DeFi Stablecoins After Terra, Tornado Cash and the Ethereum Merge

The phrase DeFi stablecoin covers several different things: tokens issued by companies against cash and short-term assets, tokens minted by smart contracts against crypto collateral, and older designs that tried to hold a peg with code and incentives alone. Since 2022, the debate has centred on which of these models can keep a peg when markets fall fast and which ones depend on confidence that can disappear overnight.

Three events shaped that debate. The collapse of Terra's UST in May 2022 showed how an algorithmic peg can unravel. The sanctions on the Tornado Cash privacy tool in August 2022 raised legal and compliance questions for anyone who touches on-chain privacy and smart contracts. The Ethereum Merge, which finished in September 2022, changed the base layer that much of DeFi runs on and altered the economics of ETH-based collateral.

This guide explains each event, what it meant for stablecoins and lending markets, and how the picture looks in 2026 based on the sources available. It is an explainer, not a recommendation. Protocol names are given as examples of designs readers can study, not as endorsements.

A useful way to read the rest of the guide is to ask one question about every stablecoin you meet: what, specifically, is holding the peg, and what happens to that thing in a crisis?

Most stablecoins in use today fall into a few broad groups.

• Fiat-backed tokens aim to hold reserves in cash and short-dated government debt. Their stability depends on the issuer's reserves, its redemption rules and its legal and banking relationships.
• Overcollateralized crypto-backed tokens are minted by smart contracts when users lock more value in collateral than they borrow. Stability depends on collateral quality, liquidation speed, oracle accuracy and the protocol's risk settings.
• Algorithmic tokens try to hold a peg mainly through supply changes and a second token that absorbs price swings. Stability depends on demand for that second token, which can vanish quickly.

Design	Main anchor	Main failure risk
Fiat-backed	Reserves and redemption	Reserve quality, banking access, issuer action
Overcollateralized	Collateral and liquidations	Sharp collateral drops, oracle errors, thin liquidity
Algorithmic	Supply rules and a sister token	Loss of confidence in the sister token

The algorithmic group drew the most attention after 2022, but the other two groups also have real risks. Reading a stablecoin's design in these terms is the fastest way to see what it can and cannot promise.

Terra's UST was designed to hold one dollar through a mint and burn relationship with LUNA. When UST traded below one dollar, holders could burn it for LUNA worth one dollar, which reduced supply and in theory pushed the price back up. This worked while demand for UST and LUNA stayed high. It stopped working when holders lost confidence and rushed to exit.

In May 2022, UST lost its peg and LUNA fell sharply as the minting loop turned into a spiral. Cryptocurrencies that underpinned several DeFi protocols dropped at the same time, because many of them held or used UST and related assets as collateral or liquidity. Losses spread through lending markets, liquidity pools and the funds that had lent into them.

The Terraform Labs team faced later legal action. The US Securities and Exchange Commission sued Terraform Labs and cofounder Do Kwon in February 2023, alleging the unregistered sale of securities to retail investors. Readers who want the current legal status should check recent court and regulatory records, because outcomes can change after any article is written.

For DeFi users, the durable lesson is about design rather than one team. A stablecoin whose peg depends mainly on a second, more volatile token needs a source of demand that can survive a panic. When that demand disappears, the peg has no reliable backstop.

Tornado Cash was a non-custodial mixing tool on Ethereum that obscured the link between deposit and withdrawal addresses. In August 2022, the US Treasury's Office of Foreign Assets Control added the tool's smart contract addresses to its sanctions list. That action made it risky for US persons to transact with those addresses and pushed many developers, node operators and DeFi frontends to review what they touched on-chain.

The sanctions raised questions that still matter for stablecoins. Stablecoin issuers and some DeFi front ends began to freeze or block certain addresses. Compliance teams at exchanges and lending platforms looked harder at wallets with links to sanctioned contracts. Some protocols began to add address screening, while others argued that immutable smart contracts should not be treated the same way as companies.

Legal developments followed. Court cases challenged the sanctions and the liability of developers, and the sanctions were later lifted in 2025 according to public reporting. Because this area changes quickly, readers should verify current status with official sources and legal counsel before making any decision about privacy tools or the addresses they use.

For a reader using stablecoins, the practical point is simple. Tokens that can be frozen by an issuer, and protocols that screen addresses, have a different risk profile from fully permissionless designs. Both features can matter for your access and your legal exposure, depending on where you live and what you do.

The Ethereum Merge completed in September 2022. It replaced proof of work, in which miners competed with computing power, with proof of stake, in which validators lock ETH to secure the network. The change reduced the network's energy use and altered how ETH is issued, which in turn changed the economics of the assets that rely on ETH.

Before the Merge, the network had been tested on the Goerli testnet, and that run gave developers and users a preview of the transition. The mainnet transition itself did not change the design of any specific stablecoin. What it did change was the background on which DeFi protocols operate: validator rewards, staking flows and the value of ETH-denominated collateral.

For stablecoins that accept ETH or staked ETH as collateral, the shift made the risk of ETH price moves and liquid staking token prices more central. A stablecoin backed by ETH is only as safe as its collateral ratio, liquidation process and the liquidity available when prices fall.

