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Demystifying the Crypto Markets Crash

On the weekend of May 8, a large crypto holder, or as we call them crypto whales, of the stablecoin $ Terra (UST) dumped ~$285Mn worth of holdings in the open market within a span of few hours. Further exacerbated by excessive shorting on LUNA on Binance and other crypto exchanges, and panic on Twitter, Terra Blockchain Network was in shambles by Wednesday afternoon GMT. The TerraForm Labs founder, Do Kwon, calls on Twitter this sell-off a deliberate attempt to cause irreversible damage to the Terra Blockchain Network and its reputation. True or not, the series of events that followed has already caused many investors go bankrupt overnight as per Reddit amidst the massive sell off in the cryptocurrency markets.

So why is this event important?

A new term came into fashion over the last few years – ‘Stablecoin’. Unlike usual cryptocurrencies that are notoriously infamous for high volatility, stablecoins are pegged to stable fiat currencies such as the US Dollar. The initial notion of using cryptocurrencies as a mode of payment finally started taking form as reality; after all, why would you pay $50 for a cake that costed $40 an hour ago?

However, the only problem – stablecoins, unlike fiat currencies, do not have real backing. For example, CBDCs, or Central Back Digital Currencies, are like these stablecoins but have real backing by the respective central banks. Most stablecoins are artificially pegged to real currencies using computer algorithms; and thus, there lies a risk of extreme currency fluctuations or impermanent losses. (Impermanent losses are losses that are incurred due to devaluation of the currency in which an asset is bought as an investment – Imagine buying an SBI share at Rs. 500. In a year, the share may trade at 550 (rise of 10%) but the Indian Rupee may depreciate by 25% against the Dollar/Gold, thus resulting in a total net loss after accounting for currency devaluation). 

US Terra or UST is a similar artificially pegged stablecoin on the Terra Blockchain network. To peg the UST to the $, a balance of demand-and-supply is created between the native coin LUNA and its sister token UST. In the past, whenever there used to be a rise or fall in the price of UST/$, the demand and supply of LUNA-UST was adjusted to bring the UST/US$ peg back to 1:1, with minor deviations of course. But this weekend, after the sudden dump of UST in open markets and withdrawal from Terra’s prominent DeFi (Decentralized Finance) lending platform – Anchor Protocol, the price of UST entered a free fall. Overpowering the algorithms’ attempt to create an artificial balance, the investor sentiments turned so negative that both UST and LUNA started tanking. As of Wednesday 1 PM GMT, they were trading at 30 cents  (down 70% in 7 days) and 80 cents (down 99% in 7 days) respectively. This resulted in LUNA alarmingly sliding down from one of the top-10 cryptocurrencies by market cap to not even in the top-30 anymore. Not surprisingly, its trading was halted on key exchanges such as Binance.

This event has become a key trigger in the current overall sell-off in the crypto markets. The Luna Foundation Guard that holds a reserve of over 42,500 bitcoins (~US$1.3Bn at US$30,000/BTC) for such occasions is trying to reverse the UST/US$ peg back to 1:1 by selling off its BTC reserves in the open markets and increase the demand for UST. The sell-off pressure is resulting in daily declines in prices of top cryptocurrencies such as Bitcoin and Ethereum that are down ~20% each in the last 7 days. Further, due to the ongoing rain of rate hikes across major economies, diversion of capital into safer assets such as fixed income instruments is resulting in liquidity crunch and repricing of riskier assets such as cryptocurrencies and stocks.

The last few months have seen cryptocurrency markets getting tormented. The cumulative market cap of all cryptocurrencies has come down to ~US$1.4Tn from its highs of ~US$3Tn in November 2021. The ripple effects of this recent trigger is likely to impact cryptocurrency prices in the near future. From NFTs to DeFi staking and lending, the magnitude of losses is expected to continue rising amidst fear of volatilities. Startups across the world that are exclusively focussing on transferring fixed yield returns through DeFi staking and lending mechanisms to their customers are now seeing themselves in huge troubles as the overall capital deployed on the behalf of their customers is now eroding faster than ever.

DISCLAIMER: Views presented are solely of the author and are not to be taken as advice to buy/sell any security.