Time Magazine: The Real Reasons Behind the Cryptocurrency Crash and What Terra’s Collapse Reveals

The cryptocurrency market has entered a free fall this month, and the demise of TerraUSD (UST) has brought even greater misery to everyone, with critics already calling the $60 billion project a Ponzi scheme.

The TerraUSD (UST) project was a stablecoin pegged to the U.S. dollar that its backers hoped would upend traditional payment systems around the world. But it collapsed within days after panicked investors scrambled to withdraw their cash, triggering a vicious and escalating bank run. The collapse bankrupted many investors and brought down the entire cryptocurrency market, wiping out as much as $400 billion in cryptocurrency market value.

“This has been the most painful few weeks in crypto history, and we’ll be thinking about this for a long time to come,” Jake Chervinsky, policy director at the Blockchain Association, a Washington-based lobbying firm, wrote on Twitter.

Terra’s investors are certainly the worst victims, but its downfall could have all sorts of short- and long-term ripple effects for cryptocurrencies and beyond, especially as skeptical lawmakers and regulators investigate the damage. “People have lost their life savings to cryptocurrency investments, and there are insufficient protections to insure consumers against these risks,” Massachusetts Senator Elizabeth Warren wrote in a statement to TIME. “We need stronger rules and enforcement to govern this highly volatile industry.”

What follows is a account of the collapse and what happened afterward.

What exactly happened?

Without any blockchain expertise, it seems difficult to explain Terra’s meteoric rise and fall in a concise summary. In fact, many of Terra’s supporters rely on obfuscation and jargon to refute some of its obvious flaws. This article provides a simple explanation.

Terra has its own blockchain, similar to Bitcoin or Ethereum, and its most important product is the UST stablecoin, which is pegged to the US dollar. Crypto traders use stablecoins as a safe haven during turbulent DeFi (decentralized finance) markets - traders will not convert their relatively volatile assets into hard currencies, which can be expensive and raise tax issues, they will just exchange them for stablecoins.

Some stablecoins derive their value from being fully backed by their reserves. If investors decide to exit, the stablecoin’s fund should theoretically have enough cash to repay all investors at once. UST, on the other hand, is an algorithmic stablecoin that relies on code, ongoing market activity, and pure faith to maintain its peg to the dollar. UST’s peg is also theoretically based on its algorithmic connection to Terra’s base currency, Luna.

Investors have been buying UST for the past six months. The main reason for their purchase is to profit from a lending platform called Anchor, which offers a 20% return to anyone who buys UST and lends it to it. Immediately after the announcement, many critics compared it to a Ponzi scheme, saying it was mathematically impossible for Terra to give such high returns to all investors. Terra team members even admitted that this was the case, but they called the high rate of return a marketing expense to increase awareness, similar to how Uber and Lyft offered heavily discounted rides in their early days.

Meanwhile, some blockchain experts said wealthy investors adopted a tactic last week in which they borrowed large amounts of Bitcoin to buy UST, intending to make huge profits when the value of UST drops, a practice known as “short selling.”

This caused UST’s peg to the dollar to depreciate. A bank run ensued, and investors who earned interest on Anchor scrambled to get out, thinking it was too late. Their actions caused the pegged currency, Luna, to collapse as well, in what is known as a “death spiral.” As of now, UST is worth 12 cents, while Luna is now worth just a fraction of a cent after being worth as high as $116 in April.

A large number of Terra and Luna investors saw their life savings disappear in a matter of days. Many investors spoke openly online about their mental health struggles and contemplating suicide, with posts all over the r/Terraluna subreddit. “I am going through the darkest, worst mental anguish of my life. I lost $180,000 and it doesn’t seem real!” one poster wrote.

Terra drags down Bitcoin and the entire cryptocurrency market

Even before Terra's collapse, the value of cryptocurrencies had been falling, a drop that was partly due to the Federal Reserve's rate hikes (they do this to prevent inflation, which causes people to spend less).

But the collapse of UST has brought another huge damage to the entire market, and the most fundamental reason is that Terra's creator Do Kwon bought billions of Bitcoin as a guarantee for UST. He and Luna Foundation Guard deployed more than $3 billion to defend the dollar peg, creating downward pressure on the market and causing other large investors to sell Bitcoin stocks. Bitcoin hit its lowest point since December 2020, and Kwon's efforts to save UST failed.

