The Terra-Luna Collapse
TerraUSD was a stablecoin that kept its $1 peg not with cash reserves but with a second token, LUNA, that could always be minted or burned to absorb price swings — a design that worked until confidence broke, at which point the mint-and-burn mechanism itself destroyed both tokens' value in days.
Prerequisites: Stablecoins and How Pegs Are Held
Most stablecoins hold a reserve of real dollars or Treasury bills so that each coin can, in principle, be redeemed for $1 of actual assets. TerraUSD (UST) worked differently: it was an algorithmic stablecoin, backed not by a reserve of cash but by a second, freely traded token called LUNA. The system let anyone burn $1 worth of LUNA to mint 1 UST, or burn 1 UST to mint $1 worth of LUNA, at any time. As long as people trusted that arbitrage would always be available, UST traded reliably near $1 — and a lending protocol called Anchor offered depositors an eye-catching 20% annual yield on UST, which pulled in tens of billions of dollars from investors chasing the return.
Why the mechanism turned into a death spiral
The arrangement depended entirely on LUNA retaining real market value, because "burn LUNA to mint UST" only defends the $1 peg if the LUNA being burned is actually worth something. In May 2022, large UST withdrawals from Anchor triggered a wave of selling that pushed UST slightly below $1. Arbitrageurs began burning UST for LUNA to profit from the gap, exactly as designed — but the sheer volume of burning meant a huge amount of new LUNA was minted and dumped onto the market simultaneously, crashing LUNA's price. As LUNA's price fell, each unit of UST redeemed produced less real value in LUNA, undermining the very mechanism meant to restore the $1 peg, which pushed UST further below $1, which triggered more redemptions. Within about a week, LUNA fell essentially to zero and UST followed it, wiping out roughly $40 billion of combined value.
What this means in practice
The collapse showed that a peg backed by a second volatile asset, rather than by an external reserve of cash or safe assets, is only as strong as confidence in that asset — and that confidence and price can unwind together in a feedback loop rather than independently. It also triggered wider "crypto contagion": several lenders and funds that held large UST or LUNA positions (or had lent against them as collateral) failed in the following months, feeding directly into the environment that produced The FTX Collapse and Crypto Contagion later that same year.
An algorithmic stablecoin backed by a second token, rather than an external cash reserve, can enter a self-reinforcing collapse: redemptions dilute the backing token's price, which makes the peg mechanism weaker, which triggers more redemptions. The 20% yield paid to UST depositors was not a sign of a safe, mature system — it was compensation for exactly this tail risk.
Don't confuse "algorithmically pegged" with "asset-backed." A stablecoin backed by real dollars or Treasuries in custody can be redeemed regardless of how its own token trades; a stablecoin backed by another crypto token can fail precisely when it's needed most, because the backing asset and the peg it's defending tend to become worthless at the same time.
Related concepts
Practice in interviews
Further reading
- Bank for International Settlements, Quarterly Review, The Crypto Shakeout (2022)