Comment: Why did Terra Luna crash, & why does it matter?

Something that might seem far away can have a big impact on seemingly unconnected areas.

Mothership | June 01, 2022, 10:49 AM

Follow us on Telegram for the latest updates:

COMMENTARY: "If crypto is just people minting fake money and sending it around, why should real people in the real economy care?"

Startup co-founder Shawn Low explains the recent crash of Luna and TerraUSD cryptocurrencies, and why it matters — even for those not currently investing in crypto.

Low has experience founding, building and advising technology start-ups. He had previously co-founded, a platform aimed at making homeownership more accessible for all, and is currently working on a new venture.

By Shawn Low

A few weeks ago, there was a major crash in the cryptocurrency (crypto) world. One of the largest stablecoins TerraUSD (UST) lost over 90 per cent of its value within a week. The loss of confidence reverberated across the crypto ecosystem causing over US$300 billion (S$412 billion) in losses for investors all over the world.

I don’t own cryptocurrency. Why does this matter to me?

The world we live in today is highly interconnected. If you told people in 2007 that Wall Street bankers had been mispricing Mortgage-Backed Securities for years, they would probably have said they had no idea what those things were, and couldn’t see why that would matter to them. Yet that resulted in the worst global financial crisis since the Great Depression.

More recently, Singapore has few direct links with Ukraine and Russia. Nonetheless, the war is contributing to global inflation and most recently, resulting in a shortage of chickens in Singapore.

What does this have to do with crypto?

Something that might seem faraway (like crypto) can have a big impact on seemingly unconnected areas (like the rest of the economy) too.

An estimated 1 in 6 adult Singaporeans own some crypto today, and adoption is expected to rise in the coming years. 80 per cent of institutional investors expect digital assets like crypto to replace traditional assets in the coming years. At home, our wealth funds Temasek and GIC have both made sizable investments in crypto and blockchain-related firms.

Many thoughtful observers are of the opinion that crypto is likely here to stay. And whether you are invested in crypto or not, it is probably worth understanding a little more about what happened and why it could matter for the global economy and Singapore.

Okay, so a cryptocurrency crashed. Aren’t cryptocurrencies notoriously volatile? Why is this surprising?

You are right. Most cryptocurrencies are highly speculative and volatile assets.

UST was supposed to be different. It was a stablecoin whose value was supposed to be pegged 1:1 to the US dollar (USD). 1 UST was supposed to always be valued and exchanged for 1 US dollar.

What is a stablecoin? I’ve only heard of Bitcoin and Ethereum

Bitcoin and Ethereum are the two largest and most common cryptocurrencies in the world. However, their value fluctuates too much for them to be used as a reliable medium of exchange. Your Bitcoin today could easily be worth 2 times or half its value in 6 months, nobody really knows.

Stablecoins, on the other hand, were created to have a stable value to enable reliable payments and transactions across the crypto ecosystem.

If stablecoins were meant to be equivalent to real currencies like the US dollars, then why bother using stablecoins at all. Why can’t people just pay using US dollars directly?

Stablecoins are often needed to access applications and protocols within the crypto ecosystem. It’s something like exchanging money for tokens in order to play the games in arcades.

How do these stablecoins work?

The original stablecoins like Tether (USDT) and USD Coin (USDC) were backed by USD denominated reserves. Every USDT / USDC token is supposed to be backed 1:1 to cash or cash equivalent assets like US Treasuries. The companies running these stablecoins publish monthly audited reports on the value of their reserve.

UST is not like these reserve-backed coins. UST is an algorithmic stablecoin whose value was supported by a partner crypto token called Luna.

What on earth is an algorithmic stablecoin?

These are stablecoins that are not entirely backed by reserves. Instead, they rely on computer algorithms to manage the supply of the stablecoins to ensure that the value retains its peg.

