Billions were wiped off the cryptocurrency market this week with the collapse of the terra “stablecoin”. But is its failure just another example of the here-today-gone-tomorrow nature of the sector, or could it be the beginning of a wider downturn?
What is terra?
Terra is a stablecoin – a cryptocurrency that is intended to have a fixed value, typically $1. Stablecoins function similarly to a bank in the crypto ecosystem, providing a safe place to store money and greasing the wheels of commerce.
Many stablecoins, such as USDC and tether, get their stability from large reserves, and are supposed to keep enough liquid assets on hand to cover all of the coins in circulation. But terra is a new breed of “algorithmic stablecoin”, which effectively prints money out of thin air and uses a complex set of “smart contracts” to try to ensure the value hovers as close to $1 as possible. That arrangement worked – until it suddenly didn’t.
What happened this week?
Terra “broke its peg”. After hovering about $1 for almost a year, the value of one coin plummeted, first to 70¢, and then further, settling around 35¢ on Wednesday afternoon. The complex algorithmic deal that was supposed to keep the coin trading at a fixed price failed, as investors raced to liquidate their positions faster than the automatic stabilisers could kick in.
The other half of the terra stablecoin is a floating token called Luna. In theory, when the terra value drops too low, Luna holders are supposed to automatically trade their coins in, propping the price up. But the value of Luna has also fallen precipitously, from $86 last week to just 86¢ today. The charismatic co-founder of Terraform Labs, which developed the stablecoin, Do Kwon, has promised action, telling investors: “I understand the last 72 hours have been extremely tough on all of you – know that I am resolved to work with every one of you to weather this crisis, and we will build our way out of this. Together.”
Why does it matter?
As with every cryptocurrency bust, thousands of investors who thought they had discovered a get-rich-quick scheme are now finding they have lost almost all their money. Some are waiting for Kwon to step in with a rescue package, but others have lost faith in the project entirely.
More fundamentally, though, terra was seen as the shining light in the “decentralised finance” ecosystem. Critics had argued that its algorithm was more like a Ponzi scheme than a real reserve-backed currency, but its continued success bought Kwon the title of “crypto’s most-watched whale”, according to a profile on Bloomberg. The project had used its reserves to buy a large stake in bitcoin, further cementing the perception that it was too big to fail – until it did.
Now, some are asking, if terra could drop from a market cap of more than $45bn to less than $5bn in two days, what else in the system is on shaky territory? Could USDC or tether collapse in a similar way? And if they went, what else would follow? The collapse of terra may not turn out to be a Lehman Brothers for the cryptocurrency world, but it shows what it could look like.
