The Terra project is a decentralized Proof-of-Stake blockchain built on Cosmos that is used for making algorithmic stablecoins pegged to a fiat currency, such as UST, which is pegged to the US Dollar. LUNA is the utility token used for staking, governance, and paying transaction fees in the Terra ecosystem. Terra is based in South Korea, and Terra currencies are popular in e-commerce in several Asian markets.
Algorithmic stablecoins have a bad reputation in decentralized finance (DeFi) for “losing their peg” and spiraling to 0 value. Terra's algorithm is said to prevent death spirals by relying on its seigniorage mechanism. Here's how Terra's algorithm works:
Terra burns LUNA to mint stablecoins, and it burns stablecoins to mint LUNA. Terra pegs the value of a stablecoin to the value of LUNA in that stablecoin's fiat. Regardless of the actual value of stablecoin, when converting between the stablecoin and LUNA, the stablecoin is always treated as worth one unit of the fiat. So even if UST is worth $.99, when converting between LUNA and UST, the UST is treated as being worth $1.
Arbitrageurs profit from this situation by buying the undervalued stablecoin and converting it to LUNA, and the same process works in reverse. The difference between the price of minting the LUNA or stablecoin tokens and their actual value is known as seigniorage. This method of rebalancing is believed to prevent death spirals.
LUNA has a $26 billion market cap, and the Terra DeFi ecosystem has $13 billion total value locked (TVL). Terra's recent Columbus-5 upgrade improved LUNA's token economics, and now the LUNA token is expected to rise in value as more Terra stablecoins are minted. This relationship may explain the recent rise in LUNA's value during the market wide crypto correction over the last week.