In this case, the algorithmic rule was that 1 UST could always be exchanged for US$1 worth of Luna. Hypothetically, if Luna was worth US$0.5, each UST would get you 2 Luna. If each Luna was worth US$5, each UST would get you 0.2 Luna.

Sure, but how does that mean that UST was always supposed to be US$1?

Because of this relationship, if UST was US$0.99, you could always buy 1 UST for US$0.99, and exchange it for US$1 worth of Luna, making a profit of US$0.01. In making the exchange, you would essentially destroy (burn) UST and create (mint) Luna. This would decrease the supply of UST until it hit US$1.

The reverse is also true. If UST was US$1.01, you could buy US$1 worth of Luna and trade it for 1UST. You would burn Luna and mint UST. This would increase the supply of UST until it hit US$1. By adjusting the supply of UST, it was algorithmically pegging it to US$1.

That’s complicated. But I guess it kinda works?

Well, there’s a catch. For this mechanism to work, people must believe that Luna is worth something. It could be worth $1 or $10, but it had to be worth something. Otherwise, if people believe that it is not worth anything, whether it’s 10 Luna or 1 million Luna, it will be worth exactly $0.

And in theory, Luna was supposed to be worth something because of the Terra ecosystem that it was supporting. Just before the crash, the Terra ecosystem was the second-largest crypto ecosystem with nearly US$30 billion in assets deposited. Within this ecosystem was a range of crypto projects including payments solutions for cheaper and faster e-commerce checkouts, crypto-exchange platforms, and lotteries.

So what made UST special and why did it grow so big?

One of the main drivers of UST’s rapid growth was Anchor Protocol, a crypto project on the Terra ecosystem. It was touted as a savings vehicle that promised people 20 per cent  annual returns on their UST holdings if people deposited their UST stablecoins there.

For comparison, your regular bank savings deposit barely yields 0.05 per cent  in interest. The returns promised by the Anchor Protocol were also roughly double the historical stock market average of around 10%.

Believing that UST was supposed to be a stablecoin backed by one of the world’s largest crypto ecosystems, people flocked to put money into Anchor Protocol and this drove up the demand for UST and Luna in a very short time.

20 per cent return! That sounds like a scam.

Hindsight is always 20/20. At the time, many, many people bought in the idea and that drove UST to become the 3rd largest stablecoin by market capitalization just barely 1.5 years after its launch in September 2020.

So what caused the crash?

It’s still unclear what exactly happened that caused the crash. There have been rumours of a speculative attack on UST but no one knows for sure.

But what is clear is that people lost confidence in the coin, and caused 1 UST to be no longer worth 1 US dollar. UST was depegged from USD.

This led to a downward spiral as people who had put money into UST quickly tried to sell their holdings, increasing the supply UST, which drove prices down further. Luna was supposed to support UST but people also lost faith in the entire ecosystem and were dumping Luna as well.

If Luna is worth nothing, the whole ecosystem is gone. Within a week, the value of UST went from US$1 to barely 7 cents. The Luna token, which had been trading as high as US$113 (S$155.19)  at the end of March, was worth less than 1 cent by mid-May.

Didn’t anyone try to do anything?

Attempts were made to revive UST, with limited success. The US$40 billion (S$54.93 billion) collapse of the Terra ecosystem also destabilised the broader crypto economy, wiping out US$300 billion (S$412 billion) in value.

To put things in perspective, the market capitalisation of two widely known tech unicorns Sea Ltd and Grab Holdings are currently at ~US$45 billion (S$61.8 billion) and ~US$10 billion (S$13.7 billion) respectively. People who converted their money into Luna and UST lost almost everything.

Ouch, that sounds painful. Okay, so what should we take away from this episode and why does it matter to me?

I think there are a few takeaways. First, I would be generally cautious about the value represented in crypto ecosystems today.

UST and Luna may have failed for a variety of reasons (e.g. speculative attack, mismanagement, lack of diversification). It may even have been doomed from the beginning if you believe that algorithmic stablecoins could never have worked in practice.

