How Terra, Tornado Cash and the Merge reshaped stablecoins

The short version: these events exposed different risks, not one shared stablecoin failure. Terra showed that an algorithmic peg can unravel; Tornado Cash raised questions about sanctions, address freezes and transaction censorship; the Ethereum Merge changed how Ethereum reaches consensus, not how stablecoins are backed.

The events unfolded in 2022:

1. TerraUSD (UST) lost its dollar peg and collapsed. Its design relied on a conversion relationship with LUNA rather than conventional reserves for every UST.
2. The US Treasury sanctioned Tornado Cash. The action triggered debate about privacy tools, compliance and the ability of issuers or infrastructure providers to restrict activity.
3. Ethereum completed the Merge. The network moved from proof of work to proof of stake. The change did not rewrite stablecoin balances or provide new backing for tokens.

For you, the practical lesson is to assess a stablecoin’s design and the service through which you use it separately. A token can trade near $1 but still carry issuer, reserve, redemption, contract, liquidity or censorship risks. The Merge did not make those risks disappear, and Terra’s collapse does not mean every stablecoin uses Terra’s mechanism.

TerraUSD, or UST, aimed to maintain a dollar value through an algorithmic relationship with LUNA. It was not a token backed one-for-one by cash or comparable assets held for redemption. When confidence in UST weakened, holders tried to exit. The system’s conversion mechanism put pressure on LUNA, and the falling value of LUNA further undermined confidence in UST. The result was a feedback loop rather than a reliable path back to one dollar.

That history is a warning against treating “stablecoin” as a guarantee. Ask how the peg is maintained and what happens when many holders want out at once. For a reserve-backed token, check what assets support it, who controls them and what redemption rights apply. For a crypto-collateralized token, look at collateral quality, liquidation rules and whether markets can absorb liquidations. For an algorithmic design, understand the stabilizing mechanism and whether it depends on another token retaining value.

A low-volatility chart is not enough. A token may trade close to its target for long periods, then lose the peg when liquidity, confidence or redemption access fails. Don’t assume a token is safe because it is widely used in DeFi.

Tornado Cash was a crypto mixing service that obscured the link between deposits and withdrawals. In 2022, US sanctions against the service brought a practical issue into focus: some stablecoin issuers can block particular addresses. Circle, issuer of USDC, blocked addresses associated with Tornado Cash after the sanctions. That did not change USDC’s dollar backing, but it showed that a token’s transferability can depend partly on decisions by its issuer.

There are several separate points of control. An issuer may freeze tokens at an address. A DeFi app’s website may restrict access even if its underlying smart contracts remain on a public blockchain. Validators or block builders may also face pressure to filter transactions. These are not identical actions, and an open protocol does not automatically remove restrictions at other layers.

Before using a stablecoin, check whether its issuer can freeze or blacklist addresses, and understand that this may affect your ability to transfer tokens. If you use a DeFi protocol, distinguish access to its interface from the operation of its contracts. Don’t assume that “decentralized” means every participant, token or route is free from control, legal obligations or operational limits.

The Merge moved Ethereum from proof of work to proof of stake in September 2022. It changed how blocks are proposed and validated, and ended Ethereum’s mining-based consensus. It did not alter the reserves or redemption promises behind USDC, USDT or other tokens. Nor did it automatically change the rules of DeFi applications already running on Ethereum.

The connection to stablecoins was mainly about infrastructure and governance. Many tokens and DeFi applications operate on Ethereum, so users asked whether validators might refuse certain transactions or comply with sanctions. The debate was about who can influence transaction inclusion, not whether stablecoins suddenly became more or less backed. A transaction that is delayed or censored could still matter to someone trying to swap, repay a loan or move collateral quickly.

Keep the risks distinct when you evaluate a token. Consensus risk concerns the network’s operation; issuer risk concerns backing, freezes and redemption; protocol risk concerns smart contracts and app rules. The Merge did not make Ethereum a stablecoin issuer and did not guarantee faster or cheaper transactions. Check current network fees and transaction conditions before acting, especially when a time-sensitive position could be liquidated.