“The way these algorithmic stablecoins are designed gives them upward force during bull markets, which is why they are so popular. But that force works the other way in a bear market, exposing their fundamental flaws. So that’s ultimately what triggered (the crash),” said Sam MacPherson, an engineer at MakerDAO and co-founder of software design firm Bellwood Studios.

The ripple effects were felt across the cryptocurrency ecosystem. The company sold about $30,000 of ether on its own to defend UST’s peg to the dollar, sending ether plunging to below $2,000 for the first time since July 2021. The sheer volume of transactions from investors trying to cash out their Ethereum-based stablecoins caused Ethereum’s transaction fees to soar, triggering a more severe run.

Shares of Coinbase, one of the largest and most mainstream companies in the cryptocurrency world, slumped 35% last week, and the entire NFT ecosystem, based on sales volume, has plunged 50% in the past seven days, according to Cryptoslam.

The cumulative result is that the entire ecosystem has lost hundreds of billions of dollars. Many worry that Terra’s collapse is just the first domino to fall, triggering a long-rumored “crypto winter.” A “crypto winter” means that mainstream investors lose interest in investing and values ​​remain depressed for months. Edward Harrison of Bloomberg wrote: “I suspect some cryptocurrencies will become worthless. As investors choose to conserve their energy, capital investment in this space will slow, repeating what happened in the dot-com bubble.”

So, what might this collapse bring next?

Regulation may become more stringent

Stablecoins have long attracted scrutiny from regulators. Congress held a hearing in December to weigh the pros and cons, and also in December, President Biden’s task force called for “urgent” action to regulate stablecoins.

Terra’s collapse provides more evidence for regulators who believe the space needs to be controlled by the government. On May 12, Treasury Secretary Janet Yellen called for “comprehensive” regulation of stablecoins, saying that while the current collapse is too small to threaten the entire financial system, stablecoins are growing rapidly. The risks they pose are the same as the “bank runs” risks we have known for hundreds of years.

Hilary Allen, a professor at American University Washington College of Law, who testified about the risks of stablecoins at a congressional hearing in December, said the aftermath of Terra’s collapse sheds light on what might happen to unregulated cryptocurrencies as they go mainstream. “In a few years, similar incidents will have wider channels and cause more widespread damage. If banks continue to stay close to this space, the situation will be even more serious. I think it’s critical that regulators and policymakers use this incident as an opportunity to build a firewall between the traditional financial system and DeFi.”

Massachusetts Congressman Jake Auchincloss told TIME that he is preparing draft legislation that would require stablecoins to be subject to federal audits. Jake Auchincloss believes that stablecoins can play a role in "maintaining the dollar as the world's reserve currency," so he has no intention of banning stablecoins. However, he wants to bring stablecoins under the jurisdiction of federal agencies such as the Office of the Comptroller of the Currency: ensuring that stablecoin issuers can prove that they have 90 days of liquid reserves and exploring the implementation of mandatory regulations for providing insurance to customers. "We will let private sector actors make their own "risk and reward" decisions, authorizing the federal government to take action to ensure that the sector does not form systemic risks," he said.

Senator Warren, who has long publicly denigrated cryptocurrencies, took Terra’s collapse as evidence that regulators need to “clamp down” on stablecoins and DeFi before it’s “too late.” According to Coindesk, the European Commission across the Atlantic is considering imposing a hard cap on the daily activities of large stablecoins.

Meanwhile, most of the cryptocurrency world seems to have grown accustomed to the looming regulatory reality.

“A lot of lives have been destroyed,” MacPherson said. “The rest of the cryptocurrency ecosystem needs to be open to working with regulators so we can prevent this from happening again.”

The boundary-pushing phase of stablecoins may be over

For years, countless ambitious blockchain developers have wanted to create a functional and secure algorithmic stablecoin, hoping that they might be more resistant to inflation than reserve-backed stablecoins and less susceptible to government supervision and seizure. But such products eventually lost their pegs to fiat currencies and failed. In the news over the past few months, UST was the most successful example in this field, but now it has become the most tragic failure.

Its fiasco will cast a long-lasting shadow on developers who try this approach next, and venture capital firms and investors may be more cautious about adopting similar models. Frax and magic internet money (MIM) are two other boundary-pushing stablecoin projects on the market. Although they maintain their pegs to the US dollar, their market capitalizations have fallen sharply in the past week.

“I think it has sufficiently destroyed all confidence in the algorithmic stablecoin model. There’s a good chance that after Terra, we may never see them again… although I never use the term ‘forever’ when talking about crypto,” Allen said.

