Death Spiral

What Is a Death Spiral?

A death spiral is a catastrophic failure mode specific to algorithmic stablecoins where a price decline triggers a self-reinforcing feedback loop that accelerates the collapse until the stablecoin loses its peg entirely. Unlike a gradual decline that might allow intervention, death spirals operate with a velocity that overwhelms any stabilization mechanism, often completing in hours or days.

The term borrows from aviation, where a "graveyard spiral" describes an aircraft entering an ever-tightening descending turn that, without pilot intervention, inevitably results in a crash. Similarly, a stablecoin death spiral involves the system's own stabilization mechanisms working against it, making recovery progressively more difficult as the situation worsens.

Death spirals emerge from the fundamental design tension in algorithmic stablecoins: the mechanism that maintains the peg during normal conditions can become destructive during stress. When confidence breaks, the same mint-and-burn arbitrage that enforces peg stability transforms into a weapon that destroys it, flooding the market with newly minted tokens while draining any backing value.

The phenomenon is also called a "reflexive depeg" because the act of trying to exit the stablecoin reflexively causes the conditions that make exit more urgent. Each rational actor seeking to preserve their value contributes to the collective destruction of everyone's holdings, a tragic commons dynamic that game theory would predict but that still catches participants off guard.

Mechanics of Collapse

Understanding death spiral mechanics requires examining how algorithmic stablecoins typically work and how that design inverts under stress.

Normal Peg Maintenance

Most algorithmic stablecoins use a two-token model: the stablecoin itself and a volatile "share" or "governance" token that absorbs price fluctuations. When the stablecoin trades above $1.00, users can mint new stablecoins by burning share tokens, profiting from the spread. This increases supply and pushes the price down toward peg.

When the stablecoin trades below $1.00, users can burn stablecoins to mint share tokens, reducing supply and theoretically pushing the price back up. The share token's value derives from this arbitrage opportunity and expectations of future protocol growth.

The Spiral Trigger

The death spiral begins when confidence in the share token collapses. Perhaps a large holder sells, external market conditions deteriorate, or a vulnerability is discovered. Whatever the catalyst, once the share token's price enters freefall, the redemption math breaks catastrophically.

Consider a stablecoin at $0.95 with a share token worth $10. A user burning 1 stablecoin might receive 0.05 share tokens (representing the $0.05 arbitrage profit). This is manageable. Now imagine the share token crashes to $0.10. Burning 1 stablecoin must yield 5 share tokens to maintain the same dollar value, increasing share token supply 100x faster.

The Acceleration Phase

As more share tokens are minted to cover redemptions, their price falls further, requiring even more tokens per redemption. This creates exponential supply growth:

• Stage 1: Initial depeg triggers normal arbitrage redemptions
• Stage 2: Heavy redemptions flood market with share tokens, crashing their price
• Stage 3: Lower share token price requires more tokens per redemption, accelerating supply growth
• Stage 4: Hyperinflation of share token destroys any remaining value, making redemptions worthless
• Stage 5: Stablecoin approaches zero as backing mechanism collapses entirely

The speed of this process often surprises observers. What appears as a manageable 5% depeg can accelerate to 95% loss within 48-72 hours as the spiral dynamics compound.

Terra/UST: The Definitive Case Study

The May 2022 collapse of Terra's UST stablecoin remains the most significant death spiral in cryptocurrency history, erasing approximately $40 billion in combined UST and LUNA market capitalization in under a week. The event reshaped industry thinking about algorithmic stability.

Pre-Collapse Conditions

UST had grown to become the third-largest stablecoin by market cap, backed by the LUNA token through Terra's mint-and-burn mechanism. The Anchor Protocol offered 19.5% yields on UST deposits, attracting massive capital inflows. At peak, over $14 billion UST existed, supported by LUNA trading near $80.

Warning signs included the unsustainable Anchor yields (subsidized from reserves that were depleting), concentration of UST in Anchor rather than diverse use cases, and the lack of exogenous collateral backing the peg. Critics had long warned about reflexivity risks, but high yields attracted users despite the concerns.