Stablecoins are used in DeFi for swaps, lending, borrowing and liquidity pools. A token’s dollar target can make it easier to compare prices, but it does not remove the risks of the application that holds or routes it. If you supply a stablecoin to a lending market, you may face contract failure, changing rates, limited withdrawal liquidity or losses if the token depegs. If you borrow against collateral, a change in collateral value or the protocol’s risk parameters can lead to liquidation.

A swap through a DEX has different risks: thin liquidity, price impact, network fees, a faulty token contract or an approval that gives a contract permission to move tokens. A stablecoin can also trade below its target on one network or venue while remaining closer to the target elsewhere. That gap may reflect local liquidity or redemption access, not a simple bargain.

Before depositing or swapping, check the exact token and network. Similar tickers can refer to different assets, and bridged versions add bridge risk. Read the app’s rules for fees, withdrawals, collateral and liquidation. Don’t judge a DeFi position only by its advertised rate or the token’s recent price.

Use this checklist before you hold a stablecoin or put it into a protocol:

• Identify the exact asset. Confirm its full name, contract address and network in your wallet or app. Check that you are not selecting a lookalike token or an unwanted bridged version.
• Understand the peg. Is it backed by reserves, crypto collateral or an algorithm? What is meant to happen when demand falls or holders seek redemption?
• Check issuer powers and redemption. Find out who can freeze tokens, who is eligible to redeem, what fees or minimums apply, and whether redemption is available where you live. If the issuer does not publish a detail you need, don’t assume the most favourable answer.
• Inspect the DeFi terms. For lending, check collateral factors, liquidation thresholds, rates and withdrawal liquidity. For swaps, review the quote, slippage, fees and token approval.
• Plan for a depeg. Decide in advance how a loss of the peg would affect your savings, debt or collateral. Avoid relying on an immediate exit if liquidity is thin.

Start with an amount you can afford to lose, and keep funds needed for near-term expenses out of experimental protocols. A stablecoin label is not a substitute for due diligence.

Several common shortcuts turn a manageable risk into a costly one. Avoid these assumptions:

• “It’s at $1, so it is fully safe.” A market price does not prove the quality of reserves, redemption access or future liquidity.
• “It is used by a big protocol, so it cannot fail.” A protocol may accept an asset without guaranteeing its peg or covering losses if the token, market or contract fails.
• “The Merge fixed Ethereum fees or censorship.” The Merge changed consensus. It did not promise a particular fee level or remove every point of control over transactions.
• “A token with the same ticker is the same asset.” Check the network and contract. A wrapped or bridged token may rely on additional systems beyond the original issuer.
• “I can always withdraw.” A protocol may have limited liquidity, paused functions or conditions that prevent an immediate exit. A market may also become expensive to trade during stress.

Don’t borrow against a stablecoin position without checking what happens if the token depegs. A token used as collateral can lose value, and a loan may be liquidated even if you expected the asset to stay close to one dollar. Keep records of the asset, network, app and terms you chose.

In 2026, treat the three episodes as a risk map. Terra is a reminder to examine the mechanism behind a peg. Tornado Cash is a reminder that issuers, interfaces and transaction infrastructure can have different powers over access or transfers. The Merge is a reminder that a network upgrade and a stablecoin’s backing are separate things.

Before choosing a stablecoin for payments, savings or DeFi, answer three questions:

1. What supports its value, and how can you redeem it? If that answer is unclear, don’t treat it as cash.
2. Who can restrict or interrupt your use? Consider issuer controls, the app’s rules, the network and any bridge involved.
3. What happens if the peg or protocol fails? Consider how much you could lose, whether you owe a loan and whether you can exit under stress.

No stablecoin eliminates crypto market or operational risk. The right choice depends on what you need to do, your location, your tolerance for loss and the specific token and protocol terms. If you cannot explain how the peg works or what could prevent an exit, pause before committing funds.