TerraUSD’s Depeg: Collateral Risk and the Death Spiral
Summary
The document explains TerraUSD’s failure as a problem in the relationship between its dollar peg and Luna, the associated cryptocurrency. In the simplified account, the system relied on reducing TerraUSD supply when holders sought to exit, with Luna serving as the backing needed to support redemptions. When Luna’s value collapsed, that mechanism could no longer provide enough support to maintain the peg.
A second explanation frames the event as a bank run: a stablecoin needs adequate collateral, liquid assets, and a withdrawal buffer to withstand redemptions. The discussion says TerraUSD was largely uncollateralized and also depended on Luna-based redemption, while rapid growth was encouraged by a high promised yield from Anchor. As Luna’s market value fell, confidence and redemption capacity deteriorated together, reinforcing the collapse. These are simplified explanations and do not provide a detailed reconstruction of the protocol, market events, or other stablecoin designs.
Key ideas
- TerraUSD’s peg depended in part on Luna’s value and redemption mechanism.
- A sharp decline in the backing asset can weaken a peg precisely when redemptions increase.
- Collateral quantity, liquidity, and withdrawal buffers affect a stablecoin’s resilience.
- High yields can attract rapid growth without ensuring that redemption support is sufficient.
Tags
Full text
# How did the algorithm pegging TerraUSD stablecoins to USD fail? # How did the algorithm pegging TerraUSD stablecoins to USD fail? This month the TerraUSD stablecoin and associated Luna reserve cryptocurrency crashed and lost most of its value. About $45 billion in market capitalization vanished within a week. Apparently there was some sort of sell-off, but then TerraUSD was supposed to be a stablecoin, being pegged to the US dollar via a complex algorithmic relationship. That algorithm must have failed. How has it failed? How fragile was this pegging of a cryptocurrency to the USD? I guess that different currencies can ultimately never be pegged perfectly and a stablecoin is a bit of a misnomer, but still I wonder how easy it might have been to break this pegging. ## Answer by phdstudent (score 10, accepted) https://quant.stackexchange.com/a/71023 It failed because the collateral of TerraUSD was Luna. Here's how it worked in very simplified terms: If people wanted to divest from TerraUSD (sell), to keep the value of TerraUSD from collapsing the algorithm would buy TerraUSD (thus decreasing the amount of circulating coins) and putting the price back at being stable. Now for the algorithm to be able to buy, it needs some cash to do so. And that cash was collateralized by Luna. When Luna collapsed, TerraUSD had no way of keeping its peg to the USD. ## Answer by Mikko Ohtamaa (score 4) https://quant.stackexchange.com/a/71025 > How has it failed? How fragile was this pegging of a cryptocurrency to the USD? > I guess that different currencies can ultimately never be pegged perfectly and a stablecoin is a bit of a misnomer, but still I wonder how easy it might have been to break this pegging. It depends on the quality of the collateral, like in all banking - How much there is collateral - How liquid is the collateral - How much there is withdrawal buffer Every time someone is withdrawing, the buffer goes down and collateral must be liquidated to refill the withdrawal buffer. If there is not enough collateral, then a bank run / death spiral may ensure. Terra UST was 90% having no collateral and then redemption via Luna burning (might be seen as collateral)? UST had grown too big and too fast because of "guaranteed" 20% APY on Anchor lending. When Luna market value dipped, there was not enough Luna left in the world to redeem all UST. That's when the run on the bank happened, causing a death spiral. What comes to other stablecoins, here is a good image from SebVentures: More about the history and features of algorithmic stablecoins in my Twitter thread.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.