Readers should not treat the Merge as a security upgrade for stablecoins. It is a base-layer change that affects the environment in which every Ethereum-based stablecoin operates. Judge each stablecoin by its own collateral, rules and liquidity, not by the fact that its underlying chain changed consensus.

After the Merge, many DeFi lending and borrowing markets began to accept liquid staking tokens as collateral. These tokens represent staked ETH while letting holders keep using it in other protocols. Lido's stETH and Rocket Pool's rETH are well-known examples of this model, and both have become common inputs for lending markets and stablecoin designs.

Liquid staking tokens carry their own risks. In June 2022, during the broader market stress, stETH traded at a meaningful discount to ETH on some venues. That discount mattered because lending and liquidation systems often assume that the collateral token can be sold close to its underlying value. When the market price falls below that assumption, liquidations can fail or lose money.

This matters for stablecoin pegs because a stablecoin backed by a liquid staking token inherits its liquidity risk. A protocol can have sound rules on paper and still struggle if the collateral cannot be sold quickly at a fair price during a panic.

When you assess a liquid staking token, look at how it is redeemed or sold, how deep the liquidity is on major venues, what the protocol says about slashing and withdrawal delays and how the token is used as collateral across lending markets. Those details decide how the token behaves in stress, not its yield alone.

Several protocols that are active today show how the lessons from 2022 have been applied in different ways.

• Curve is a decentralized exchange built for low-slippage trades between stablecoins and similar assets, and it also has its own crvUSD stablecoin. Stableswap pools are central to how many DeFi stablecoins find liquidity.
• Sky, the rebranded MakerDAO, issues the USDS and DAI stablecoins through overcollateralized vaults and is governed by SKY token holders. Its design has changed over time as it added more collateral types and reserve assets.
• Liquity V2 is an Ethereum borrowing protocol where users set their own interest rate and mint the BOLD stablecoin against accepted collateral such as ETH, wstETH or rETH.
• Frankencoin is an overcollateralized Swiss franc stablecoin on Ethereum that is designed to avoid price oracles.

Each of these projects makes different trade-offs between decentralization, collateral variety, governance and liquidity. A design that relies on one collateral type is simpler to reason about but more exposed to that asset's price. A design with many collateral types can spread risk but adds more rules to understand.

Before relying on any of these stablecoins, read the protocol's current documentation, check its audit history and confirm the collateral it accepts. Parameters such as collateral ratios and debt ceilings can be changed by governance, so the documentation is the place to find the current settings.

Early 2026 reporting described new dollar-token efforts involving large payment and financial firms, and a separate DeFi-focused stablecoin competition. Some of these reports are at the planning or claim stage. Treat any launch as unconfirmed until the issuer publishes its reserve or collateral structure, redemption terms, audit reports and legal status in its own materials.

New entrants can bring real improvements, such as clearer reserve disclosure or better integration with payment systems. They can also repeat old mistakes, such as relying on incentives to attract liquidity or depending on a second token for stability. The questions that mattered in 2022 still apply.

If you see a headline about a new stablecoin, ask who issues it, what backs it, how redemption works in a stress event, who can freeze or block transfers, and which regulator, if any, oversees it. Compare the answers with what the protocol or issuer publishes, not with what commentary says about it.

News about competition between stablecoin designs can change quickly. For current facts, rely on primary documents from the issuer and on official regulatory filings, and read commentary with the understanding that it may reflect an author's view.

Use this checklist before putting money into any stablecoin or DeFi protocol. It is a general approach, not financial advice.

1. Identify the backing. Write down whether the token is fiat-backed, overcollateralized or algorithmic, and what asset or rule holds the peg.
2. Read the redemption path. Confirm how you can exit at or near the target value, and whether that path depends on a single intermediary.
3. Check the collateral. For overcollateralized designs, list the accepted collateral types and how the protocol values them.
4. Test liquidity. Look at where the token trades and how deep the market is, especially during volatile periods.
5. Review the oracle and liquidation design. Find out which price feeds the protocol uses and how quickly it liquidates positions.
6. Look at audits and incident history. Read the audit reports and any public post-mortems from past problems.
7. Understand the freeze and screening rules. Find out whether the issuer or protocol can block addresses and what compliance steps apply.
8. Monitor the peg. Check price on several venues and set your own limits for when you would reassess.

No checklist removes risk. It helps you see the mechanisms that decide how a stablecoin behaves when conditions turn, which is the part that 2022 made clear.

Several figures in this area change often, including peg prices, total value locked, borrowing rates and liquidity depth. Any number in an article can be out of date by the time you read it, so this guide avoids stating them.

For current data, use these sources in combination. Check the protocol's own dashboard and documentation for parameters such as collateral ratios and debt ceilings. Use independent market data for prices and liquidity across venues. Read the issuer's latest reserve reports or the protocol's governance proposals for changes. Review regulatory and court records for legal status.

When two sources disagree, trust the primary document over the summary. A governance vote or a published reserve report is closer to public sources than a social media post about them.

For a clearer view of the wider DeFi lending and stablecoin landscape, look at how protocols such as Aave V3, Sky and Morpho describe their markets and risk settings, and compare those descriptions with the data you can verify yourself.