TerraUSD stablecoin collapses and its sister token luna loses almost all its value

TerraUSD, an algorithmic stablecoin meant to hold a value of one dollar, has lost its peg and fallen far below that level this week. Luna, the token designed to absorb its volatility, has collapsed to a tiny fraction of its value from just days ago.

Unlike stablecoins backed by cash and short-term securities, TerraUSD relied on an arbitrage mechanism with luna. When the stablecoin traded below a dollar, users could swap it for newly created luna. In a crisis, that design led to a rapid increase in luna supply and a collapse in its price, which in turn further weakened confidence in the stablecoin.

Much of TerraUSD's demand came from Anchor, a lending protocol that offered yields of around 20 percent on deposits. As withdrawals accelerated, the system could not stabilise the peg, despite attempts to support it with bitcoin reserves.

The effects are spreading:

• Bitcoin and other major tokens have fallen sharply
• Other stablecoins have seen large redemptions
• Investors, many of them retail users, face heavy losses

Regulators have already pointed to the collapse in calls for stablecoin rules. US Treasury officials said it illustrates the risks of the sector. The episode is likely to shape future legislation, particularly on reserve requirements for stablecoins.