The Collapse Sequence

On May 7, 2022, large UST withdrawals from Anchor coincided with significant sells on Curve pools, pushing UST briefly to $0.985. The Luna Foundation Guard (LFG) began deploying Bitcoin reserves to defend the peg, but this signaled vulnerability rather than strength.

By May 9, UST had fallen to $0.75. LUNA's price dropped from $80 to $30 as redemptions minted billions of new tokens. On May 10, UST touched $0.23 while LUNA crashed below $1. The spiral had entered its terminal phase.

The final stages saw LUNA supply explode from 350 million to 6.5 trillion tokens as the protocol desperately tried to absorb redemptions. By May 13, UST traded below $0.10 and LUNA below $0.0001. The mechanism had hyperinflated LUNA into worthlessness while failing to restore UST's peg.

Aftermath

The Terra collapse triggered broader market contagion, contributing to the insolvency of Three Arrows Capital, Celsius, Voyager, and other interconnected entities. Regulatory scrutiny of stablecoins intensified globally. Do Kwon, Terra's founder, faced criminal charges in multiple jurisdictions.

Warning Signs and Risk Factors

Post-mortems of death spirals reveal common patterns that can serve as early warning indicators:

Structural Vulnerabilities

• Pure algorithmic design: No exogenous collateral backing means nothing stops the spiral once it starts
• Yield subsidies: Unsustainable returns often mask underlying fragility and attract hot money that flees at first sign of trouble
• Concentrated holdings: When large holders control significant supply, their exit can single-handedly trigger cascades
• Single use case dependency: If most stablecoin supply sits in one protocol or venue, that becomes a systemic chokepoint

Market Signals

• Persistent minor depegs: Frequent dips below $0.99 suggest weakening confidence in stabilization mechanisms
• Share token volatility: Excessive volatility in the backing token indicates market uncertainty about sustainability
• Reserve depletion: Declining reserves or emergency reserve deployments signal approaching stress limits
• Liquidity withdrawal: Large holders exiting or reducing exposure often precedes broader confidence collapse

Prevention Mechanisms in Modern Designs

Post-Terra stablecoin designs incorporate various mechanisms intended to prevent or slow death spirals, though none have proven completely effective against severe confidence loss.

Collateral Floors

Hybrid collateral models maintain partial or full reserve backing. Even if algorithmic components fail, the collateral provides a floor value. Protocols like Frax moved toward 100% collateralization after Terra's collapse demonstrated the risks of under-collateralization.

Redemption Circuit Breakers

Some protocols implement rate limits on redemptions during stress periods. While controversial (they prevent users from exiting), circuit breakers can slow spirals enough for governance intervention or market stabilization. The trade-off is reduced user confidence from knowing exits can be restricted.

Over-Collateralization

Crypto-collateralized stablecoins like DAI require depositors to lock more value than they borrow (typically 150%+). This buffer absorbs price declines before the stablecoin itself is affected, though it creates capital inefficiency.

Diversified Backing

Rather than relying on a single volatile token, modern designs use diversified collateral including other stablecoins, real-world assets, and yield-bearing positions. This reduces single-point-of-failure risk, though introduces complexity and additional dependencies.

Lessons for Stablecoin Design

The death spiral phenomenon has fundamentally shaped contemporary thinking about stablecoin architecture:

Exogenous value matters. Stablecoins backed only by endogenous tokens (those created by the same protocol) face inherent reflexivity risks. External collateral, whether fiat, Bitcoin, or other assets, provides a non-circular source of value that can anchor the peg during stress.

Yields are not free. High yields on stablecoin deposits must come from somewhere. Sustainable yields from lending and DeFi activities are modest (2-8% APY). Double-digit yields typically indicate subsidies that will eventually deplete, creating withdrawal pressure precisely when the protocol is least able to handle it.

Confidence is the ultimate collateral. Even well-designed mechanisms can fail if users lose confidence. This creates a paradox: protocols must design for worst-case scenarios while hoping those scenarios never occur. The act of preparing for bank runs can itself undermine confidence.

Fully-reserved models have won. The market has largely migrated toward fully collateralized stablecoins like USDC, USDT, and increasingly Bitcoin-native options like USDB. While less capital efficient, these designs avoid the reflexivity that enables death spirals. Regulatory frameworks like MiCA's EMT requirements codify this preference for full backing.

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