The End of Algorithmic Stablecoins: Lessons from Terra and FTX

Algorithmic stablecoins-digital assets designed to maintain price stability through algorithmic mechanisms rather than traditional collateral-have faced existential scrutiny since the collapses of Terra's UST and FTX's stablecoin. These failures exposed structural vulnerabilities and regulatory blind spots, raising the question: Are algorithmic stablecoins a flawed experiment or a cautionary tale for the broader crypto ecosystem?

The Fragile Illusion of Stability

Algorithmic stablecoins rely on market confidence and algorithmic governance to maintain their peg to fiat currencies. Terra's UST, for instance, operated on a two-token system: UST (a stablecoin) and Luna (a volatile token). When UST's price deviated from $1, users could arbitrage by burning UST to mint Luna (or vice versa), theoretically stabilizing the peg. However, this design proved catastrophic during liquidity shocks. A single large sell order in May 2022 triggered a death spiral, as the algorithm failed to absorb the sudden loss of confidence, leading to a $40 billion collapse according to a 2025 study.

FTX's stablecoin, FTX USD, faced a similar fate. The token was backed by FTX's native FTT token, which had no intrinsic value and was manipulated to inflate FTX's balance sheet. When FTX's financial mismanagement became public, the stablecoin lost its peg, accelerating the exchange's collapse. These cases highlight a critical flaw: algorithmic stablecoins are not inherently stable. Their value depends on continuous liquidity and trust-a fragile foundation in times of crisis.

Structural Design: A House of Cards

Post-crisis analyses reveal systemic risks embedded in algorithmic stablecoin design. A 2025 systematization of knowledge (SoK) study of 157 academic papers and 95 stablecoins concluded that stability is an emergent and fragile state, not an inherent property according to research. The study emphasized that stablecoins often involve trade-offs in risk specialization, such as yield mechanisms that transform them into complex financial instruments rather than simple payment tools. For example, UST's reliance on Luna's burn-and-mint mechanism created a self-reinforcing loop that collapsed under stress.

Experts like Zoey Wen and Kani Chen introduced the Stablecoin Architecture & Resilience Matrix (SARM), a framework to evaluate stablecoin credibility according to a 2025 paper. Key metrics include:
- Collateral Quality: Traditional stablecoins (e.g., Tether) use fiat or sovereign bonds, while algorithmic models rely on volatile tokens.
- Peg Resilience Coefficient (PRC): Measures a stablecoin's ability to maintain its peg during liquidity shocks.
- Governance Attack Surface (GAS): Assesses risks from centralized control or governance flaws.

UST and FTX USD scored poorly on these metrics, underscoring their susceptibility to collapse.

Regulatory Gaps and the Path Forward

The Terra and FTX collapses exposed glaring regulatory gaps. U.S. regulators have since moved to classify stablecoins as investment contracts under securities law, applying stricter oversight to models resembling algorithmic stablecoins. South Korea and other jurisdictions are adopting similar frameworks, emphasizing competence-based accreditation over wealth-based criteria to protect investors according to research.

However, regulation alone is insufficient. The SoK study argues for technological design reforms, such as hybrid models that combine algorithmic mechanisms with over-collateralization according to a 2025 study. For instance, Tether's price stability is influenced by Bitcoin liquidity and market confidence according to research, suggesting that even fiat-collateralized stablecoins face systemic risks during macroeconomic turbulence.

The Death of an Era?

The SARM framework and post-crisis analyses suggest algorithmic stablecoins are unlikely to regain mainstream trust without radical redesigns. Their reliance on market confidence-a factor beyond algorithmic control-makes them inherently unstable. As Cho-Hoi Hui's 2025 economic analysis notes, stablecoins act as safe-haven assets during crises but fail when liquidity dries up according to research.

Regulators and developers must prioritize transparency, collateral diversification, and decentralized governance to rebuild trust. Yet, the lessons from Terra and FTX are clear: algorithmic stablecoins, as currently designed, are a high-risk, high-reward experiment that may have reached its end.