Understanding The Crypto Crash

The cryptocurrency market is volatile, and the recent meltdown illustrated just how quickly things could change. Even stable coins such as Bitcoin keep dropping in value partly due to its ties to the stock market and also because Terra-Luna, another cryptocurrency, just tanked. This event amounts to the worst reset in crypto history since the 80 percent decline of Bitcoin in 2018. 

However, this time, the falling prices have had a bigger impact on the people and institutions that hold these currencies. Some critics now say that crypto is dead and that it was long overdue; however, other traders and investors liken this crash to the 2008 financial crisis.

How it started

In 2008, Satoshi Nakamoto created Bitcoin. This virtual currency was touted as a decentralized alternative to the traditional financial system. Rather than relying on the traditional gatekeepers, such as banks, crypto proponents opted to conduct transactions themselves, recording each one on a secure, shared ledger. 

Tech giants from Elon Musk, Marc Andreessen, and Jack Dorsey, embraced crypto as it grew into an almost cult-like movement. The value of Bitcoin and other cryptos exploded, minting new crypto millionaires virtually overnight. Cryptocurrencies saw a boom in activity during the coronavirus pandemic when excessive cash in the financial system led to people day trading for entertainment. As such, the number of people who own cryptos rose from 1%to 16%. 

To tame the volatility of the crypto market, stablecoins were introduced. They are designed to be the rocks of the crypto world. Unlike other cryptos, these peg their value on another commodity, currency, or financial instrument such as the US dollar. They provide an alternative to highly volatile currencies such as Bitcoin, making them more suitable for a wider range of use. They are even used by exchanges to even out the volatility of other cryptos and are favored as safer bets to invest in. 

This is where Terra USD and Luna come into the story. Since stablecoins aim to address the volatility of the crypto market, investing in them seemed like a good idea. Terra had the backing of credible venture firms such as Light speed Venture Partners and Arrington Capital. They invested a lot of cash into the currency, giving cryptocurrency investors a sense of false security. Despite its 1-to -1 peg to the US dollar, the price of the algorithmic stablecoin TerraUSD plummeted by over 60 % overnight. This sudden crash was caused by the drop of the Luna token, which was used to peg Terra. It slumped more than 80% overnight, dropping the market price of the TerraUSD to $0.31 as of last week.    

Algorithmic stablecoins such as Terra are not the same as other stablecoins. They are not pegged on fiat money and don’t hold collateral assets to stabilize their value. Rather they are supported by another token in a push-me-pull-you situation. For Terra, Luna was its balancing token. It, for instance, balanced variations in the stablecoin’s value by increasing or decreasing the supply of Luna tokens through incentives to keep trading the tokens as predicted. 

These algorithmic stable coins were supposed to be the holy grail: stable units that self-corrected independently and elegantly, much like how water finds its own level. They appealed to Bitcoin pursuits because they sort to avoid what regular stablecoins such as Tether rely on: a tie to the real world and financial markets. They operate on code alone, and if they perform as predicted, they could show that code is the future of finance. 

Things were looking up. In February, Terra sealed a multimillion-dollar agreement, and its blockchain rose from 7th place to 2nd, unseating Ethereum. However, in May, things started to take a nosedive as the coin crashed to well below the $1 value it was created to maintain. Similarly, the token meant to absorb Terra’s volatility had also crashed from over $60 to $0.88. 

When UST reached $0.37, Terraform Labs, the company that manages the coin, temporarily stopped transactions on its network to safeguard against further decline. They also froze transactions to keep token holders from taking what little they had left and splitting. Since the network restarted, Terra UST has fluctuated below $0.50 while Luna hovers just above 0. 

How long this crash might last

How long the crash might last is unclear. Digital assets keep changing and are especially tricky to identify or even deduce what they truly mean. However, as crypto got bigger, their prices go more ties to the traditional financial market indexes such as S&P 500. 

The prices of cryptocurrencies have a difficult time weathering the storm, especially when the world around them is falling apart. The fall in cryptocurrency is part of a broader withdrawal from risky assets triggered by rising interest rates, inflation, and uncertain economic times thanks to the Ukraine-Russia war. 

These factors compound the pandemic hangover that saw the stock prices of items prized during lockdown drop. Think of Zoom or Netflix. However, unlike these drops in stock prices, crypto’s decline is more severe. As per an Arcane Research report, Bitcoin’s correlation to traditional markets has hit an all-time high of 0.70, where -1 means it’s discordantly correlated and 1 means it is perfectly synced. Think of it this way. While the S&P 500 price is down 18%, Bitcoin’s down 40%, and in the wake of the Terra-Luna collapse, it has dropped another 20% compared to a 5% decline in the S&P 500. 

A crypto drama has been brewing, and these past events have only added fuel to the flames. Everyone in the crypto scene has their own theory as to why this happened. Many feared a UST bank run could irreversibly damage Bitcoin and even take down the whole crypto market. However, despite the massive losses, there isn’t a sense of existential crisis as many critics predicted. 

The obvious signs indicated the market was overextended and that this was inevitable. Take, for instance, hyped-up tokes such as Shiba Inu and SafeMoon. They were popular among retail investors but have lost most of their notoriety and value after peaking in 2021. 

Lessons learned

As the prices of Terra-Luna fall, there’s a silver lining in all this. Unlike precious crashes, long-term crypto players don’t feel like there’s an existential risk to crypto. Today, crypto is driven by smart contract applications such as NFTs, gaming DAOs, and Defi, and these won’t go away. This crash doesn’t spell the end of crypto, as some might think it will bring down the fluff plaguing cryptocurrencies. 

In a booming industry such as the crypto markets and smart contract applications, it’s not uncommon to see fluctuations. With new blockchain platforms coming up, the bear market is a good stress test to weed out low-quality currencies and find the cracks in what seems to be stable cryptos. 

All in all, the Terra-Luna crash came as a shock to everyone, and while some predicted it, no one could have predicted the devastating effects this has had. That said, new innovations such as smart contract applications are driving the need for cryptos meaning you can be optimistic about the growth of web economies and blockchain innovations.