In early May, the floor fell out of the cryptocurrency markets, with many people losing their life savings. You can question why they had their life savings invested in cryptocurrencies in the first place, but what made the price fall so far, so fast?
The answer is a combination of things, the core of which is a currency called Terra (Luna), which is meant to be a stablecoin. Stablecoins are backed by real assets, such as US dollars, and are meant to be, therefore, much more, well, stable. How did Terra become unstable? More importantly, having peaked at $120 per coin in April, how could it lose 98% of its value in under 24 hours on May 11?
The answer is, essentially, because there was a downturn in all crypto during April and May, but more importantly because Terra is not the same as other stablecoins which are backed by real assets. Terra was issued as an algorithmic stablecoin. Unlike other stablecoins, this means that is uses blockchain technology to print money using smart contracts, similar to the way Ethereum’s smart contracts work. The aim of the algorithm is to ensure that Terra’s value remained at $1 per coin.
However, the smart contracts can only be executed while the currency has the belief of investors. When investors started losing faith and began withdrawing funds, the knock-on effect was that the algorithm could no longer execute contracts to maintain parity with the US dollar. The price dropped to $0.70 and then again to $0.35 per coin. In other words, as more people withdrew funds the harder it became for the algorithms to keep the coin stable.
The stabiliser is meant to be the Luna token. When Terra dips below $1, it can be swapped for Luna tokens (at a small profit). In theory, that’s meant to keep the value of both stable. But people lost faith in Luna tokens at exactly the same time as withdrawing money from Terra. The price of the “sister” token dropped from about $86 at the start of the week to just $0.003 on Friday 13. Essentially, investors rushed to liquidate their digital assets quicker than the “algorithmic stabiliser” could deal with it.
A lack of substance?
This development has raised questions among crypto-watchers. The fundamental questions are: how could a cryptocurrency, using the technologies that are meant to create stability, drop from a market cap of $40bn to $500m overnight? Could that happen to bitcoin and other cryptocurrencies? Is this market just a massive Ponzi scheme, or does it have substance?
In the financial community, I am sure many will be sitting with smug smiles on their face. The Germans call it schadenfreude. I call it a sucker punch for those who don’t investigate the markets well and do not understand the risks involved in investment.
If you invested your life savings in a system you don’t understand, then it’s no wonder you have lost that money. Equally, why are you investing your life savings in something you don’t understand? Markets have risk. They go up and down. Only invest what you are prepared to lose. That’s something the financiers understand well.
No sign of stopping
Does this mean a flight to safety, the rise of central bank digital currencies (CBDCs) and the end of bitcoin? No. It is just another bump on the rocky road to creating decentralised finance (DeFi).
Many have never experienced these bumps, but they occur often. The website 99bitcoins.com tracks the media predictions of bitcoin’s expected doom, and there have been many since 2010. And yet, the idea lives on. Why? Because there is a friction between national government-issued coins and networked coins.
It’s quite hard to send cash over the internet and, with the four-pillar model of cards or the percentage-plus costs of intermediaries, it makes absolute sense to try to move to a networked system that is fast and free. That’s what DeFi is trying to achieve.
So, the move to DeFi won’t end here. I’m very aware of the faults and virtues of both systems – fiat currencies and cryptocurrencies – and believe the endgame will be a hybrid model of central bank digital currencies, stablecoins and cryptocurrencies.
The issue with Terra was not the structural faults of these systems. It was the structural faults of Terra, and the fact that too many people believe these currencies are all about ‘HODLing’ (keeping cryptocurrencies as an investment), instead of what currencies are really about: allowing the exchange of value to buy and sell products and services.
That’s where the real fault lies, and it’s nothing to do with a Ponzi scheme. It’s all about creating currencies that work for value exchange in a networked world.