Regardless, the broader point is that when push came to shove, not enough people believed that the Terra ecosystem was worth something anymore. By the end, Luna had so many zeros after the decimal point that it was essentially worthless. This is in spite of the fact that Terra was — if the crypto press was to be believed — a vibrant ecosystem supporting many projects with real-world applications.

Are you saying that there’s a crypto bubble?

Bubbles are always hard to recognise in the moment. However, I see a number of parallels with the dot com bubble from over 20 years ago. The internet was new then and we were still discovering how exactly it could be used. Low interest rates fueled a period of easy money. Internet companies could raise money without needing to show profitability or even revenue. Speculation drove valuations way beyond actual value in the short term, which was not sustainable.

Crypto and blockchain today are still technologies looking for mainstream use cases and adoption. Comparing it to the internet, it’s still in the days of the dial-up modem. A far cry from today’s on-demand YouTube and Netflix, one-click e-commerce checkouts, and where information about anything and everything can be literally found from a device you carry around.

Personally, I’m quite bullish on crypto and blockchain technology over the long-term, particularly its use in providing a trusted and decentralised means of ownership. This is a real problem with many potential use cases in the real world. For instance, 70 per cent  of the world’s population still does not have legal property rights to their land.

However, the noise of crypto is blocking out most of the signal today.

But if crypto is just people minting fake money and sending it around, why should real people in the real economy care?

One of the risks with crypto is its possible contagion effect on the real economy.

Depending on when you measure it, the total crypto market is worth ~US$1-2 trillion (S$1.37-2.75 trillion) today. This is ~1-2 per cent of the US$90 trillion (S$123.60 trillion) total value of all publicly traded companies globally, and may appear relatively small.

That said, keep in mind that the 2008 financial crisis was also triggered by the securitized subprime mortgage market that isn’t too far off in size from the size of the crypto market today.

In fact, the European Central Bank flagged this exact risk in their biannual report released this month. The ratings agency Fitch also sounded the alarm last year that stablecoins could pose risks to short-term credit markets especially if there was a run on the stablecoin, and all holders suddenly decided to trade in their stablecoins for cash.

Notably, the crypto market has been growing fast, and some estimates have it growing by 50 per cent  annually, to over US$30 trillion (S$41.2 trillion) by 2027. If it’s not a risk now, it will certainly be by then.

So what is the government doing about it?

Singapore has an aspiration to be a responsible crypto hub. The recent crash was probably a blight on this aspiration as TerraLabs (the company that owns the Terra ecosystem) and its associated entity Luna Foundation Guard (LFG) are both registered in Singapore. And Singapore is already known to be one of the more open environments for crypto experimentation.

However, regulating crypto is not really that easy.

How so?

For one, there’s the obvious issue that crypto is mostly borderless. Bans in one jurisdiction will just lead crypto businesses to relocate to other more permissive locales.

China has put up probably some of the toughest bans globally, and haven’t been fully able to stop people from crypto mining or people from using crypto within its borders.

So why can’t we just do what China is doing then?

Well, new technology can also represent new opportunities. In this sense, crypto being digital and requiring some responsible oversight could actually play to Singapore’s strengths. We are already an established financial hub with a well-respected regulatory framework.

With the right regulatory oversight, it could also attract new entrants in this industry to set up shop in Singapore, creating jobs and stimulating our economy.

But what about Singaporeans who lose their money in crypto?

On this front, the government is already taking some steps to protect retail consumers such as not allowing crypto-related advertisements and halting the use of crypto ATMs.

However, it’s unlikely that any regulation will be entirely successful at preventing people from gambling on crypto.

Like in a casino, there will always be some who throw caution to the wind, who are going to end up getting hurt.

Unlike a casino though, the regulatory challenges on a decentralised online network will be more technically challenging to navigate. Ultimately, it is caveat emptor/buyer beware and consumers have to take responsibility for their own actions.

Read more from Low here:

Top photo by Shubham Dhage on Unsplash