Algorithmic Stablecoins and the TerraUSD Crash
link to page 2 
INSIGHTi
Algorithmic Stablecoins and the TerraUSD
Crash
May 16, 2022
What Are Algorithmic Stablecoins?
Stablecoins are a type of cryptocurrency that aim to maintain a stable value. There are several classes of
stablecoins that each use different methods to try to achieve this, one of which is algorithmic stablecoins.
While no precise definition captures all of their features, algorithmic stablecoins typically use an
algorithm or smart contract to manage the supply of tokens and guide their value to some reference asset
(for example a fiat currency, such as the U.S. dollar). Algorithmic stablecoins generally do not attempt to
achieve value by holding a reserve of fiat-denominated assets with a value in a 1:1 relationship with the
value of the stablecoin. Instead, algorithmic stablecoins use different mechanisms to control the supply or
value of the stablecoin, including the minting or burning of coins, rebasing, and arbitrage.
What Happened with TerraUSD?
TerraUSD (UST) stablecoin uses an arbitrage mechanism typical of some algorithmic stablecoin
arrangements consisting of two coins or tokens: the stablecoin, in this case UST, meant to maintain a
stable value or “peg,” and a balancer token, in this case, LUNA, the value of which can fluctuate. An
algorithm manages the relationship between these two coins to attempt keeping the stablecoin pegged to
the reference. If strong demand pushed the price of UST above its peg, arbitrageurs could buy $1 worth of
LUNA, trade it for 1 UST (worth more than $1) and sell UST for a gain. If UST falls below $1, someone
can buy $0.99 worth of UST and trade it for $1 worth of LUNA. In both instances arbitrageurs net a profit
and ostensibly maintain the peg.
Over the past week, UST lost its peg to the dollar (Figure 1), and both UST and balancer coin LUNA
were dropped from various cryptocurrency exchanges. UST hit a low of $0.12 at 9 a.m. on May 16, 2022.
Congressional Research Service
https://crsreports.congress.gov
IN11928
CRS INSIGHT
Prepared for Members and
Committees of Congress
link to page 3
Congressional Research Service
2
Figure 1. TerraUSD (UST)
U.S. Dollar Value of UST as of May 16, 2022, at 9 a.m.
Source: CoinMarketCap.
There are two other factors relevant to this incident. First, Terraform Labs, the UST stablecoin manager,
established Anchor, a decentralized lending protocol in which UST holders could park their UST for a
reported 20% annual percentage yield. This protocol attracted demand for UST because of high yields.
However, Anchor experienced sizeable UST withdrawals late last week foreshadowing the depegging.
Also, in early 2022, Terraform Labs began purchasing bitcoin to hold in the Luna Foundation Guard
(LFG) in response to some concerns about the peg. The LFG could sell bitcoin to prop up the stablecoin
and defend the peg, which it claims to have done during the selloff but about which there is some
skepticism.
Policy Issues Relating to the “Run” Risk
UST had a market capitalization of more than $18 billion in early May. Some observers voiced financial
stability concerns because of UST’s contagion effects on other crypto assets and the crypto ecosystem’s
interconnectedness with the traditional financial system. The sudden drop in UST’s prices reflects a
classic “run-like” scenario, where a large number of investors withdraw their investments simultaneously,
triggering negative feedback loops and contagion effects.
Some argue that stablecoins could be subject to runs if coin holders have suspicions about the reserve
assets backing the par value. The run-like behaviors already occurred for algorithmic stablecoins during
relatively calm market conditions. In contrast, vulnerabilities like this are generally expected to possibly
cascade and become more influential during broader market distress.
The UST event is not the first time an algorithmic stablecoin displayed run-like behavior. The Iron
Titanium (TITAN) token faced a run-like scenario in June 2021 and saw its price crash to near zero within
one day. Similar to how UST functions with LUNA, the algorithmic stablecoin Iron is partially supported
by TITAN. Because Iron is structured using TITAN and USD Coin, when TITAN’s price collapsed, Iron
was trading off the peg by more than a quarter (Figure 2).
Congressional Research Service
3
Figure 2. IRON Stablecoin and TITAN Price
U.S. Dollars, 2021
Source: International Monetary Fund, Global Financial Stability Report.
