Beginning on 9 May 2022, the tokens made headlines after UST began to break its peg to the US dollar. Over the next week, the price of UST plunged to 10 cents, while Luna fell to "virtually zero," down from an all-time high of $119.51. Before the crash, Luna was one of the top ten largest cryptocurrencies on the market. The collapse wiped out almost $45 billion of market capitalization over the course of a week.

On 13 May, Terraform Labs temporarily halted the Terra blockchain in response to the falling prices of UST and Luna. Despite the company's attempts to stabilize UST and Luna via its bitcoin and other cryptocurrency reserves from the Luna Foundation Guard, the 1:1 peg of UST to USD did not materialize. As of 16 May 2022, blockchain analysts claim that the usage of the bitcoin reserves of LFG still remains largely uncertain. Likely causes of the collapse included mass withdrawals from the Anchor Protocol days before the collapse, investor concerns about cryptocurrencies more generally, and a drop in the price of bitcoin. During the collapse, holders converted Terra into Luna via the mint-and-burn system, which caused the price of Luna to collapse due to its increased supply. This, in turn, destabilized the balancing mechanism between the currencies.

On 25 May, a proposal was approved to reissue a new Luna cryptocurrency and to decouple from and abandon the devalued UST stablecoin. The original blockchain is now called Terra Classic (LUNC), and the original Luna token is called Luna Classic. The new Luna coin is called "Terra 2.0" by investors and has lost valuation in the opening days of being listed on exchanges.

In an August 2022 interview on the NFTV series Coinage, which occurred a few months following the collapse, Terra founder Do Kwon remarked that his faith in Terra now "seems super irrational." However, he would also deny that the Terra system was a Ponzi scheme.

On 23 March 2023, Kwon attempted to travel to Dubai using falsified Costa Rican documents while also carrying falsified Belgian travel documents, but was intercepted and arrested at Podgorica Airport in Montenegro. A federal grand jury in Manhattan subsequently laid eight charges against Kwon, including securities fraud, commodities fraud, wire fraud, and conspiracy. The following month, KBS News reported that Kwon had sent 9 billion won, equaling USD $7 million, to the law firm Kim & Chang, prior to the collapse of TerraUSD.