May22 , 2022

Explained: Why Luna crash has raised questions about stability of crypto assets

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The sharp crash in Luna, the sister cryptocurrency of algorithmic stablecoin Terra, which has rendered it almost worthless, has sent shockwaves throughout the cryptocurrency market, with experts likening the crash in the crypto market to be as severe as the big financial crisis of 2008. The near-collapse of these stablecoins, considered to be comparatively safer investment bets within the crypto universe, has also prompted regulators and authorities to call for stricter laws governing these financial assets.

What has happened?

Stablecoins are tokens pegged to the value of a government-backed currency such as the US dollar or commodities like gold or silver. Tether (USDT) and USD Coin (USDC) are the two leading stablecoins. The value proposition of these tokens is that they largely trade around $1 per token, which gives investors some security in highly volatile market situations.

TerraUSD, or UST, is different from Tether in that it is not backed by a fiat currency or other commodities, but instead relies on a complex mix of code and a sister token called luna to stabilise its price. Terra is referred to as an algorithmic stablecoin, meaning that its value is not determined by the financial collateral in the traditional markets but by lines of complex computer code.

In order to maintain its dollar peg, Terra’s algorithm, which is a set of well-defined instructions, incentivises investors to take advantage of price changes between Terra and its sister token Luna, meaning that UST is heavily dependent on the Luna token. In simple terms, it means that on paper, if Terra’s price falls below $1, traders can “burn” the coin, or permanently remove it from circulation in exchange of the Luna cryptocurrency, and conversely, if Terra’s value climbs over $1, investors can burn Luna and create new Terra, making gains in the process and keeping the value of the coin close to a dollar.

Last week, after UST depegged from $1 to around $0.45, it led to tremendous sell pressure Luna, which resulted in the coin losing almost all of its value. This meant that Luna tanked to a few decimal cents from its peak of more than $110 per token, meaning that investors have lost almost all of their wealth from the cryptocurrency. Estimates suggest that the token has wiped out $40 billion from investors’ pockets — a big fall from grace for a cryptocurrency that was considered to be among the top ten tokens before the crash.

What is the near-term impact of the crash?

The severe crash could deplete investors’ trust in the crypto market. As investors lost almost all the value of their investments in Terra and Luna, exchanges, including Indian ones like WazirX and CoinDCX, have delisted the currencies from their platforms so that new investors don’t end up buying them. The crash also sent ripples throughout the crypto market, which fell more than 16 per cent on Thursday. Bitcoin, the most popular cryptocurrency, saw its value fall below $27,000 amid the bloodbath in the crypto market, its lowest since December 2020. However, since then, it has shown tepid signs of stability.

What does it mean in the big picture?

Regulators could sweep in to tighten norms around investments in stablecoins. Gary Gensler, the chair of the US Securities and Exchange Commission, who has previously likened stablecoins to poker chips, has renewed calls for regulations around the crypto asset class. Amid the Terra and Luna crash, she said, “I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability”. According to a WSJ report, US Treasury Secretary Janet Yellen reiterated calls for the US Congress to authorise regulations for stablecoins. Commenting on the Terra developments, Yellen said: “I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability. We really need a consistent federal framework”. The report noted that a Treasury-led panel of regulators recommended last year that Congress write legislation that would regulate stablecoin issuers similarly to banks.

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