Many observers consider the stablecoin industry as not adequately regulated. While in the traditional
financial system, a run-like scenario could be somewhat mitigated by regulatory safeguards and
backstops, the stablecoin industry has not incorporated such measures. For example, in the traditional
financial system, bank deposit insurance and liquidity facilities could reduce market participants’
incentives to have a run. For more background, see CRS products on Stablecoins: Background and Policy
Issues and How Stable Are Stablecoins?
Policy Proposals
Recent legislative proposals have considered what entities should be allowed to issue stablecoins, the
reserves needed to back a stablecoin, and the disclosures that stablecoin issuers should have to make
available. Committees in both the Senate and House have held hearings on stablecoins where the reserves
backing these digital assets were a central issue.
With respect to reserve disclosure and composition, there have been a few recent legislative proposals. In
March 2022, Representative Hollingsworth introduced H.R. 7328, which would establish auditor-verified
reporting requirements for stablecoin issuers and restrict the assets that could back a stablecoin. Senator
Hagerty introduced a Senate version of the bill, S. 3970, in May 2022. There have also been some
discussion drafts in the House and Senate. These discussion bills provide a possible framework for
stablecoin issuers. For example, while these drafts differ in their approach, they would establish
institutions eligible to issue stablecoins, create disclosure requirements for the assets backing stablecoin,
provide standards for the composition of those reserves, and consider avenues for financial backstops for
stablecoins.
Regulators have also taken measures to address the risks associated with stablecoins. For example, in
addition to the President’s Working Group report on stablecoins, the banking regulators have jointly
participated in “policy sprints” focused on crypto assets, including stablecoins. Additionally, last year, the
Basel Committee on Banking Supervision released a consultative document on prudential treatment of
crypto exposures for public comment, and they are expected to finalize their consultative framework this
year. The Treasury Department is reportedly working on a report on TerraUSD.
Congressional Research Service
4
Author Information
Paul Tierno
Eva Su
Analyst in Financial Economics
Analyst in Financial Economics
Andrew P. Scott
Analyst in Financial Economics
Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff
to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of
Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of
information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role.
CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United
States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However,
as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the
permission of the copyright holder if you wish to copy or otherwise use copyrighted material.
IN11928 · VERSION 1 · NEW
INSIGHTi
Algorithmic Stablecoins and the TerraUSD
Crash
May 16, 2022
What Are Algorithmic Stablecoins?
Stablecoins are a type of cryptocurrency that aim to maintain a stable value. There are several classes of
stablecoins that each use different methods to try to achieve this, one of which is algorithmic stablecoins.
While no precise definition captures all of their features, algorithmic stablecoins typically use an
algorithm or smart contract to manage the supply of tokens and guide their value to some reference asset
(for example a fiat currency, such as the U.S. dollar). Algorithmic stablecoins generally do not attempt to
achieve value by holding a reserve of fiat-denominated assets with a value in a 1:1 relationship with the
value of the stablecoin. Instead, algorithmic stablecoins use different mechanisms to control the supply or
value of the stablecoin, including the minting or burning of coins, rebasing, and arbitrage.
What Happened with TerraUSD?
TerraUSD (UST) stablecoin uses an arbitrage mechanism typical of some algorithmic stablecoin
arrangements consisting of two coins or tokens: the stablecoin, in this case UST, meant to maintain a
stable value or “peg,” and a balancer token, in this case, LUNA, the value of which can fluctuate. An
algorithm manages the relationship between these two coins to attempt keeping the stablecoin pegged to
the reference. If strong demand pushed the price of UST above its peg, arbitrageurs could buy $1 worth of
LUNA, trade it for 1 UST (worth more than $1) and sell UST for a gain. If UST falls below $1, someone
can buy $0.99 worth of UST and trade it for $1 worth of LUNA. In both instances arbitrageurs net a profit
and ostensibly maintain the peg.
Over the past week, UST lost its peg to the dollar (Figure 1), and both UST and balancer coin LUNA
were dropped from various cryptocurrency exchanges. UST hit a low of $0.12 at 9 a.m. on May 16, 2022.
Congressional Research Service
https://crsreports.congress.gov
IN11928
CRS INSIGHT
Prepared for Members and
Committees of Congress
link to page 3
Congressional Research Service
2
Figure 1. TerraUSD (UST)
U.S. Dollar Value of UST as of May 16, 2022, at 9 a.m.
