Terra and Luna
In May 2022 a stablecoin that was supposed to work without real reserves lost its peg to the dollar within a few days. Both tokens involved fell practically to zero, and by some estimates 40 billion dollars or more of value vanished.
A stablecoin is supposed to be worth one dollar at all times. Most manage this by depositing dollars or safe investments. Terra did it differently. The peg was supposed to work through a second token called Luna.
Simplified, it worked like this: if Terra fell below a dollar, you could swap it for newly created Luna worth one dollar. That was meant to push the price back up. On top of that, a program called Anchor lured people with almost 20 percent interest on Terra, and that's exactly what brought most of the demand.
In May 2022 the peg began to slip. Many wanted out, so more and more Luna was created. That pushed Luna's price down, which in turn destroyed confidence in Terra. In early April Luna was still above 100 dollars. A few days after the crash began, it was worth less than a cent.
That's exactly what the lesson DeFi warns about. Nobody could convincingly explain who earned the 20 percent. Where that explanation is missing, the return comes from the money of the next people to pay in, and that always ends the same way.
The system depended on a loop between two tokens, without any collateral from outside. Something like that stays stable as long as more and more people join, and tips over as soon as more want to leave. Support then comes from new Luna, whose price falls as a result, so ever more of it is needed. This self accelerating loop is called a death spiral.
The almost 20 percent interest didn't come from real income. It was mostly paid from a pot filled specially for the purpose. So the program bought demand, and it was clear the pot would run dry at some point. Demand that only exists because of a subsidised return disappears with the subsidy.
There are three kinds of stablecoins. Some deposit dollars or short term investments. The second kind deposits more crypto than it issues. The third tries without any reserves at all, only through rules in the program. Only the first two have backing outside their own system. The third kind has already failed several times.
Summary
- Without external backing, stability is only a function of growing demand.
- A twenty-percent yield with no nameable source is a subsidy.
- Algorithmic stablecoins with no collateral have failed multiple times.
Did you get it?
What is a death spiral in this context?
Support comes from issuing a second token. Its price falls as a result, and even more of it has to be issued.
Where did the high yield come from?
Mostly from a pot filled specially for the purpose. So the demand was subsidised.
Which stablecoin types have external backing?
Those that deposit dollars or safe investments, and those that deposit more crypto than they issue. The ones without reserves have no backing.
Your task
An offer lures you with almost 20 percent interest on a stablecoin. Where does the money for that return come from? Choose any offer with a high yield, find the explanation in its description of who earns the return, and write it down in one sentence. If you find none, note that too.
Sources and further reading
- Public price data and protocol documentation from May 2022.
- SEC complaint against Terraform Labs and Do Kwon. View source ↗
- Federal Reserve Bank of Richmond, Economic Brief 22-24, Why Stablecoins Fail: An Economist's Post-Mortem on Terra (2022): how UST and Luna worked, the 19.5 percent Anchor rate and the May 2022 collapse. Retrieved October 9, 2026. View source ↗