The Terra-Luna crash in May made it clear that cryptocurrency is inherently volatile and prone to systemic crises. Yet, as long as there is excess liquidity sloshing about, speculative finance will fight any effort to regulate “alternative assets”, the gambling chips.
THE meltdown in May 2022 in the cryptocurrency world, in which the values of digital coins plunged and rendered some near worthless, is a wake-up call. It once again showed that cryptocurrencies are nothing but a bunch of insubstantial, digital “bits” created by speculators as “coins” for speculation. Since 2009, when the first bitcoin was minted, privately generated cryptocurrencies have failed to live up to the claim that they offer an alternative to government-backed and regulated fiat currencies. They are hardly used in routine economic transactions. They mainly serve as virtual instruments on which speculators, with money to lose and the time and inclination to gamble, place costly bets. And consequently their “value” is volatile. For example, the value of a single bitcoin rose from a low of less than $30,000 on July 20, 2021, to a high of more than $67,000 in the middle of August 2021 and fell to less than $30,000 in late May 2022. Yet the promise of high returns in short periods of time is appealing to the speculative instincts of ordinary, ill-informed citizens.
A recent survey by the European Central Bank (ECB) found that as many as one in 10 EU households “may own cryptoassets”, and a survey by the US Federal Reserve revealed that 12 per cent of US adults held cryptocurrencies in 2021. With such penetration, what happens in the crypto world affects the decisions of those in the regular economy. Those who fear that the growing popularity of an asset so fickle could destabilise the rest of the economy are calling for it to be banned or severely regulated.
The European Central Bank (ECB) headquarters in Frankfurt. A recent survey by the ECB found that as many as one in 10 EU households “may own cryptoassets”.
| Photo Credit: REUTERS/Kai Pfaffenbach/File Photo
Yet, there is no shortage of digital currency enthusiasts. They present the crypto world as decentralised and transparent because of the use of blockchain technology. They even attribute the volatility in the value of these tokens to the limited volume of cryptos in circulation. The original token Bitcoin was designed to be limited to 21 million units released over time (of which more than 19 million have already been mined). However, with no regulatory control over the creation of tokens, new cryptocurrencies—such as ethereum and dogecoin—were created, and crypto presence expanded considerably. Supply alone cannot explain volatility. Demand swings generated by speculative investments are crucial to it.
Moreover, volatility, while not just the result of speculation, also whets the appetite of speculators and aggravates it. This could create a problem in the crypto world that can spill over into the regular economy. Despite the misplaced belief that the crypto world exists apart from and is insulated from the fiat money economy, digital tokens are valued in terms of dollars, euros, and other “fiat” currencies issued by governments. The growth of the cryptocurrency ecosystem requires conversion of regular currencies into digital ones. And those making that conversion need to be given the option of converting crypto holdings into regular money. This tether to the fiat money economy handicaps the crypto world in which quick buy-or-sell decisions necessitated by high volatility are hampered by the cumbersome process of moving between crypto and regular worlds. Given the price volatility, any delay in acquiring or disposing of cryptocurrencies can entail losses. And such delays are likely if transactions involve converting fiat currency into digital coins and vice-versa.
A cryptocurrency ATM, operated by trading platform Biotcoin Romania, inside a bar in Bucharest in May. A recent survey by the European Central Bank found that as many as one in 10 EU households “may own cryptoassets”.
| Photo Credit: Andrei Pungovschi/Bloomberg
An unregulated financial system, however, has ways of circumventing constraints. In the case of cryptocurrency, the mechanism devised to undo the link to the fiat money economy was the “stablecoin”. First spotted in 2014, stablecoins, such as Tether and USD Coin, are meant, in principle, to be tokens that are pegged in value to fiat currencies (most often the US dollar) and maintain a fixed ratio (normally one-to-one) with them. Given this characteristic, they serve as the medium in which temporarily idle savings or wealth in the crypto universe can be held. If stability in value is ensured, the holding of stablecoins entails no loss while easing transactions in the crypto world. Not surprisingly, they proved to be popular. The value of stablecoins in circulation rose from a little more than $21 billion to close to $130 billion over the year ending October 2021. According to The Wall Street Journal, stablecoins accounted for around $160 billion of the $1.3 trillion cryptocoins in circulation at the beginning of the last week of May. With this stable wall created at the junction of the crypto and fiat money worlds, the crypto “economy” could function as if it was more or less independent and self-contained.
What was crucial to this new arrangement, therefore, was the mechanism through which the value of stablecoins could be kept stable. In principle, that stability was to be ensured by backing them with reserves of instruments such as Treasury bonds or commercial paper that are “liquid”, in the sense of being easily convertible to cash in fiat currency at short notice. The issuer of a stablecoin backed the issue with fiat money. That obviously sets limits on the volume of stablecoins that are likely to be generated since it requires holding cash in forms that yield no or low returns. Such dependence of the volume and value of stablecoins in circulation on backing with fiat currency-denominated assets reduces the “independence” of the crypto world from that of fiat currencies.
Crypto players issuing stablecoins tried working around this by not revealing the volume and nature of the assets backing a stablecoin, which is easy to do since in the unregulated world of cryptos, such information is not in circulation. Both the New York Attorney General and the Commodity Futures Trading Commission of the US fined the issuers of Tether and the linked exchange Bitfinex, for example, on allegations that their claims of full dollar backing were not correct and that they had concealed losses.
