Case Study: The Terra-Luna Stablecoin Collapse
Over 7 to 9 May 2022 the algorithmic stablecoin TerraUSD (UST) lost its $1 peg and never recovered, collapsing within days and taking its sister token LUNA down with it. UST was not backed one-for-one by safe reserves. It held its peg through a design that let anyone always redeem 1 UST for $1 worth of newly minted LUNA, and vice versa. Much of the demand came from the Anchor protocol, which paid depositors a yield of roughly 19 to 20 percent that was unsustainable. When confidence cracked and holders rushed to redeem, mass redemptions minted enormous amounts of new LUNA, so LUNA’s supply hyperinflated and its price collapsed toward zero, destroying UST’s backing. Tens of billions of dollars of value were wiped out across the Terra ecosystem within days, showing that an unbacked stablecoin can suffer a classic bank run.
Why it matters
A stablecoin is only as stable as the assets standing behind it. UST had no pile of safe reserves, only a promise that you could always swap it for $1 worth of a second token whose price was itself propped up by demand for the first. That is reflexive, not stable. Once enough holders doubted the peg and ran for the exit, redemptions minted ever more Luna, each unit worth less than the last, so the very act of defending the peg destroyed the value meant to defend it. This is the same self-fulfilling dynamic as a bank run, with code replacing the teller window.
Worked examples
UST trades at $0.95. The protocol promises you can always burn 1 UST to mint $1 worth of Luna. Why does this arbitrage stop working in a panic?
In calm times the arbitrage holds the peg. You buy UST cheaply at $0.95, burn it for $1 of Luna, and pocket the difference, which pushes UST back toward $1. In a panic everyone redeems at once, so the protocol mints huge amounts of new Luna and floods the market. Luna’s price collapses, so $1 worth of Luna soon means a near-infinite number of nearly worthless tokens. The redemption no longer delivers real value and the peg breaks for good. This is the death spiral.
Compare UST with a stablecoin that holds $1 of short-term Treasuries and cash for every coin issued. Which faces a redemption run, and why?
A fully reserved stablecoin can hand every holder a real dollar of safe assets, so a rush to redeem drains reserves but need not destroy value. UST backed each coin only with its own sister token, so mass redemption inflated Luna’s supply and crushed its price. The reserved coin is closer to a warehouse receipt. UST behaved like a leveraged bet on its own ecosystem’s confidence.
Common mistakes
- ✗Anything labelled a stablecoin is safe and fully backed by dollars. UST was algorithmic and held no one-for-one safe reserves, so it carried run risk that a fully reserved coin does not.
- ✗A high advertised yield is a sign of strength. The roughly 19 to 20 percent Anchor yield was an unsustainable subsidy that pulled in speculative demand, and it made the eventual run larger, not smaller.
- ✗Only old-fashioned banks can suffer runs. UST shows a run can hit any institution that promises instant redemption while standing on assets that lose value precisely when everyone redeems at once.
Revision bullets
- •UST was an algorithmic stablecoin, not reserve-backed, paired with Luna through a mint-and-burn arbitrage
- •May 2022: the peg broke, redemptions hyperinflated Luna, and the system collapsed in a death spiral
- •It was a bank run in code, and it proved an unbacked stablecoin is not truly stable
Quick check
Why did the UST de-peg turn into a collapse rather than a brief wobble?
In what sense was the Terra-Luna episode a bank run?
Connected topics
Sources
- BIS Bulletin No 69 (2023)Bank for International Settlements. Crypto shocks and retail losses. BIS Bulletin No 69, 2023.Documents the May 2022 Terra/UST collapse, the resulting retail losses, and crypto run dynamics.
- Liu, Makarov and Schoar (2023)Liu, J., Makarov, I., and Schoar, A. Anatomy of a Run: The Terra Luna Crash. NBER Working Paper No 31160, 2023.Analyses UST as an algorithmic stablecoin, the role of the Anchor yield, and the run that hyperinflated Luna.