What is an algorithmic stablecoin, and why did TerraUSD collapse?

Rules instead of reserves

Fed staff describe algorithmic stablecoins as ones that try to match supply to demand with rules, usually run by smart contracts. They hold few or no assets in reserve.¹

The idea is simple. If the price goes above $1, new coins are issued. If it falls below $1, coins are taken out of circulation.¹ Fed staff point out that shrinking the supply is the hard part.¹

A common design links the stablecoin to a second token. Traders are meant to profit by swapping between the two, which pushes the stablecoin back to $1.¹ The Fed note says this fails if both tokens fall in price at the same time, causing what is called a "death spiral".¹

The FSB's 2023 recommendations say a global stablecoin should not get its value from algorithms.⁴

How UST was meant to work

Terraform Labs launched TerraUSD, or UST, in 2020, according to US prosecutors.⁵ Its promotional materials claimed one UST could always be swapped for $1 worth of LUNA, the Terra blockchain's own token, and the other way round.⁵

So if UST traded at $0.95, a trader could in theory buy one UST and swap it for $1 worth of LUNA, taking a profit. Fed staff class UST as a design where users are given incentives to swap the stablecoin for another token, taking it out of circulation. That was meant to push its price back up.^5,1

The weak point is the one the Fed note describes. The swap only helps while the second token holds its value. If both tokens fall at the same time, the mechanism fails.¹

The SEC alleged in 2023 that Terraform marketed UST as a "yield-bearing" stablecoin, advertised as paying as much as 20% interest through the Anchor Protocol.²

The collapse, May 2022

In May 2022, UST lost its peg to the dollar. The price of UST and its sister tokens fell to close to zero.² The SEC said about $40 billion of market value was wiped out nearly overnight.³ Prosecutors put investor losses at over $40 billion.⁵

Fed staff noted that the collapse spread through the crypto market, and the total value of algorithmic stablecoins fell back to 2021 levels.¹

How the cases ended

The SEC case. In February 2023, the SEC charged Terraform Labs and its co-founder and chief executive, Do Kwon, with fraud.^2,5 In April 2024, a jury found them liable for securities fraud.³ In June 2024 they agreed to pay more than $4.5 billion, and Terraform agreed to wind down its business.³ Terraform had filed for Chapter 11 bankruptcy in January 2024.³

The criminal case. Do Kwon was extradited to the US on 31 December 2024 and pleaded guilty in August 2025.⁵ On 11 December 2025, a US judge sentenced him to 15 years in prison for wire fraud and conspiracy to commit securities, commodities and wire fraud.⁵ He was also ordered to forfeit over $19 million.⁵

What prosecutors said about May 2021. The US Attorney's office said UST had already dropped below 92 cents in May 2021. Kwon claimed the protocol had restored the peg on its own, and prosecutors called that a lie.⁵ They said he had agreed with a high-frequency trading firm to buy large amounts of UST to prop up the peg.⁵