Terra Luna is a stable coin tied to the US dollar that its backers anticipated would disrupt existing payment systems around the world. This month, cryptocurrency markets have been in free – fall, aggravated by the failure of a $60 billion venture that opponents have labeled a Ponzi scam.
However, it was washed away in a matter of days as anxious investors attempted to withdraw their funds, resulting in a violent, self-enforcing bank run. Many investors declared bankruptcy as a result of the meltdown, which also brought down the whole crypto market, wiping away nearly $400 billion in market capitalization.
On Twitter, Jake Chervinsky, the director of policy at the DC-based lobbying group Blockchain Association, stated, “This is among the most traumatic days in crypto history & one we’ll grapple with for a long time to come.”
While Terra Luna shareholders were hit the hardest, its demise could have short- and long-term ramifications for cryptocurrency and then beyond, particularly as suspicious legislators and authorities survey the damage.
“People are losing their life savings via cryptocurrency investments, but there are not enough safeguards to protect consumers from these risks,” Massachusetts Senator Elizabeth Warren told TIME. “To control this pretty unstable sector, we need tighter laws and enforcement.”
Here’s what went wrong, and what’s next.
What Happened, Exactly?
Without prior knowledge of the blockchain, Terra’s fast ascent and collapse can be difficult to explain simply. To counter much of its glaring shortcomings, many of its supporters used obfuscation and language. Here’s a quick rundown.
Terra Luna, like Bitcoin and Ethereum, has its own blockchain. The UST stablecoin, which is tethered to the US dollar, is its flagship model. Crypto traders use stable coins as safe havens when marketplaces in DeFi (decentralized finance) get bumpy: instead of changing their more unstable assets into actual cash, which can be costly and result in tax issues, traders just trade them for stablecoins.
Some stable coins get their worth from the fact that they are entirely supported by reserves: if investors chose to cash out at any point, the stable coin’s basis should potentially have quite enough cash on hand to refund them in one go. UST, on the other side, is an algorithmic stable coin that maintains its tie to the dollar through coding, continuous market activity, and blind faith. The algorithmic relationship between UST and Terra’s basic currency, Luna, supposedly supported the peg.
Investors have been purchasing UST for the past six months with one goal in mind: to gain from a lending and borrowing platform called Anchor, which provided a 20% rate to anybody who purchased UST and lent it to the protocol.
Many detractors instantly compared this possibility to a Ponzi scam, claiming that it would be technically impossible for Terra to pay such a high return to all of its investors. Terra team members even admitted as much—but compared the rate to a marketing investment to raise awareness, similar to how Uber and Lyft offered heavily reduced fares at the start of their operations.
According to several blockchain specialists, affluent investors borrowed large sums of Bitcoin to acquire UST weeks ago, with the purpose of profiting handsomely when the price of UST collapsed, a strategy known as short-selling.
As a result, UST de pegged to the dollar. Investors who had received interest through Anchor were racing to get out before it was too late, resulting in a bank run. In a “death spiral,” their action prompted the associated currency Luna to plummet as well. UST is currently around 12 cents, while Luna is just a fraction of a penny after reaching a high of $116 in April.
Many Terra and Luna investors’ life savings disappeared in a couple of days. People speak up about their psychological problems and thoughts of suicide on the r/Terraluna subreddit. “I’m going through some of the deepest, most intense mental suffering I’ve ever experienced in my life.” One poster remarked, “It still doesn’t seem real that I lost $180,000.”
Terra dragged down Bitcoin and the whole crypto market
Cryptocurrency values were already on the fall before Terra’s meltdown, owing in part to the Federal Reserve boosting interest rates. (This was done to prevent inflation, which caused individuals to spend less money.)
The crash of UST, however, caused another knock in the broader market, owing to the fact that Terra founder Do Kwon had purchased billions in Bitcoin as a safety net for UST. He exerted a downturn on the market when he and the Luna Foundation Guard invested more than $3 billion to maintain the peg, leading other significant investors to dump their Bitcoin shares. Bitcoin fell to its lowest level since December 2020, and Kwon’s attempt to preserve UST failed.
“The way these algorithmic stablecoins are structured, they have an upwards impetus throughout bull markets,” says Sam MacPherson, a MakerDAO engineer and co-founder of the software design firm Bellwood Studios. “However, during bear markets, the very same forces act in the opposite direction, exposing fundamental problems.” So that’s what ultimately sparked.”
The repercussions were felt across the whole crypto community. Because companies sold about $30,000 of Ether to preserve UST’s peg, the cryptocurrency fell under $2000 for the first time since July 2021. As additional investors attempted to cash out their Ethereum-based stable coins, the transaction volume led Ethereum’s transaction costs to rise, leading even more cash to be lost.
Last week, Coinbase, one of the largest and most well-known cryptocurrency exchanges, fell 35%. As per Cryptoslam, the NFT ecosystem’s sales volume has dropped 50% in the last 7 days.
Hundreds of billions of dollars were lost in the environment as a result of the cumulative effect. Many fear Terra’s demise will set off a long-awaited “crypto winter,” in which mainstream investors lose interest and prices remain low for months. “I presume some cryptocurrencies will be meaningless, and capital investment in the space will slow to a crawl as investors help and support their losses, much like we saw during the Internet bubble,” Bloomberg’s Edward Harrison wrote.
So, what might happen as a result of the accident?
Regulations Might Tighten
Authorities have been watching stable coins for a long time. In December, Congress held a hearing to assess the risks and advantages. President Biden’s working committee urged for “immediate” action to control them the same month.
The fall of Terra provides authorities with even more ammunition to claim that space should be under government control. On May 12, Treasury Secretary Janet Yellen termed for “comprehensive” stable coin regulations, claiming that while the current collapse is too small to endanger the entire financial system, stable coins are “growing very rapidly” and “reveal the very same type of issues that we have known for ages in connection with bank runs.”
The fallout of the Terra crash, according to Hilary Allen, a professor at American University Washington College of Law who gave testimony about the dangers of stable coins at a congressional hearing in December, offers a glimpse of what could be in the supermarket if crypto moves toward the mainstream without a regulation. “Something like this might have many more avenues to inflict larger damage in a few years,” she says, “particularly if the banks continue to push nearer to this space.” “It’s vital, in my opinion, that regulators and policymakers see this as an opportunity to build whatsoever barriers they can between both the traditional banking system and DeFi.”
Representative Jake Auchincloss of Massachusetts tells TIME that he’s working on legislation that would require stablecoins to be inspected by the federal government. Auchincloss does not want stablecoins to be banned because he feels they can help “maintain the US dollar as the world’s reserve currency.” But he wants stablecoins to be regulated by a federal agency such as the Comptroller of the Currency, and he wants to see if stable coin makers can show they have 90 days of liquid reserves and if they should be required to provide the insurance to users. “We’re going to strengthen the federal government to make sure that no systemic danger emerges from the private sector,” he says.
Senator Warren has been a strong opponent of cryptocurrency, citing Terra’s demise as proof that regulators must “crackdown” on stablecoins and DeFi “now before it’s too late.” According to Coindesk, the European Commission is contemplating placing a hard cap on the everyday activities of major stablecoins.
However, most of the crypto community appears to have accepted the inevitability of impending regulation. “Many lives have been destroyed.” “The rest of the crypto ecosystem needs to be open to collaborating with authorities so that we can prevent future incidents like this,” MacPherson adds.