Crypto Crash: Can Terra (Luna) Ever Recover?

The Terra (CRYPTO: LUNA) blockchain is powered by two cryptocurrencies: Terra and Luna. Terra is a stablecoin tied to the value of fiat currencies. For example, TerraUSD (CRYPTO: UST) is pegged to the U.S. dollar. And Luna is used to absorb stablecoin price volatility.

Earlier this week, TerraUSD lost its peg and the stablecoin saw its price plunge to $0.30. It has since regained some of its value, though its price is still well-below the $1 target. Not surprisingly, spooked investors have sold Luna hand over fist in an effort to distance themselves from the catastrophic meltdown. In fact, Luna has lost 99% of its value in the last few days.

Is this a buying opportunity? Or is the Terra blockchain in trouble?

How does the Terra blockchain work?

Arbitrage is the simultaneous buying and selling of an asset to capitalize on small price discrepancies in different markets. The Terra stablecoin maintains its price through a built-in arbitrage mechanism. Here's how it works.

Let's say demand for TerraUSD drives its price up to $1.02. To restore its peg, the blockchain allows traders to burn $1 worth of Luna to mint one TerraUSD coin. The trader can then sell that TerraUSD coin to earn a profit of $0.02. At the same time, the arbitrage mechanism increases the supply of TerraUSD, which eventually brings its price back to $1.

The system works the same in reverse. If a sell-off pushes the price of TerraUSD down to $0.98, traders can burn one TerraUSD coin to mint $1 worth of Luna. Once again, the trader makes a $0.02 profit and the arbitrage mechanism restores the peg, increasing the price of TerraUSD by reducing its supply.