Crypto markets are in freefall this month—and their struggles have been gravely exacerbated by the demise of a $60 billion project that critics are calling a Ponzi scheme.
TerraUSD (UST) was the subject of the proposed project. This stablecoin, which is tied to the U.S. dollars, has supporters who hoped that it will revolutionize payment systems all over the world. Investor panic and attempts to take out their cash caused a bank run that led to the destruction of TerraUSD (UST) within days. It caused financial ruin for many and brought down the crypto market as a whole.
“This is among the most painful weeks in crypto history & one we’ll reckon with for a long time to come,” Jake Chervinsky, the head of policy at the DC-based lobbying firm Blockchain Association, wrote on Twitter.
Terra investors are the worst affected, however, the downfall of Terra could cause ripples for cryptocurrency and other digital currencies, particularly as cautious regulators and lawmakers assess the impact. “People have lost their life savings through crypto investments, and there aren’t enough protections in place to safeguard consumers from these risks,” Massachusetts Senator Elizabeth Warren wrote in a statement to TIME. “We need stronger rules and stronger enforcement to regulate this highly volatile industry.”
Here’s what happened, and what lies in store following the debacle.
Was it really?
Terra’s rapid rise and fall can be difficult to explain succinctly without any prior knowledge of the blockchain. Many of the boosters of Terra used jargon and opaque language to hide their obvious shortcomings. Here’s a brief explanation.
Terra, like Ethereum and Bitcoin, is its own cryptocurrency. Its most prominent product is the UST stabilitycoin which is pegged at the U.S. dollars. Crypto traders use stablecoins as a safe haven when the markets in DeFi (decentralized financial infrastructure) become chaotic. Instead of turning volatile assets into hard money, which could be costly and cause tax consequences, traders trade them for stabilitycoins.
Some stablecoins derive their value from being fully backed by reserves: if investors decide they ever want out, the stablecoin’s foundation should theoretically have enough cash on hand to repay all of them at once. UST is an algorithmic stablecoin that relies on code, market activity and belief to maintain its dollar peg. UST’s peg was also theoretically propped up by its algorithmic link to Terra’s base currency, Luna.
UST investors have bought UST over the past six month to take advantage of a platform that lends and borrows money called Anchor. Anchor was offering a 20% yield for anyone who buys UST or loans it to other protocol members. Many people immediately accused Terra of being a Ponzi scheme. Terra team members even acknowledged that this was the case—but likened the rate to a marketing spend to raise awareness, in the same way that Uber and Lyft offered severely discounted rides at the beginning of their existence.
However, some experts in blockchain say wealthy investors used a scheme to borrow large amounts of Bitcoin and buy UST last week. The intention was to make huge profits on the fall of UST’s value, also known as short-selling.
This resulted in UST being depegged from the US dollar. There was a bank panic, and investors who were earning interest through Anchor tried to escape the situation as soon as possible. Their activity caused the linked currency Luna to also crash in what is known as a “death spiral.” As of now, UST is worth 12 cents, and Luna is worth fractions of a penny after being worth as much as $116 in April.
In a matter days, the life savings of numerous Terra and Luna investment made disappeared. There was a lot of suicide talk on the r/Terraluna forum. “I’m going through some of the darkest, most severe mental pain of my life. It still doesn’t seem real that I lost $180,000,” one poster wrote.
Terra took down Bitcoin and all of the crypto market
Before Terra’s crash, cryptocurrency values were already on the decline, due in part to the Federal Reserve raising its interest rates. (They did it to curb inflation. This has resulted in people spending less.
But UST’s crash put another dent in the overall market, most centrally because Terra creator Do Kwon had bought billions worth in Bitcoin as a safeguard for UST. He and the Luna Foundation Guard, which cost more than $3B to protect the peg, caused downward pressure to the market. This led to large investors selling their Bitcoin shares. Bitcoin hit its lowest point since December 2020, and Kwon’s ploy to save UST was unsuccessful.
“The way these algorithmic stablecoins are designed, they have this upward force during bull markets, which is how they get so popular,” says Sam MacPherson, an engineer at MakerDAO and the co-founder of the software design company Bellwood Studios. “But the same forces act in reverse during bear markets and expose their fundamental flaws. That is ultimately what triggers bear markets. [the crash].”
