The Terra and UST collapse
How a confidence-dependent conversion mechanism turned a stablecoin depeg into a reflexive collapse.
Why this event still matters
TerraUSD, known as UST, was promoted as a stablecoin designed to maintain a value near one US dollar without holding an equivalent pool of conventional dollar reserves. Its mechanism allowed UST to be exchanged for a dollar's worth of the related token LUNA. The arrangement depended on liquid markets and continuing confidence in LUNA's value. [1][2][4]
By early May 2022, UST had grown to roughly $18 billion and demand had been supported by high yields available through the Anchor protocol. When holders tried to leave, conversions increased the supply of LUNA just as its price was falling. The mechanism meant to stabilize UST therefore weakened the asset expected to absorb the redemptions. [2][3]
Event reconstruction
Stablecoin use expands
UST supply and yield-driven demand grow rapidly.
Redemptions rise
Holders convert or sell UST as confidence weakens.
LUNA issuance accelerates
Conversion expands LUNA supply while demand and price fall.
The stabilizing mechanism fails
Both assets lose value and leveraged positions across the ecosystem unwind.
The peg depended on confidence
UST was an algorithmic stablecoin that sought to maintain one dollar through conversion with LUNA. A holder could exchange UST for a dollar's worth of newly created LUNA. The mechanism required a market willing to value and absorb LUNA. [1][2]
High deposit yields supported demand for UST, but yield-driven demand is not the same as a reserve asset that can be redeemed at par. The arrangement remained stable only while participants expected the conversion and market-value relationship to hold. [1][2]
Why arbitrage could not guarantee the peg
The conversion mechanism created an incentive to buy discounted UST and redeem it for a dollar's worth of LUNA. That incentive was sometimes described as an assurance that the peg would restore itself. In practice, the trade still depended on conversion capacity, execution time, and the ability to sell the received LUNA without driving its price lower. [1][2]
As redemptions accelerated, the quantity of LUNA issued for each UST rose because LUNA's unit price was falling. The arbitrage profit measured at the start of a transaction could disappear before the new tokens were sold. A mechanism can be logically consistent for small deviations and fail under a run when its own activity changes the value of the absorbing asset. [1][3]
What reserves and governance could not repair in time
The Terra ecosystem had accumulated bitcoin and other resources intended to support UST during stress. A reserve can help only if it is large, liquid, operationally accessible, and deployed through a credible process before confidence collapses. Selling reserve assets into a broad crypto decline can also transmit pressure beyond the stablecoin itself. [1][5]
Emergency governance actions and chain interruptions could slow parts of the mechanism but could not recreate the lost external value. Once UST and LUNA were both deeply impaired, changing issuance or conversion rules redistributed remaining claims rather than producing dollars. This is why disclosure should separate stabilization tools from legally enforceable redemption against segregated assets. [2][4]
Redemption created a death spiral
When confidence weakened in May 2022, holders sold or redeemed UST. Conversions increased LUNA supply while LUNA's price and market capitalization were falling. More units had to be created to absorb the same nominal amount of UST. [1][2]
That feedback loop undermined the asset intended to stabilize the system. UST fell far below its target and LUNA's value collapsed. The design could not produce external dollar resources when confidence in both linked tokens disappeared. [1][2]
Stress spread through collateral and leverage
UST and LUNA were used across exchanges, lending protocols, and liquidity pools. Falling prices impaired collateral, triggered liquidations, and forced participants to unwind positions in other assets to meet obligations or reduce risk. [1][2]
The episode distinguishes a stabilization mechanism from asset backing. A peg can trade close to one dollar for a long period without possessing the resources needed to satisfy a run at that value. [1]
Application to collateral selection
Collateral should be stress-tested for redemption, custody, liquidity, and correlation with the position it supports. A token called stable should not automatically receive a one-dollar assumption. [1][2]
If the settlement asset, collateral asset, and market exposure share a failure channel, account risk can compound. Venue haircuts and eligibility changes may arrive only after stress is visible. [1]
Yield concentrated the run risk
Anchor's advertised yields, at times near 20%, made it a major destination for UST. That concentrated demand around an incentive that required continuing subsidies or sufficient borrowing activity. When confidence weakened, many holders had a similar reason to exit and similar routes through which to do so. [2][3]
The Federal Reserve's review described UST as roughly $18 billion before the collapse and noted the broader strains that followed. The episode was not isolated inside one pair of tokens: funds, lenders, exchanges, and other crypto businesses had direct positions or counterparties exposed to the unwind. [3][4]
What to carry forward
Terra's collapse distinguishes price stability in calm markets from credible redemption under stress. A stablecoin is only as durable as the assets, mechanisms, governance, and market capacity behind its promise. If the stabilizing asset is created by the same system and loses value when redemptions rise, the design can become reflexive rather than stabilizing. [1][3][4][5]
The stabilizing asset and liability were reflexively linked
Redemptions expanded supply into declining demand
A depeg impaired collateral and liquidity simultaneously
A peg mechanism is not the same as redeemable reserves
Yield can conceal the source of demand
Stress correlated collateral and settlement assets together
Sources and primary documents
Claims above link to the numbered records used in this case file.
Expanded case file with a full introduction, deeper analysis, conclusions, and claim-level citations.
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