What does TerraUSD’s death mean for the crypto market?

In the week of May 9, we saw the spectacular death of cryptocurrency TerraUSD. It shook the crypto world. The market value of the entire crypto market fell by $ 300 billion, or 15%. Bitcoin also fell sharply, but less than other cryptocurrencies. Why did TerraUSD fall so hard in such a short time? What kind of coin was it? And what does the fall of this cryptocurrency mean for other cryptocurrencies and the sector as a whole?

In the world of cryptocurrencies, there are several ways in which the value of the coin is determined. Ease of use plays a role, as does the cryptocurrency used on the Ethereum platform. But also the promise of future opportunities as a means of savings, such as with Bitcoin.

Transaction funds

There are also cryptocurrencies that are used as a means of transaction to trade with other cryptocurrencies. These transaction coins are called stablecoins because they aim to maintain a stable 1-to-1 exchange rate with common currencies such as the euro and the dollar. Traders prefer to use stack coins for transactions within the cryptocurrency ecosystem because then there is no need for any conversion to and from mainstream currencies. This conversion is inconvenient and time consuming due to the strict money laundering laws and regulations that banks have to comply with. This is not necessary with stack coins.

To put the value of these cryptocurrencies into perspective, the three most important stack coins today – Tether ($ 73 billion), USDC ($ 53 billion) and BinanceUSD ($ 18 billion) – together represent a market value of $ 144 billion. That’s more than 10% of the current total market value of $ 1.3 trillion.

Growth in stablecoins market value (Source: The Block)

Stable value

The value of a stack coin should never fall below a fixed value, for example $ 1 or € 1. This stable value makes them suitable for trades because in theory there is no price risk. But how can the value of a stablecoin remain exactly $ 1 or $ 1? The most common and safest way is for the organization behind the currency to support its value by buying securities – usually short-term government bonds in practice – and holding cash. These funds are very liquid and are easy to buy or sell to secure the value of $ 1. The most common stablecoin that uses this type of coverage is Tether. Another is USDC, the stablecoin managed by the cryptocurrency exchange platform Coinbase.

Another way to stabilize a stablecoin is through an algorithm. The issuer of such a cryptocurrency then uses a mathematical formula to determine how many purchases or sales should be made of a particular currency to stabilize its value. By regulating the supply of stablecoin in this way, the price can be brought to $ 1. The money that investors in this type of stack coins with algorithm put in is therefore not invested in low-yield securities such as with Tether. Examples of coins that work with an algorithm are ‘magic internet money’ (MIM), ‘frax’ (FRAX) and ‘neutrino usd’ (USDN) as well as the crashed coin TerraUSD.

Algorithm

Stablecoin TerraUSD consisted of two components, UST and another coin, Luna. Its inventor, 31-year-old Korean Do Kwon, devised an inventive ‘burn and mine’ procedure to keep its value around $ 1. The currency that was to remain stable, UST, was bought or sold by Luna. If UST fell below $ 1 because demand for it fell, a quantity of UST was “burned” by the algorithm’s price adjustment. This price adjustment made it attractive for owners of Luna to buy UST. Increased demand for UST pushed the price back to $ 1. In one year, this algorithm-backed stablecoin became immensely popular and brought enormous wealth to many people.

People who owned Luna could trade, borrow and borrow with it on the TerraUSD trading platform. The platform promised an interest rate of 20% on deposits. This high interest rate created a large buffer that increased confidence in UST and Luna, which in turn pushed up prices. At the end of April, there was an amount of $ 18 billion in cryptocurrencies in the platform’s account, on which it paid a high interest rate.

pyramid scheme

Do Kwon bought an amount of Bitcoin worth $ 3.5 billion with the money invested by investors. He also invested a lot of money in the community of software developers who designed smart contracts for the trading platform. The Luna was also recommended by influential venture capitalists such as Michael Novogratz. Investors called themselves “lunatics”, meaning lunatics. Novogratz had another tattoo in January this year with the word maniac in it, to show that he fully believed in this coin.

The first problems arose when investors decided to withdraw money from the crypto market due to financial turbulence in the stock markets and in the ‘normal’ money and capital markets. Investors began selling positions in UST. Its value dropped to under $ 1, and new Lunas were created to accommodate this. However, the amount needed to support UST was so large that Luna was also quickly written off and eventually dumped. The result was a price implosion for both UST and Luna. In one day, both cryptocurrencies became virtually worthless. The algorithm-backed stablecoin proved to be a pyramid scheme that could only continue if prices and deposits rose. In the end, Novogratz’s company, Galaxy Digital, lost $ 112 million.

At the height of its popularity, TerraUSD was the third largest stable currency, after Tether and USDC, with a market value of about $ 40 billion, the value of total outstanding coins. The two charts below clearly show the price development of the two components of TerraUSD. UST dived below $ 1 and the value of the Luna implied:

TerraUSD price trend (Source: Coinmarketcap)

The value of stablecoin terraUSD completely collapsed (Source: Coinmarketcap)

Winners and losers

How could this happen? For the first time since the introduction of Bitcoin and later the many other thousands of cryptocurrencies, there was a headwind in the form of rising interest rates in the ‘normal’ financial economy. This spectacle produces winners and losers. Investors who believed in the golden mountains of cryptocurrencies are the losers. Bitcoin also fell sharply during the fall of the stock market and the subsequent fall of UST / Luna. On Monday, May 16, the fund behind Luna announced that the offering of Bitcoin had actually been sold in a hectic attempt to save UST after all.

Paradoxically, the crypto sector may become a winner in the long run. After the implosion of the dotcom bubble in 2001, the internet really grew. Business models were developed that really helped people. A similar development may present itself in the crypto sector. These difficult market conditions are necessary to separate the wheat from the chaff in the crypt world. After all, there are currently almost 20,000 different cryptocurrencies, most of which have no added value at all. Some coins – such as TerraUSD – are ponzi schemes of parties trying to take advantage of the popularity of virtual coins. The most solid cryptocurrencies will emerge as the winner. Given the gloomy state of the Western monetary and financial system, this is both desirable and even probable.

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