All across the cryptocurrency ecosystem, ripple effects could be felt. Because firms sold around $30,000 of Ether in their own attempt to defend UST’s peg, Ether also plunged below $2000 for the first time since July 2021. As many investors tried to cash out their Ethereum-based stablecoins, their sheer number of transactions caused Ethereum’s transaction fees to spike, causing people to forfeit even more money.
Coinbase, one of the crypto world’s biggest and most mainstream companies, slumped 35% last week. Cryptoslam also reported that the NFT ecosystem lost 50% last week in terms of sales volume.
This led to losses of hundreds of millions of dollars throughout the ecosystem. Many worry that Terra’s crash is the first domino precipitating a long-foretold “crypto winter,” in which mainstream investors lose interest and values remain low for months.“ I suspect some cryptocurrencies will be worthless and that capital investment in the space will slow to a crawl as investors nurse their losses, much as we saw in the Internet bubble,” Bloomberg’s Edward Harrison wrote.
The crash could have a number of consequences.
The regulations could be tightened
Stablecoins are a subject of intense scrutiny by regulators for a long time. In December, Congress heard their benefits and risks. The same month, President Biden’s working group called for “urgent” action to regulate them.
Terra’s crash gives even more ammo to regulators who argue that the space needs to be roped under government control. On May 12, Treasury Secretary Janet Yellen called for “comprehensive” regulations of stablecoins, saying that while the current crash is too small to threaten the whole financial system, stablecoins are “growing very rapidly. They present the same kinds of risks that we have known for centuries in connection with bank runs.”
Hilary Allen from American University Washington College of Law, who gave testimony about the dangers of stablecoins during the December congressional hearing, said that the Terra crash provides a hint of what might happen if crypto moves toward mainstream status without regulatory oversight. “In a few years time, something like this could have many more pathways to cause broader harm, especially if the banks continue to get closer to this space,” she says. “I think it’s critical that regulators and policymakers see this moment as a time to put up whatever firewall they can between the traditional financial system and DeFi.”
Massachusetts Representative Jake Auchincloss tells TIME that he’s in the process of drafting legislation requiring stablecoins to be federally audited. Auchincloss doesn’t seek to ban stablecoins, as he believes they could play a role in “keeping the U.S. dollar as the world’s reserve currency.” But he hopes to bring stablecoins under the purview of a federal bureau like the Comptroller of the Currency; to make sure stablecoin issuers can prove they have 90 days of liquid reserves; and to explore the idea of mandating that they provide insurance for customers. “We’re going to let private sector actors make their own risk-reward decisions, and we’re going to empower the federal government to ensure that there’s no systemic risk forming from the sector,” he says.
Senator Warren has been one of the most vocal public detractors of crypto, and took Terra’s collapse as evidence for why regulators need to “clamp down” on stablecoins and DeFi “before it is too late.” Across the Atlantic, the European Commission is considering implementing a hard cap on the daily activity of large stablecoins, according to Coindesk.
Many in the crypto community seem to be resigned to new regulations. “A lot of lives have been ruined. The rest of the crypto ecosystem needs to be open to working with regulators such that we can deter these types of situations from happening in the future,” MacPherson says.
It is possible that the Boundary Pushing Stablecoins are dead.
Many years ago, blockchain developers who were ambitious set out to make a stablecoin that was safe, functional, and secure. They hoped they would be stronger against inflation than the reserve-backed stablecoins, and also less subject to government surveillance or seizure. They all failed to meet their goals and eventually fell off the peg. UST, for a few months, was the medium’s crowning success story—and now is its biggest failure.
Any developer who tries to replicate it will see its crushing defeat as a reminder that venture capital investors and other investors are likely to be less interested in investing in the same models. Other boundary-pushing stablecoins like Frax (magic internet money) and MIM saw huge drops in market caps last week, despite keeping their dollar peg.
“I think this has rightly destroyed any faith in the algorithmic stablecoin model,” Allen says. “It’s quite possible after Terra, we might never see them again—although I never say never when it comes to crypto.”