Terra stablecoin pricing on the DeFi Llama website on a laptop computer arranged in the Brooklyn borough of New York, US, on May 16.
| Photo Credit: GABBY JONES / Bloomberg
An alternative had to be found. This is where the crypto coins—Terra and Luna—that were at the centre of the “May mayhem” come in. Terra and Luna are versions of what are termed “algorithmic stablecoins” created by Terraform Labs, a firm co-founded by South Korean digital entrepreneur Do Kwon. The idea of these twin, interlinked stablecoins was to weaken the dependence of the crypto on the fiat currency world, while pegging their value to the dollar. To do this the designers of Terra claimed to have done away with the need to back stablecoins with assets denominated in fiat currencies such as Treasury bonds. Kwon’s “algorithmic stablecoin” was based on a routine that could purportedly automatically stabilise the value of Terra. Whenever Terra’s value fell short of one dollar, an “algorithm” worked to “burn” units of that stablecoin through exchange for units of Luna, which too had its value pegged to the dollar on a one-is-to-one basis. The sellers of Terra gain by exchanging one token valued at less than a dollar for one Luna whose value equals a dollar. With the sale and withdrawal of Terra tokens, the available supply of Terra falls because of which its value is expected to rise and be restored to its $1 level. On the other hand, if the value of Terra rises above $1, then Luna coins are similarly burned to generate units of Terra, the increased supply of which brings its value down to one dollar.
This story left unanswered the question as to what would ensure that the value of Luna would remain stable vis-a-vis the dollar. Kwon promised to ensure Luna’s stability by backing it with cryptocurrencies, especially bitcoin. He created a reserve fund of bitcoins and other cryptocurrency resources, owned by the Luna Foundation Guard, a non-profit he co-founded, that would, in an emergency, protect the value of Terra and shore up confidence in the value of Luna. The foundation had by early May been funded with $3.5 billion worth of bitcoins and sundry amounts of other cryptocurrencies.
In sum, the promised “stability” of Terra was based on two bets: that the process of algorithmic arbitrage between Terra and Luna would keep the former’s value at $1 and that the stability of Luna could be ensured by backing it with cryptocurrencies whose values were volatile. This digital artifice was to ensure Terra’s stability and generate confidence in its value, releasing cryptos from overly depending on fiat currencies. Kwon obviously did not do all this out of love. He must have expected to make a large fortune as the creator and issuer of Terra.
In May, the Terra-Luna arbitrage scheme collapsed, causing the “May mayhem”. For Kwon’s Terra-Luna combine to succeed, it had to attract support from more than venture capitalists and giddy investors, the self-proclaimed “lunatics”. It needed support and demand from a wider range of investors who would then generate the confidence that could make Terra a substitute for fiat currency at the border of the crypto and non-crypto worlds. To win that support, Kwon offered buyers of Terra an option of lending their Terra for a promised 20 per cent yield.
The offer saw a rush of investors to Terra. Coins were acquired with the sole purpose of benefiting from the high lending yield. Around $15 billion of TerraUSD was invested up until May 2022, when the scheme unravelled. It had been built on a structure in which one set of crypto coins was backed by other crypto coins that were in turn backed by other crypto coins, and so on. Such a structure in the real world would be called a Ponzi scheme.
When the overall uncertainty was compounded by fears that the issuers of Terra were overextended, a pull-out of investments began, setting off a decline in Terra’s value that the arbitrage involving Luna could not stop. Terra’s value dipped precipitously because of the sheer weight of the number of coins that had been minted to satisfy investors attracted by the high yields that Terra-lending offered. When Terra’s value began to slide relative to the dollar in May, panic gripped speculative investors, who began to pull their coins out to redeem them for Luna and protect the value of the original investment. Creating huge volumes of Luna to keep Terra stable undermined confidence in Luna, whose value began to decline. This required selling the backstop bitcoin reserve to buy Terra tokens and restore the peg.
The volume of withdrawals was so large and occurred in such a short period of time that the bitcoin nest backing the system proved inadequate to the task. Soon every Luna was worth only a few cents. If Luna could not hold, Terra could not hold either. Given the interlinkages between coins in the crypto world, the value of other cryptocurrencies such as Bitcoin, the strongest, was also eroded, as the large reserve was sold. Other stablecoins such as Tether and USD coin were soon threatened bythe contagion. Many investors lost money, some their life’s savings.
The Terra episode made it clear that the crypto space is not only inherently volatile but is prone to systemic crises as it expands in size and draws into its operations players other than a bunch of risk-loving digital gamblers and high–net worth speculators. That should worry regulators since the myth that the crypto world is relatively independent of and isolated from the normal financial system is being challenged.
If a mass of investors is being drawn into the crypto world because of the promise that coin appreciation offers large profits or for lending schemes that offer high returns, those investors must be buying their way with money borrowed from banks and other intermediaries in the regular financial system. Without that, it is difficult to explain how a combination of the number of coins issued and the value of those coins resulted in the size of the crypto market increasing from around $500 billion towards the end of 2020 to close to $3 trillion a year later.
Bitcoin signage displayed during the CoinDesk 2022 Consensus Festival in Austin, Texas in the US on June 9.
| Photo Credit: Jordan Vonderhaar / Bloomberg
With the regular financial system awash with cheap liquidity and interest rates at historic lows, investors are looking for new and alternative assets to speculate on. Hedge funds and asset management firms too are now increasingly exposed to cryptoassets. According to Financial Times, the ECB recently noted that some international and eurozone banks were “already trading and clearing regulated crypto derivatives, even if they do not hold an underlying cryptoasset inventory”.
The difficulty is that it is not easy to assess what the flow of capital from the real to the crypto financial system is. But what is clear is that with speculation and volatility still rife, any destabilising tendency in the crypto market can have a severe impact on the rest of the financial system and the economy.
The Terra-Luna crisis has starkly underlined those features of cryptos that the sceptics have often warned against. Yet, the concerns are already subsiding. As long as there is excess liquidity in the system, speculative finance will fight any effort to regulate the “alternative assets” or the chips they gamble with in their newly built virtual casinos.