LUNA is Terra’s native governance token that serves as the backing for its UST stablecoin.

UST is not backed by a fixed amount of fiat dollars like other stablecoins such as USDC or USDT. Instead, the supply of LUNA acts as the backing for UST and absorbs changes in UST demand by regulating supply. The fundamental mechanism is that users can always exchange 1 UST for $1 worth of LUNA.

Assume there are 1 million UST in the market, backed by $1 million worth of LUNA. Let’s say that UST demand rises, and it breaks its peg to the upside, with 1 UST worth more than $1. Terra mints new UST by burning an equal amount of LUNA to restore the peg. Conversely, if UST demand falls and the peg is broken to the downside, UST holders can exchange their tokens for $1 worth of LUNA until the peg is restored.

In other words: the supply of LUNA contracts if demand for UST rises, causing the price of LUNA to rise. The supply of LUNA expands if demand for UST falls, causing the price of LUNA to fall. As a result, volatility is shifted from UST to LUNA.

In the long run, increased demand in UST will lead to a contraction of the LUNA supply and an increase in demand for LUNA. As new dApps appear on Terra and more integrations with other blockchains through bridges are created, awareness and demand for UST should rise, and with it, the demand for LUNA, leading to a subsequent reduction in LUNA supply.

The Bull Case for UST and LUNA

The bull case for the ecosystem is the mass adoption of UST across the cryptocurrency space, leading to a price surge in LUNA. If LUNA in the future is worth $1,000 or even $10,000 or more, its supply curve will be highly inelastic since burning 1 UST at a price of $10,000/LUNA burns a fraction of the LUNA it does now.

This is the goal of the LUNA project, which has become even more explicit with last year’s Columbus-5 upgrade. After the upgrade, the seigniorage LUNA incurred to mint UST is burned and no longer allocated to a community treasury. This results in an even quicker burn of LUNA as long as the demand for UST keeps expanding, similar to the London Hard Fork on Ethereum.

Risks for UST and LUNA

If demand for UST declines for some reason, LUNA will suffer as a result. That is exactly what happened following the Wormhole hack that saw $320 million in Wrapped Ethereum stolen. The price of LUNA has plummeted 50% from its all-time high of around $100 after panic gripped the market in the aftermath of the hack. Although the Terra Station and the Terra Station wallet were never compromised, the damage to the reputation of Wormhole – the Terra bridge to other blockchains – took a serious hit.

Source: https://coinmarketcap.com/alexandria/article/what-is-terra-a-guide-to-terra-s-ecosystem