Many crypto leaders have tried to discredit UST over the last week. Some argue that stablecoins that are reserve-backed are comparatively stable and should be allowed continue to prosper with minimum regulation. Chervinsky from the Blockchain Association wrote on Twitter that UST was “in a category of its own,” compared to other models that are “very stable and reliable.” Matt Maximo, a researcher at the crypto investor Grayscale Investments, wrote to TIME in an email that UST’s crash could lead to more demand for dollar-backed or overcollateralized stablecoins.
Allen claims that even though they are reserve-backed, stablecoins carry some risk. “The best analogy with these reserve stablecoins is with money market mutual funds,” she says, referring to a type of fund whose failure helped trigger the 2008 financial crisis. “And those have had runs and have been bailed out.” (The economics journalist Jacob Goldstein made the same comparison in TIME’s Future of Money issue in October.)
It is possible that venture capital will stop investing in crypto
The crypto market has seen an amazing amount of capital flow into it over the past two years via venture capital companies, most recently from Andreessen Horowitz. Terra, the original Terra. beneficiaryPantera Capital, Delphi Digital and many other brand-name investors are among them.
UST’s crash could raise mistrust on both sides. “It is likely that many of the institutions that have invested in the space may see significant short-term losses, resulting in a slowdown in venture investing,” Maximo writes to TIME. Chris McCann and Edith Yeung, general partners at the crypto-focused VC firm Race Capital, told Bloomberg this week that they had heard of deals falling apart, being repriced, or even founders getting “ghosted” by potential investors.
MacPherson, on the other hand, turned the blame for Terra’s crash in part onto the VC firms that lent their institutional trust to the perilous project. “I think they should take some responsibility with how they’ve ruined some of these regular folks who invested in UST not knowing the de-peg risk,” he says. “Some of the [firms] made a lot of money off this, and I think they should compensate those who have lost.”
At the moment, Terra’s major investors are being forced to decide whether to help bail the project out or cut and run. Over the past week, many of their investors have been extremely quiet. Michael Novogratz is the CEO and founder of Galaxy Digital, a billionaire. giant Luna shoulder tattoo Since May 8, has not tweeted in January
Lightspeed Venture Partners was a prominent crypto-focused investment firm. They invested $250,000 to acquire the Luna token. “Lightspeed has been investing in blockchain for over 8 years. We view this as an important computing paradigm shift, bigger than Bitcoin’s volatile price. We are doubling down, specifically in infrastructure, DeFi and emerging use cases,” they wrote.
Decentralized finance is slowing, despite all the excitement.
Much of the promise of crypto lies in its decentralized nature: that its value doesn’t derive from manipulable controlling authority like a bank or a government, but rather sleekly-designed code and network effects. This week, some crypto enthusiasts have argued that Terra’s crash was a successful stress test for this hypothesis: that Bitcoin’s perseverance amid such a giant sell-off proves its durability.
But Terra’s crash did reveal many centralized pressure points in the ecosystem, which, if they didn’t break, at least bent significantly. While there’s no CEO of crypto, one charismatic founder—Terra’s Do Kwon—was able to single handedly create a project that then erased hundreds of billions of dollars in value. The Federal Reserve could then use his power to protect his cryptocurrency, finally destroying the whole market. Kwon didn’t immediately reply to our request for comment.
The attack showed the vulnerability of Curve pools—decentralized exchanges in which prices can shift quickly due to whales exiting or entering them—and Binance, the world’s largest cryptocurrency exchange, which did not have deep enough liquidity to sustain the massive amounts of UST entering circulation.
In fact, the Terra saga shows that blockchain’s decentralized nature allows bad actors to have an outsized impact on the system. Many enthusiasts believe that such events help to eliminate those who are trying to profit from the system and lead to a stronger and better educated user community. “The permissionless nature of the blockchain means that we can’t prevent it,” MacPherson says. “But I think we should do a better job of informing the public what the risks are.”
Ponzi schemes might find fewer takers… or not
Whether the debacle sticks in people’s minds as a learning experience is another question entirely. Justin Sun, the crypto entrepreneur and controversial figure in crypto announced on Thursday an algorithmic stablecoin that offers a 40% rate of return for lenders. Galois Capital responded with a humorous response. tweeted: “This industry being a self-regulating one requires that learning happen. The results were mixed.” It seems that there are still plenty of crypto investors who will accept extremely high risk, so long as the prospect of extremely high riches remains.
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