Invest: How Terra and Luna (are supposed to) work

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An “algorithmic stablecoin” sounds complicated, and there are a lot of people with incentives to pretend that it is complicated, but it is not. Here is how an algorithmic stablecoin works:

  1. You wake up one morning and invent two crypto tokens.
  2. One of them is the stablecoin, which I will call “Terra,” for reasons that will become apparent.
  3. The other one is not the stablecoin. I will call it “Luna.”
  4. To be clear, they are both just things you made up, just numbers on a ledger. (Probably the ledger is maintained on a decentralized blockchain, though in theory you could do this on your computer in Excel.) 
  5. You try to find people to buy them.
  6. Luna will trade at some price determined by supply and demand. If you make it up on your computer and keep the list in Excel and smirk when you tell people about this, that price will be zero, and none of this will work.
  7. But if you do a good job of marketing Luna, that price will not be zero. If the price is not zero then you’re in business.
  8. You promise that people can always exchange one Terra for $1 worth of Luna. If Luna trades at $0.10, then one Terra will get you 10 Luna. If Luna trades at $20, then one Terra will get you 0.05 Luna. Doesn’t matter. The price of Luna is arbitrary, but one Terra always gets you $1 worth of Luna. (And vice versa: People can always exchange $1 worth of Luna for one Terra.)
  9. You set up an automated smart contract — the “algorithm” in “algorithmic stablecoin” — to let people exchange their Terras for Lunas and Lunas for Terras.
  10. Terra should trade at $1. If it trades above $1, people — arbitrageurs — can buy $1 worth of Luna for $1 and exchange them for one Terra worth more than a dollar, for an instant profit. If it trades below $1, people can buy one Terra for less than a dollar and exchange it for $1 worth of Luna, for an instant profit. These arbitrage trades push the price of Terra back to $1 if it ever goes higher or lower.
  11. The price of Luna will fluctuate. Over time, as trust in this ecosystem grows, it will probably mostly go up. But that is not essential to the stablecoin concept. As long as Luna robustly has a non-zero value, you can exchange one Terra for some quantity of Luna that is worth $1, which means Terra should be worth $1, which means that its value should be stable.

All of this is correct, and quite straight, except for Point 7, which is insane. If you overcome that – if you can find a way to make Luna worth some nonzero amount of money – then everything works fine. That is the whole ballgame. In theory this seems hard, since you just made up Luna. In practice it seems very easy, as there are dozens and dozens of cryptocurrencies that someone just made up that are now worth billions of dollars.

However, …