tokens.
Because of this Luna has added about 6.5 trillion tokens in the last few days, and there are still about 11.2 billion UST tokens in circulation. As people exchange those, the price will only get lower and the supply will only get higher.
No one wants to trade $1 of LUNA for 1 UST right now, because they would be receiving something worth less than the amount they traded. So the supply of LUNA is only going up.
And the only demand for LUNA right now are people who think buying a million LUNA for $100 is going to make them rich if it ever gets back to a dollar or even a penny.
Spoiler alert, it's most likely not going to recover. The project is almost definitely dead.
Buying LUNA right now is a great way to watch your money disappear.
Summary
TerraUSD and Terra Luna are two coins that work together. TerraUSD ($UST) is a stablecoin pegged to $1, and Terra Luna ($LUNA) is its backing coin. UST is a medium of exchange and LUNA is where you can store your value.
You can trade 1 UST for $1 worth of LUNA at any time. Trading these two coins with each other helps maintain the supply of UST to match demand to always keep it around $1.
If you exchange LUNA for UST, you are burning LUNA and adding UST to the supply. IF you exchange UST for LUNA, then you are burning UST and adding LUNA to the supply.
In May 2022, UST unpegged from its $1 value and began to drop. People rushed to exchange their UST for LUNA in order to make an easy profit and try to stabilize UST.
However, due to a market crash demand for crypto was low and the supply of LUNA increased by an amount which demand could not keep up with, lowering the price of LUNA. As the price got lower, more and more LUNA were created as more people were dumping their UST. As more LUNA were created, the price further lowered, creating more LUNA per trade, lowering the price. Unfortunately, it got stuck in this cycle until finally the price went to nearly zero.
It's always sad watching a crypto project die, especially when it had so much promise and was a genuine project. I do hope that LUNA can somehow recover, but I'm 99.99 (read: 100%) sure it won't. If it does, it would be the greatest comeback in crypto history.
We will see!
