The dramatic collapse of TerraUSD (UST), once the third-largest stablecoin, sent shockwaves across the cryptocurrency market, triggering a broad selloff and raising fundamental questions about the viability of algorithmic stablecoins. What was designed as a self-sustaining mechanism to maintain price stability unraveled rapidly, dragging its sister token LUNA—once dubbed the “Crypto茅台”—from a peak market capitalization of over $40 billion to near zero in just days.
At the heart of this crisis lies a critical flaw: algorithmic stability is not true stability. Unlike traditional stablecoins backed by real-world assets, UST relied solely on code, incentives, and market psychology to maintain its $1 peg—a model that ultimately proved fragile under pressure.
How UST Was Supposed to Work
UST was an algorithmic stablecoin developed by Terraform Labs, designed to maintain a 1:1 value with the US dollar without holding dollar reserves. Instead, it used a complex token-burning and minting mechanism tied to its sister token, LUNA.
Here’s how it was supposed to function:
- When **UST traded above $1**, users could burn $1 worth of LUNA to mint 1 UST and sell it for a profit—increasing UST supply and pushing the price down.
- When **UST traded below $1**, users could burn 1 UST to claim $1 worth of newly minted LUNA—reducing UST supply and pushing the price back up.
This arbitrage incentive loop was meant to stabilize UST’s price organically. In theory, market participants would act rationally to profit from deviations, restoring equilibrium.
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But when confidence eroded, this system turned toxic.
The Death Spiral: How UST and LUNA Collapsed
In May 2025, a wave of UST redemptions began. As more users tried to exit, the protocol minted increasing amounts of LUNA to fulfill redemption requests. This caused massive inflation in LUNA’s supply, crashing its price.
As LUNA’s value plummeted, the system lost its ability to absorb downside pressure on UST. The arbitrage mechanism broke down because no one wanted to hold a rapidly devaluing asset (LUNA) in exchange for slightly discounted UST.
The result? A death spiral:
- UST fell below $1 and kept dropping—reaching as low as **$0.091**.
- LUNA, once trading above $100, crashed to **$0.0086**, effectively zero.
- Market panic spread, dragging down Bitcoin, Ethereum, and other major cryptos.
This wasn’t just a market correction—it was a systemic failure of an unproven financial model.
Why Algorithmic Stablecoins Are Inherently Risky
Several experts interviewed by media outlets had long warned that algorithmic stablecoins were unsustainable.
“The idea that you can maintain a stable value without real collateral is fundamentally flawed,” said Gu Yanxi, a blockchain researcher. “Most of these tokens are essentially securities masked as utilities—and they operate outside regulatory frameworks.”
Key weaknesses include:
- No tangible backing: Unlike USDT or USDC, which are backed by cash or cash-equivalent reserves, UST had no real-world assets.
- Overreliance on confidence: The system only works if people believe it will continue working. Once trust breaks, there’s no safety net.
- Inflationary design: Redeeming UST creates new LUNA, diluting existing holders—a recipe for collapse during mass exits.
- Ponzi-like dynamics: Early adopters earn high yields (e.g., via Anchor Protocol), funded by perpetual expansion rather than real income.
These factors make algorithmic stablecoins vulnerable to bank-run scenarios—exactly what happened with UST.
What This Means for Other Stablecoins
The fallout briefly impacted even the most trusted stablecoins:
- USDT dipped to $0.95 before recovering to $0.997.
- USDC remained largely stable at $1.00, briefly rising to $1.0079 due to flight-to-safety demand.
The contrast is telling.
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USDT and USDC are reserve-backed stablecoins, meaning each token is theoretically redeemable for one US dollar held in bank accounts or short-term securities. Their stability depends on transparency and auditability—issues that have plagued USDT in the past due to limited disclosure.
Still, as one investor noted:
“As long as reserves are sufficient and regularly audited, asset-backed stablecoins won’t face the same existential risks as algorithmic ones.”
Regulatory scrutiny remains a concern—but not the same kind of structural risk seen with UST.
Regulatory Reactions: A Warning Shot for the Industry
UST’s collapse didn’t go unnoticed by policymakers.
Janet Yellen, U.S. Treasury Secretary, stated during a Senate hearing that the event highlighted how unregulated crypto markets pose systemic risks to financial stability. She emphasized the need for comprehensive legislation on dollar-backed stablecoins.
James B. Bullard, President of the St. Louis Fed, echoed this sentiment, calling the episode proof that stablecoins carry significant risk—even if not yet systemic.
Gu Yanxi believes this moment will accelerate regulatory action:
“Yellen is signaling that the U.S. government wants regulated institutions to issue dollar stablecoins—not decentralized protocols operating in legal gray zones.”
This suggests a future where only regulated, reserve-backed stablecoins issued by banks or licensed entities will survive long-term.
Impact on Traditional Finance: Limited but Cautionary
While large financial institutions have largely avoided exposure to tokens like LUNA, the crash serves as a cautionary tale.
Most traditional players entering crypto focus on Bitcoin and select institutional-grade products. Even fintech-focused firms maintain limited exposure to experimental assets.
However, this event may make them more cautious:
- Increased skepticism toward “innovative” but unproven models.
- Stronger emphasis on collateralization and regulatory compliance.
- Greater interest in central bank digital currencies (CBDCs) as safer alternatives.
Ultimately, while direct financial damage was minimal, confidence in decentralized finance (DeFi) took a hit.
Frequently Asked Questions (FAQ)
Q: What caused UST to lose its $1 peg?
UST lost its peg when massive redemptions overwhelmed the arbitrage mechanism. With no real reserves to back it, panic selling triggered a death spiral between UST and LUNA.
Q: Is any algorithmic stablecoin safe?
Currently, no algorithmic stablecoin has proven long-term resilience. All rely heavily on market confidence and are vulnerable during downturns.
Q: Are USDT and USDC safe?
They are safer than algorithmic alternatives because they’re backed by real assets. However, risks remain around transparency and regulation—especially for USDT.
Q: Could this crash affect the broader economy?
Not directly. The crypto market is still relatively small and isolated. But regulators now see clearer risks to financial stability if stablecoins grow unchecked.
Q: What’s the future of stablecoins?
The trend is moving toward regulated, reserve-backed models—possibly issued by banks or central banks. Decentralized experiments like UST may fade without oversight and trust.
Q: Can LUNA ever recover?
The original LUNA is effectively worthless. A new chain (Luna 2.0) was launched without the algorithmic stablecoin component, but it lacks the economic model that defined the original—and investor trust remains shattered.
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Final Thoughts: Innovation Needs Foundation
The fall of “Crypto茅台” is more than a market event—it’s a lesson in financial engineering without fundamentals. While innovation drives progress in blockchain, stability cannot be coded into existence without real value behind it.
For investors, developers, and regulators alike, the message is clear:
Trust must be earned through transparency, not promised by algorithms.
As the crypto industry evolves, the winners will be those who combine innovation with responsibility—building systems that don’t collapse when stress hits.
The era of unchecked experimentation may be ending. What comes next could be stronger—if we learn from the collapse of UST and LUNA.