Terra and Luna (2022): The Stablecoin That Wasn't

6.1 What it was

TerraUSD (UST) was an algorithmic stablecoin (Module 1, Chapter 5, and Module 9, Chapter 7), designed to hold a value of $1 without being backed by dollars or overcollateralised crypto. Instead, it relied on a mint-and-burn relationship with a sister token, LUNA:

Situation	Intended mechanism
UST below $1	Users could burn 1 UST to mint $1 worth of LUNA, profiting by buying cheap UST, which reduced UST supply
UST above $1	Users could burn $1 of LUNA to mint 1 UST, increasing UST supply

A lending protocol in the Terra ecosystem, Anchor, offered depositors close to 20% yield on UST, attracting enormous demand. By early 2022, UST was one of the largest stablecoins, and LUNA one of the largest crypto assets.

People trusted it because it was large, growing, backed by prominent investors, and led by a confident founder. The yield seemed stable, and the mechanism seemed elegant.

In numbers, a near-20% yield meant a $1,000 deposit was promised about $200 a year, against safe rates then of only a few percent. A gap that large is a warning that the yield is being subsidised or taking hidden risk (Module 15, Chapter 10).

6.2 What happened

Date	Event
May 2021	UST briefly lost its peg. The founder publicly credited the protocol's design for its recovery. US prosecutors later said that, in fact, a trading firm had secretly been enlisted to buy UST and restore the peg
Early 2022	Anchor's high yield required subsidies; deposits grew rapidly
Early May 2022	Large withdrawals and sales of UST pushed it below $1
Days that followed	Holders burned UST for LUNA and sold the LUNA; LUNA's price collapsed as its supply exploded; confidence vanished in a spiral
Within about a week	UST was far below $1 and LUNA was worth almost nothing; tens of billions of dollars in market value were wiped out

6.3 The death spiral

The design worked in normal times but contained a fatal feedback loop under stress:

1. UST falls below $1.
2. Arbitrageurs burn UST and mint LUNA, then sell LUNA.
3. Selling LUNA pushes its price down.
4. Lower LUNA prices mean more LUNA must be minted to absorb each UST.
5. LUNA supply explodes and its price collapses further.
6. Confidence in UST falls, so more holders exit.
7. Repeat.

This is the reflexivity described in Module 11, Chapter 2, operating at the core of a stablecoin.

"So the thing meant to save the peg became the thing that destroyed it," said Mint.

"Because the backing was confidence in a token whose value depended on that same confidence," said Hash.

Chapter 6 · The Terra death spiral

When UST traded below one dollar, holders burned UST to mint a dollar's worth of LUNA and sell it. The extra LUNA supply pushed LUNA's price down, so each depegged UST minted even more LUNA, deepening the discount and feeding the loop until both collapsed. An Anchor yield near 20% had drawn in the deposits at risk.

6.4 Warning signs

Warning sign	Module
A stablecoin without full reserves	Module 9, Chapter 7
A near-20% yield on a stablecoin with no clear sustainable source	Module 2, Chapter 11; Module 15, Chapter 10
Yield subsidised by reserves, which were being drawn down	Module 9, Chapter 10
A previous depeg, attributed to the protocol's design	Module 10, Chapter 7
Reflexive mechanism linking stablecoin value to a volatile token	Module 11, Chapter 2
Extremely confident founder dismissing critics	Module 5, Chapter 11
Concentration: huge share of UST in one protocol	Module 9, Chapter 12

6.5 Aftermath

Contagion. The collapse triggered failures across the industry, including hedge funds and lenders with exposure to Terra, and set off the wider 2022 crisis (Chapter 7).

Legal outcomes. The founder, Do Kwon, was arrested in Montenegro in 2023 and later extradited to the United States. He pleaded guilty to fraud charges in August 2025 and, in December 2025, was sentenced in New York to 15 years in prison. He also faced proceedings in South Korea.

Industry impact. Algorithmic stablecoins largely lost credibility. Regulators accelerated stablecoin rules, including reserve requirements in the EU and the US (Module 14, Chapters 7 and 8).

6.6 Lessons

1. Stable is a goal, not a guarantee (Module 1, Chapter 5).
2. Yields far above safe rates carry risk proportional to their size (Module 15, Chapter 10).
3. Reflexive designs can fail suddenly and completely.
4. Past depegs are evidence; find out how they were resolved.
5. Concentrated, subsidised growth is fragile (Module 9, Chapter 12).
6. Founder confidence isn't evidence (Module 5, Chapter 11).

6.7 Try it yourself

Pick any stablecoin offering yield. Answer: what backs it, where its yield comes from, whether it has ever depegged and how it recovered, and whether its value depends on another token's price. Use the stablecoin evaluation table from Module 10, Chapter 7.

Key takeaways from this chapter

1. TerraUSD was an algorithmic stablecoin relying on a mint-and-burn relationship with LUNA, boosted by a near-20% yield.
2. In May 2022, a depeg triggered a death spiral, wiping out tens of billions of dollars within about a week.
3. Prosecutors later said a 2021 depeg recovery publicly credited to the protocol had actually been supported by a trading firm.
4. Warning signs included no full reserves, unsustainable subsidised yield, past depegs, reflexive design, and concentration.
5. The founder pleaded guilty and was sentenced to 15 years in the US in December 2025.
6. The collapse triggered 2022's contagion and accelerated stablecoin regulation.