Source: CoinMarketCap.
There are two other factors relevant to this incident. First, Terraform Labs, the UST stablecoin manager,
established Anchor, a decentralized lending protocol in which UST holders could park their UST for a
reported 20% annual percentage yield. This protocol attracted demand for UST because of high yields.
However, Anchor experienced sizeable UST withdrawals late last week foreshadowing the depegging.
Also, in early 2022, Terraform Labs began purchasing bitcoin to hold in the Luna Foundation Guard
(LFG) in response to some concerns about the peg. The LFG could sell bitcoin to prop up the stablecoin
and defend the peg, which it claims to have done during the selloff but about which there is some
skepticism.
Policy Issues Relating to the “Run” Risk
UST had a market capitalization of more than $18 billion in early May. Some observers voiced financial
stability concerns because of UST’s contagion effects on other crypto assets and the crypto ecosystem’s
interconnectedness with the traditional financial system. The sudden drop in UST’s prices reflects a
classic “run-like” scenario, where a large number of investors withdraw their investments simultaneously,
triggering negative feedback loops and contagion effects.
Some argue that stablecoins could be subject to runs if coin holders have suspicions about the reserve
assets backing the par value. The run-like behaviors already occurred for algorithmic stablecoins during
relatively calm market conditions. In contrast, vulnerabilities like this are generally expected to possibly
cascade and become more influential during broader market distress.
The UST event is not the first time an algorithmic stablecoin displayed run-like behavior. The Iron
Titanium (TITAN) token faced a run-like scenario in June 2021 and saw its price crash to near zero within
one day. Similar to how UST functions with LUNA, the algorithmic stablecoin Iron is partially supported
by TITAN. Because Iron is structured using TITAN and USD Coin, when TITAN’s price collapsed, Iron
was trading off the peg by more than a quarter (Figure 2).
Congressional Research Service
3
Figure 2. IRON Stablecoin and TITAN Price
U.S. Dollars, 2021
Source: International Monetary Fund, Global Financial Stability Report.
Many observers consider the stablecoin industry as not adequately regulated. While in the traditional
financial system, a run-like scenario could be somewhat mitigated by regulatory safeguards and
backstops, the stablecoin industry has not incorporated such measures. For example, in the traditional
financial system, bank deposit insurance and liquidity facilities could reduce market participants’
incentives to have a run. For more background, see CRS products on Stablecoins: Background and Policy
Issues and How Stable Are Stablecoins?
Policy Proposals
Recent legislative proposals have considered what entities should be allowed to issue stablecoins, the
reserves needed to back a stablecoin, and the disclosures that stablecoin issuers should have to make
available. Committees in both the Senate and House have held hearings on stablecoins where the reserves
backing these digital assets were a central issue.
With respect to reserve disclosure and composition, there have been a few recent legislative proposals. In
March 2022, Representative Hollingsworth introduced H.R. 7328, which would establish auditor-verified
reporting requirements for stablecoin issuers and restrict the assets that could back a stablecoin. Senator
Hagerty introduced a Senate version of the bill, S. 3970, in May 2022. There have also been some
discussion drafts in the House and Senate. These discussion bills provide a possible framework for
stablecoin issuers. For example, while these drafts differ in their approach, they would establish
institutions eligible to issue stablecoins, create disclosure requirements for the assets backing stablecoin,
provide standards for the composition of those reserves, and consider avenues for financial backstops for
stablecoins.
Regulators have also taken measures to address the risks associated with stablecoins. For example, in
addition to the President’s Working Group report on stablecoins, the banking regulators have jointly
participated in “policy sprints” focused on crypto assets, including stablecoins. Additionally, last year, the
Basel Committee on Banking Supervision released a consultative document on prudential treatment of
crypto exposures for public comment, and they are expected to finalize their consultative framework this
year. The Treasury Department is reportedly working on a report on TerraUSD.
Congressional Research Service
4
Author Information
Paul Tierno
Eva Su
Analyst in Financial Economics
Analyst in Financial Economics
Andrew P. Scott
Analyst in Financial Economics
Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff
to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of
Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of
information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role.
CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United
States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However,
as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the
permission of the copyright holder if you wish to copy or otherwise use copyrighted material.
IN11928 · VERSION 1 · NEW