The Legal and Market Risks of Algorithmic Stablecoins and Large Market Makers

The rise of algorithmic stablecoins has introduced a new layer of complexity to global financial systems, blending innovation with systemic vulnerabilities. These stablecoins, which rely on algorithmic mechanisms rather than traditional collateral to maintain price stability, have drawn intense regulatory scrutiny due to their fragility and potential to amplify market stress. As jurisdictions grapple with balancing innovation and stability, the interplay between algorithmic stablecoins and large market makers has emerged as a

critical focal point for investors and policymakers alike.

Regulatory Scrutiny and the Fragility of Algorithmic Models

Algorithmic stablecoins, such as the now-defunct TerraUSD (UST), have been repeatedly exposed as inherently unstable constructs. Unlike fiat- or crypto-collateralized stablecoins, which maintain reserves to back their value, algorithmic models depend on confidence and algorithmic rebalancing of token supply to sustain a peg to the U.S. dollar. This design proved catastrophic during the 2022 Terra-Luna collapse, where a loss of confidence triggered a "death spiral" that erased $40 billion in value within days.

Regulators have responded with increasingly stringent frameworks. According to the EU's MiCA regulation, enacted in 2025, stablecoins must be fully backed by high-quality liquid assets and subjected to third-party audits. Similarly, the U.S. GENIUS Act, passed in 2025, imposes reserve requirements, par redemption rights, and transparency obligations on stablecoin issuers. These measures aim to mitigate the risks of algorithmic models, which lack the liquidity and transparency of their collateralized counterparts. However, regulatory fragmentation persists, with some jurisdictions lagging in implementation, creating fertile ground for regulatory arbitrage and unregulated stablecoin activity.

Market Makers and Systemic Risk Amplification

Large market makers play a dual role in crypto ecosystems: they provide liquidity but also contribute to systemic risk during periods of stress. During the October 2025 crypto crash, for instance, market makers exacerbated volatility by withdrawing liquidity as algorithmic stablecoins like USDe de-pegged. Institutional investors, who typically act as liquidity providers by purchasing stablecoins at par and redeeming them at $1, retreated due to capital constraints and eroding confidence in issuers' ability to honor redemptions. This liquidity void allowed stablecoin prices to plummet below $1, triggering cascading liquidations and a $19 billion collapse in the broader market.

The October 2025 crisis also highlighted infrastructure vulnerabilities. Oracle failures-systems that propagate price data across decentralized finance (DeFi) platforms-triggered false liquidations on exchanges with no inherent selling pressure. Market makers, unable to step in during critical moments, left a vacuum that amplified the crisis. This interplay between algorithmic failures, oracle inaccuracies, and liquidity withdrawal underscores how market makers can act as both stabilizers and accelerants of systemic risk.

Case Study: The Terra-Luna Collapse and Its Aftermath

The 2022 Terra-Luna collapse remains a seminal case study in algorithmic stablecoin fragility. UST's dual-token model, which relied on LUNA to rebalance supply and demand, collapsed when a liquidity shock triggered a self-reinforcing de-peg. Market makers and automated trading algorithms, which depend on stablecoins for hedging and liquidity provision, accelerated the crisis by initiating panic exits and automated selling. The event not only destabilized the Terra ecosystem but also exposed broader vulnerabilities in DeFi, including leverage, governance, and market microstructure. According to a ScienceDirect analysis, these failures highlight systemic risks in decentralized finance.

Regulators have since used the Terra-Luna crisis to justify stricter oversight. The Bank for International Settlements has emphasized that stablecoins, while promising for tokenization, fail to meet the "three key tests of a viable monetary system"-singleness, elasticity, and integrity-when compared to central bank reserves. This critique underscores the need for systemic safeguards, particularly as stablecoins increasingly underpin cross-border payments and institutional finance.

Implications for Investors and the Path Forward

For investors, the risks of algorithmic stablecoins are twofold: legal uncertainty and market instability. Regulatory actions like MiCA and the GENIUS Act signal a shift toward full collateralization and transparency, but enforcement gaps remain. Meanwhile, the October 2025 crash demonstrates how market makers' liquidity strategies can exacerbate crises, turning isolated failures into systemic events.

The path forward requires a delicate balance. While innovation in stablecoin design-such as hybrid models combining algorithmic mechanisms with partial collateralization-offers potential solutions, regulators must ensure global coordination to prevent arbitrage. Investors, in turn, must remain vigilant, prioritizing stablecoins with transparent reserves and robust governance. As the crypto market evolves, the lessons from Terra-Luna and October 2025 will likely shape a more resilient, but heavily regulated, financial landscape.