Q&A: the collapse of terra and what it could mean beyond crypto | Cryptocurrencies

The collapse of a multibillion-dollar cryptocurrency called terra has sparked a wave of “fear, uncertainty and doubt” across the sector, leading some, like Coinbase’s chief executive, Brian Armstrong, to suggest the industry is heading for another “crypto winter”. But how did one coin stumbling cause such panic? And could a downturn spill into the wider economy?

How does crypto work?

The term cryptocurrency covers a broad swathe of digital assets all based on the same fundamental structure as bitcoin: a publicly available “blockchain” that records ownership without having any central authority in control. Advocates argue it allows for a truly censorship-resistant economy and, thanks to successor platforms such as ethereum, a new version of the web that allows for payments and ownership to be built in at the base level.

Critics counter that, more than a decade after bitcoin was created, the sector has yet to spawn an actually useful product, instead merely enabling the creation of a wave of speculative bubbles and zero-sum gambling that has lost some retail investors as much money as it has made for others.

Both sides agree the recent collapse in the crypto market is evidence of waning interest, but the real question is whether it is simply temporary or a more permanent crunch that will expose the sheer quantity of scams and frauds that pervade the sector.

What is the state of crypto?

Almost half the sector’s entire value, $ 582bn (£ 475bn), is still tied up in the original cryptocurrency, bitcoin. Half again, $ 250bn, 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 ($ 80bn) and USD Coin ($ 50bn), are effectively the sector’s banks, taking customer deposits, holding them as reserves, and issuing tokens that are supposedly guaranteed to have a fixed value relative to conventional currencies.

The projects that sit on top of that infrastructural layer are comparatively small. That includes non-fungible tokens, or NFTs – unique assets used to denote ownership of assets such as digital art. According to analytics firm CoinMarketCap, the entire NFT sector is worth $ 10bn. 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 $ 70bn.

What sparked the crash?

Despite hopes among adherents that cryptocurrencies, particularly bitcoin, would act as a counter-cyclical investment and a hedge against inflation, the sector started contracting at the same time as the wider selloff in tech, with bitcoin slumping from $ 48,000 in March to less than $ 38,000 by the beginning of May.

However, last week the collapse of the terra stablecoin precipitated a much steeper plunge. Unlike larger rivals, terra did not have customer deposits backing it – instead, its stable value of $ 1 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 when terra “depegged” from the dollarand slipped into a “death spiral”, automatically printing ever more worthless luna, which crashed the price further.

By the end of Thursday, the market capitalization of the project had fallen from $ 41bn to $ 6.6m, “the largest destruction of wealth… in a single project in crypto’s history,” according to Charles Hayter of the analytics firm CryptoCompare. By Monday terra was trading at just $ 0.11.

How did it spread?

Terra’s initial collapse sparked a further wave of selling, knocking 15-25% off the value of most of the major cryptocurrencies. The rush to exit the market hit stablecoins particularly hard, causing tether to depeg for most of Wednesday, Thursday and Friday. The company has since approved $ 7.6bn worth of withdrawals that have brought the token back to within 0.1% of parity with the US dollar.

Other projects are more directly affected by terra’s collapse. Hayter warns there is “significant exposure” in much of the DeFi sector, as well as traditional finance products relying on terra to provide depositors with high yields. Celsius Network, for instance, offered an 18% annual interest rate on deposits of the stablecoin, while avalanche, a blockchain project, invested $ 100m in it.

On Friday morning, the DeFi protocol Venus announced it had lost $ 13.5m from its treasury after it accidentally accepted terra using an out-of-date valuation, while Blizz Finance lost its entire holdings due to the same flaw.

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

Will the contagion spread beyond crypto?

Nikolaos Panigirtzoglou, a global market strategist at US investment bank JP Morgan, says tether redemptions could cause problems in credit markets because the collateral held by tether includes commercial paper, a form of short-term corporate debt used by companies to cover expenses such as monthly payroll. “It will be a problem for credit markets if a lot of commercial paper is to be sold in a short space of time,” he says. Tether’s commercial paper reserves reportedly amount to just under $ 30bn.

Panigirtzoglou also warns of a risk of a wider asset sell-off by retail investors nursing losses. “Crypto investors who have lost a lot of money and who have also invested in equity markets could decide to de-risk, by taking their money out of equities.” However, he says the prospect of a share sell-off was less likely because equity prices have been depressed in recent months and retail investors might not want to compound their crypto losses.

Could Contagion Causes A Credit Crunch-Style Crash?

Not as the market currently stands, according to James Knightley, the 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 last week’s gyrations. “It may not be particularly systemically important now, but if the crypto markets were to recover and grow strongly over coming years and then we get a second bust when it is systemically important then regulators would not be able to forgive themselves.”

Teunis Brosens, ING’s head economist for digital finance and regulation, said there would be a systemic risk if insurers and banks got more heavily involved in crypto assets – although this is less likely to happen as regulators circle. “Increased participation and exposures by traditional financial institutions [to cryptocurrencies] is mostly limited to asset managers, which pass on any losses to their clients. “

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