What happened when an algorithmic stablecoin lost its peg?

In May 2022, roughly $40 billion of market value evaporated in about a week. The Terra/UST collapse is the definitive case study in this course because nothing was hacked, no key was stolen and no bug was exploited. The system did exactly what it was designed to do, and that is what destroyed it.

The design

Two tokens on the Terra blockchain:

• UST — an algorithmic stablecoin targeting $1.00, backed by no external collateral. Not every algorithmic design is uncollateralised — some are hybrid, holding reserves against part of the supply — but UST's was, which is the version that matters for what follows.
• LUNA — the volatile companion token.

The mechanism was a mint-and-burn arbitrage enforced by the protocol: 1 UST could always be burned to mint $1 worth of LUNA, and $1 worth of LUNA could always be burned to mint 1 UST.

In theory this pins the peg. If UST trades at $0.98, buy it, burn it for $1.00 of LUNA, sell — a two-cent profit that removes UST supply until the discount closes. If UST trades at $1.02, mint new UST from LUNA and sell it. Elegant, symmetrical, and dependent on one unstated assumption: that LUNA is worth something.

The demand was rented, not earned

UST's growth came overwhelmingly from Anchor Protocol, which paid depositors roughly 19.5% on UST. At the peak, Anchor held around 75% of all UST in existence.

Ask the Unit 4 question early: where did 19.5% on a dollar-denominated deposit come from? Borrower interest and staking rewards on borrowers' collateral covered part of it — and the rest came out of a reserve that had to be topped up, reportedly by about $450 million in February 2022. On roughly $14 billion of deposits, the promised interest alone is:

14,000,000,000 × 0.195 = $2.73 billion a year

A subsidy of that scale is not a yield. It is a customer-acquisition cost with an expiry date, and it meant most UST holders were there for the rate rather than for the currency — the most fragile deposit base imaginable.

The death spiral, as arithmetic

Here is the mechanism that turns a wobble into a wipe-out. The amount of LUNA minted when UST is redeemed is:

LUNA minted = UST burned ÷ LUNA price

The LUNA price is in the denominator. So:

• At LUNA = $60, redeeming $100 million of UST mints 1.67 million LUNA.
• At LUNA = $1, the same $100 million mints 100 million LUNA.
• At LUNA = $0.01, it mints 10 billion LUNA.

Each redemption dilutes LUNA, which pushes LUNA's price down, which means the next redemption mints more LUNA, which pushes the price down faster. The feedback loop is not linear — it is hyperbolic, and it accelerates exactly when holders most want out. The protocol's daily conversion capacity acted as a partial brake; widening it to absorb the pressure simply let the dilution run faster.

The week

• Early May 2022 — UST supply peaked around $18.7 billion; LUNA had traded above $100 the previous month.
• 9 May — UST broke below $0.99 and did not recover; large redemptions began.
• 10–11 May — UST fell into the $0.60s and then lower as the mint mechanism ran at scale.
• 12–13 May — UST reached single-digit cents. LUNA's supply expanded from roughly 350 million tokens to more than 6.5 trillion — an expansion of roughly 18,000× — and its price went to effectively zero. The Terra blockchain was halted on 12 May and again on 13 May.

The aftermath extended well beyond Terra: several centralised lenders and funds with exposure failed over the following months. Terraform Labs filed for Chapter 11 bankruptcy in January 2024, and in April 2024 a New York jury found Terraform Labs and its co-founder liable for civil fraud.

The three transferable lessons

1. Circular collateral is not collateral. If asset A's backing is asset B, and B's value derives from demand for A, the system is reflexive. It amplifies in both directions and there is no floor under it.
2. A subsidised yield is a liability with a maturity date. Anchor's 19.5% did not compensate risk; it purchased deposits. When the subsidy became unsustainable the deposits left, and they were the demand.
3. "It has worked so far" is not evidence of stability. UST held its peg through eighteen months and a great deal of volatility. A mechanism that survives normal conditions tells you nothing about the tail it was never tested against.

This is a factual account of a documented past episode, offered as education. It is not a claim about any stablecoin today.

Try it now

1. The two largest crypto assets are below. Navigate both to 5–15 May 2022 and Measure that fortnight on each. Describe, neutrally, what happened to the broader market during the collapse week — a failure in one protocol priced into everything.

2. Redo the death-spiral arithmetic yourself: how much LUNA is minted by $500 million of UST redemptions at prices of $80, $5, $0.10 and $0.001? Write the four numbers in a column and look at the shape they make.
3. Write two sentences explaining to a beginner why "algorithmic" described the peg mechanism and not the backing — and why that distinction was the whole story.