Over the past week, many leading figures within the cryptocurrency community have rushed to distance themselves from UST and other types of stablecoins, arguing that stablecoins backed by reserves are relatively safe and should be allowed to continue to thrive with minimal regulation. The Blockchain Association’s Chervinsky wrote on Twitter that UST is “in a class of its own” compared to other “very stable and reliable” models. Matt Maximo, a researcher at cryptocurrency investor Grayscale Investments, wrote in an email that a collapse of UST could boost demand for dollar-backed or over-collateralized stablecoins.

However, Allen believes that reserve-backed stablecoins still have risks. “The funds most similar to these reserve stablecoins are the money market mutual funds whose collapse drove and triggered the 2008 financial crisis. They caused runs and were bailed out.” (Economics reporter Jacob Goldstein made the same analogy on this issue in Time magazine’s October issue “The Future of Money”).

VCs may stop investing in cryptocurrencies

Over the past few years, venture capital firms have poured a lot of money into the cryptocurrency space, perhaps most notably Andreessen Horowitz. Terra itself is also the beneficiary of a number of brand-name investors, including Pantera Capital and Delphi Digital.

The collapse of UST could cause distrust on both sides. "Many institutions investing in the space are likely to see huge losses in the short term, leading to a slowdown in venture capital," Maximo wrote in a letter to Time. Chris McCann and Edith Yeung, general partners at cryptocurrency-focused venture capital firm Race Capital, told Bloomberg this week that they have heard of deals falling apart, repricings and even founders being "abandoned" by potential investors.

MacPherson, on the other hand, blamed Terra’s collapse in part on venture capital firms that lent their institutional credit to dangerous projects. “I think they should take some responsibility because they ruined some regular people who invested in UST without knowing the risks of decoupling,” he said. “Some ‘companies’ made a lot of money on this, and I think they should compensate those who suffered losses.”

Terra’s major investors are now being forced to choose whether to bail out the project or run. Many of them have been silent over the past week. Galaxy Digital’s billionaire founder and CEO Michael Novogratz, who showed off a large shoulder tattoo of the moon in January, has not tweeted since May 8.

A representative from Lightspeed Venture Partners, a large cryptocurrency-focused firm that invested $250,000 in Luna tokens, wrote that they remain focused on the space. “Lightspeed Venture Partners has been investing in the blockchain space for over 8 years. We believe this is a paradigm shift in computing that is more important than the short-term ups and downs of Bitcoin’s price. We are doubling down on our efforts, especially in infrastructure, DeFi, and emerging use cases,” they wrote.

Decentralized finance hype may be slowing

Much of the promise of cryptocurrency lies in its decentralized nature, the idea that its value comes not from manipulable controlling institutions like banks or governments but from cleverly designed code and network effects. Some cryptocurrency enthusiasts this week saw Terra’s collapse as a successful stress test of that assumption: Bitcoin’s ability to hold up during such a massive sell-off proved its durability.

But Terra’s collapse did reveal many centralized pressure points in the ecosystem. If not broken, they at least bent sharply. While cryptocurrencies don’t have CEOs, Do Kwon, the charismatic founder, single-handedly created Terra. After hundreds of billions of dollars in market value were wiped out, he used his position of power to defend his token like the Federal Reserve and in turn crushed the entire market (we wrote to Do Kwon for comment but have not yet received a response).

The attack showed the vulnerability of decentralized exchange Curve pools, whose prices can change rapidly due to the entry and exit of "whales". At the same time, Binance, the world's largest cryptocurrency exchange, also exposed its weakness of insufficient liquidity and difficulty in coping with the large amount of UST entering circulation.

Indeed, Terra’s saga shows that the decentralized nature of blockchain means bad actors can have a huge impact on the system. But many enthusiasts say such incidents actually help weed out those who seek to abuse the system, fostering a stronger and more educated user base moving forward. “The permissionless nature of blockchain means we can’t stop it, but I think we should do a better job of informing the public about the risks,” MacPherson said.

Fewer people would fall for Ponzi schemes... maybe

Whether this failure will stick in people’s minds as a learning experience is another entirely different question. Controversial cryptocurrency entrepreneur Justin Sun announced on Thursday the launch of a new algorithmic stablecoin that offers lenders an annual interest rate of up to 40%. Galois Capital responded sarcastically on Twitter. “This is a self-regulating industry and someone needs to learn a lesson. The results are mixed.” It seems that as long as the lure of extremely high wealth returns remains, there will still be many cryptocurrency investors willing to accept extremely high risks.