A Reverse Death Investigation. In May 2022, an estimated $40 billion to $60 billion in market value evaporated in a matter of days when the TerraUSD stablecoin lost its peg to the U.S. dollar and its sister token LUNA fell from above $80 to a fraction of a cent. This dossier examines how an "algorithmic" stablecoin marketed as a breakthrough in decentralized finance was, on inspection, a confidence mechanism with no reserve floor, and how its design guaranteed that a loss of confidence would feed on itself.
Terraform Labs, founded by Do Kwon, built an ecosystem around two linked tokens. TerraUSD, or UST, was designed to trade at one dollar. LUNA was the volatile governance and absorption token. Unlike reserve-backed stablecoins that hold cash and short-term securities against every unit issued, UST held no such reserves. Its peg was maintained by an arbitrage promise.
How the Peg Was Supposed to Work
The mechanism was elegant on paper. The protocol always allowed one UST to be exchanged for one dollar's worth of newly minted LUNA, and vice versa. If UST traded below a dollar, arbitrageurs could buy it cheaply, redeem it for a dollar of LUNA, and profit, with the buying pressure pushing UST back toward parity. If UST traded above a dollar, the reverse trade minted new UST and earned the difference.
The fatal assumption was that LUNA would always have enough market value to absorb redemptions. The system had no hard collateral. It relied entirely on the market's continuing willingness to value LUNA. That willingness was, in turn, propped up by demand for UST, and a great deal of that demand existed for one reason.
The Anchor Problem
Anchor Protocol, a lending platform within the Terra ecosystem, offered depositors a yield of roughly 20% on UST. This rate was far above anything available in traditional markets or in most of decentralized finance, and it was not generated by sustainable lending revenue. It was substantially subsidized from a reserve. Anchor's yield was the principal reason ordinary holders parked billions in UST.
A stablecoin whose stability depends on a 20% subsidized yield is not stable. It is a deposit run waiting for a trigger.
By early 2022, a very large fraction of all UST in existence sat in Anchor chasing that yield. The demand was not organic use as a medium of exchange; it was yield-seeking capital that would leave the moment the yield or the peg looked unsafe.
The Depeg
In early May 2022, large UST withdrawals coincided with a thinning of liquidity in the Curve pool where UST traded against other stablecoins. UST slipped below its peg. The arbitrage mechanism activated: holders redeemed UST for LUNA, which meant minting enormous quantities of new LUNA. As LUNA's supply exploded, its price collapsed, which made each UST redemption mint even more LUNA to cover the same dollar. The mechanism designed to defend the peg became the engine of its destruction.
Within days the figures were staggering. LUNA's supply expanded from hundreds of millions of tokens into the trillions. Its price fell toward zero. UST never recovered its peg. An emergency deployment of bitcoin reserves held by an associated foundation was insufficient to halt the collapse, and those reserves were themselves consumed in the failed defense.
The Aftermath and the Charges
The collapse rippled through the wider crypto market, contributing to the failure of leveraged funds and lenders exposed to Terra and to the broader downturn that followed. Investigators in multiple jurisdictions opened cases.
- U.S. authorities charged Do Kwon with fraud, alleging he misled investors about UST's stability and about the role a trading firm had played in restoring an earlier, smaller depeg in 2021, which had been presented publicly as proof the mechanism self-corrected.
- South Korean prosecutors pursued their own charges, and Kwon was detained in Montenegro on passport-related matters before extradition proceedings.
- The U.S. Securities and Exchange Commission obtained findings against Terraform Labs and Kwon over the marketing and sale of the tokens.
The forensic conclusion is direct. An algorithmic stablecoin with no genuine collateral is a reflexive system: its solvency and the confidence of its holders are the same variable. Such a design can appear robust through long stretches of calm and rising prices, but it carries within it a positive feedback loop that, once tripped, accelerates rather than dampens. The 20% yield masked the fragility by manufacturing demand that was never going to stay. When it left, there was nothing underneath.