Q&A: The Terra Collapse and What It Could Mean Beyond Crypto | Cryptocurrencies

The collapse of a multi-billion dollar cryptocurrency called terra has sparked a wave of “fear, uncertainty and doubt” across the industry, leading some, like Coinbase chief executive Brian Armstrong, to suggesting that the industry is heading for another “crypto winter”. But how could a stumbling coin cause such panic? And could a slowdown ripple through the wider economy?

How does crypto work?

The term cryptocurrency covers a wide range of digital assets, all based on the same fundamental structure as bitcoin: a publicly available “blockchain” that records ownership without having the control of any central authority. Proponents argue that this enables a truly censorship-resistant economy and, thanks to successor platforms such as Ethereum, a new version of the web that allows payments and ownership to be integrated at the grassroots level.

Critics counter that, more than a decade after bitcoin’s inception, the industry has yet to spawn a truly useful product, merely allowing a wave of speculative bubbles and zero-sum games to be created that have resulted in losing to some retail investors as much money as it made to others.

Both sides agree that the recent crash in the crypto market is evidence of waning interest, but the real question is whether this is just a temporary or more permanent crisis that will expose the amount of scams and frauds that invade the sector.

What is the state of crypto?

Nearly half of the sector’s total value, $582bn (£475bn), is still tied to the original cryptocurrency, bitcoin. Another half, $250 billion, is in Ethereum, a more programmable successor to bitcoin, which provides the infrastructure that underpins many other projects.

Then there are stablecoins, the biggest examples of which, such as tether ($80 billion) and USD Coin ($50 billion), are actually the banks in the business, taking customer deposits, holding them like reserves and issuing tokens that are supposed to be guaranteed to have a fixed value against conventional currencies.

Projects that rely on this infrastructure layer are relatively small. This includes non-fungible tokens, or NFTs – unique assets used to denote ownership of assets such as digital art. According to analyst firm CoinMarketCap, the entire NFT industry is worth $10 billion. Meanwhile, the “decentralized finance” (DeFi) sector, which aims to mimic traditional banking services such as foreign exchange, current accounts and loans, is worth less than $70 billion.

What triggered the crash?

Despite adherents’ hopes that cryptocurrencies, particularly bitcoin, would act as a counter-cyclical investment and inflation hedge, the sector began to contract alongside the sell-off in technology, bitcoin falling from $48,000 in March to less than $38,000. by early May.

However, last week the collapse of the stablecoin terra precipitated a much steeper fall. Unlike bigger rivals, terra had no supporting customer deposits – instead, its stable $1 value was based on faith in its underlying algorithm, which maintained its value by printing a sister cryptocurrency, luna. But over the course of Monday and Tuesday, that faith was shattered as the earth ‘decoupled’ from the dollar and slipped into a ‘death spiral’, automatically printing more and more worthless luna, which drove the price down again.

By the end of Thursday, the project’s market cap had fallen from $41 billion to $6.6 million, “the biggest wealth destruction…in a single project in crypto history,” according to Charles Hayter. from analytics company CryptoCompare. On Monday, terra was trading at just $0.11.

How did it spread?

Terra’s initial collapse triggered a new wave of selling, causing the value of most major cryptocurrencies to fall by 15-25%. The rush out of the market hit stablecoins particularly hard, causing a loss of tether for most of Wednesday, Thursday and Friday. The company has since approved $7.6 billion in withdrawals that have brought the token to within 0.1% of parity with the US dollar.

Other projects are more directly affected by the terra collapse. Hayter warns that there is “significant exposure” in much of the DeFi sector, as well as traditional financial products that rely on terra to provide depositors with high returns. Celsius Network, for example, offered an 18% annual interest rate on deposits of the stablecoin, while Avalanche, a blockchain project, invested $100 million in it.

On Friday morning, DeFi protocol Venus announced that it had lost $13.5 million of its cash after accidentally accepting terra using an outdated valuation, while Blizz Finance lost all of his assets due to the same defect.

“We believe it will take time for market volatility in the ecosystem to subside – in the coming weeks we will uncover the true cost of this crash,” Hayter says.

Will the contagion spread beyond crypto?

Nikolaos Panigirtzoglou, global market strategist at US investment bank JP Morgan, says tether buybacks could cause problems in credit markets because collateral held by tether includes commercial paper, a form of debt. short-term business used by businesses to cover expenses such as monthly payroll. “It will be a problem for credit markets if a lot of commercial paper has to be sold in a short time,” he says. Tether’s commercial paper reserves are said to be just under $30 billion.

Panigirtzoglou also warns of a risk of broader asset sales by retail investors suffering losses. “Crypto investors who have lost a lot of money and also invested in the stock market might decide to reduce risk by withdrawing their money from stocks.” However, he says the prospect of a stock sell-off was less likely because stock prices have been depressed in recent months and retail investors may not want to compound their crypto losses.

could contagion cause a credit crunch type crash?

Not in the current state of the market, according to James Knightley, chief international economist at ING Bank in New York. Crypto is nowhere near as systemically important as housing, the trigger of the 2008 financial crisis. He adds, however, that regulators will take note of the swings over the past week. “It may not be particularly important from a systemic point of view now, but if crypto markets were to recover and grow strongly over the next few years and then we get a second crash as it is systemically important, regulators could not forgive themselves.”

Teunis Brosens, chief economist for digital finance and regulation at ING, said there would be systemic risk if insurers and banks become more involved in crypto assets – although this is less likely to happen when the regulators go round in circles. “Increased participation and exposures of traditional financial institutions [to cryptocurrencies] is mainly limited to asset managers, who pass on losses to their clients.

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