In the second week of May 2022, the Terra ecosystem collapsed. UST, an algorithmic stablecoin that was supposed to maintain a value of one US dollar, broke its peg and fell rapidly. Luna, the associated governance token whose mechanics were supposed to support the stablecoin, lost nearly all of its value over a few days. Approximately $60 billion of market value was wiped out. The shockwaves would roll through the cryptocurrency industry for the rest of the year and into 2023.
What had happened mechanically was a death spiral. UST maintained its peg through a process where users could exchange one UST for one dollar of Luna at any time, and vice versa. When confidence in UST fell and large holders started redeeming, Luna was minted to absorb the redemptions, increasing Luna supply rapidly. The increase in Luna supply put downward pressure on Luna’s price. The downward pressure on Luna’s price made the system look less safe, which triggered more redemptions, which produced more Luna. The cycle accelerated to the point of practical worthlessness within days.
Algorithmic stablecoins had been criticised by skeptics for years on essentially these grounds. The mechanism worked while confidence was high. It would not work under stress. The Terra collapse was the most public example to that point of the criticism being correct.
The broader effect was the start of what came to be called crypto winter. Several lending and trading firms that had taken significant exposure to Terra collapsed in the weeks and months that followed. Three Arrows Capital, Celsius, Voyager, and eventually FTX all failed during the period that started with Terra and continued through 2022. The interconnections between major participants in the cryptocurrency industry meant that the failures cascaded in ways that were not always visible until they had already happened.
The failures changed the regulatory conversation in significant ways. The argument that cryptocurrency was a sophisticated, technologically advanced financial system that did not need traditional financial regulation became much harder to make after the Terra collapse and the failures that followed. Regulatory pressure from multiple jurisdictions accelerated.
What survived the period was a smaller, more sober industry. The speculation was substantially reduced. The serious building work continued, often without much attention. The lessons of Terra would be referenced repeatedly in the design of subsequent stablecoins and the regulatory frameworks that began to emerge around them.