From Terra Crash to the Bear Stash
From the crash of Luna to the bankruptcy of 3 Arrows Capitals — what does this mean for the cryptocurrency sector?
2022 has seen carnage in the cryptocurrency industry. In 2021 the market was valued at over $3 trillion, having quadrupled its 2020 year-end value. But within May this year, this fallen to around $1 trillion, dragging the cryptocurrency industry into the bear market.
The trigger point for this avalanche? The crash of TerraUSD. Even the launch of Luna 2.0 can’t help much, price tanked over 88% in just 4 hours since its launch. The numbers indicated a substantially problematic phenomenon that the crypto space failed to tackle.
The fall of the crypto “blue-chip”
Terra is a blockchain started by the Terra Foundation, with one of the most revolutionary product its stablecoin on chain — TerraUSD (UST).
While other stablecoins like USDC, USDT and BUSD are pegged to an actual state-issued fiat currency like US dollars, UST was, instead, backed by its chain native token LUNA, and built on the premise that with clever algorithms and a large reserve of bitcoin, that its dollar peg could be maintained simply by the burning and minting of LUNA tokens to make an exchange.
The mechanism worked as follows: If UST fell below $1, the algorithm would buy the coin and convert it into LUNA, earning arbitrage profits. The increased demand for UST, coupled with the supply falling as people burn it in exchange for LUNA, would drive the price back up.
To draw investors’ support for UST, Terra’s Anchor Protocol offered them massive annual yields of 19.5%. And to secure confidence, Terraform Foundation bought around $2.3 billion in bitcoin and announced plans to increase the reserves to $10 billion of crypto assets — reassuring investors that it would be able to easily sell and buy TerraUSD to keep the $1 peg.
For a while, this seemed to work. In 2021, while Bitcoin had its ups and downs, Terra remained within a stable price point.
As investor confidence rose, so did the price of the LUNA token. It started 2021 at $0.66 and closed at $89, hitting an all-time high of $104.58 in March this year. Market capitalization of TerraUSD likewise exploded, ascending from $3 billion to $15 million market cap in March 2022.
Then, on 8 May, $2 billion in TerraUSD was extracted all at once.
UST depegged to $0.91, and hundreds tried to cash in on the drop. But the mechanism for exchanging UST for LUNA couldn’t keep up. When it became clear the peg could not be retained, widespread panic ensued, setting off a vicious cycle of investors pulling out and sending UST, LUNA and the entire crypto ecosystem into a downward spiral within days.
A similar tale of risk and hubris
One might see Terra’s rapid fall from grace and devastating ripple effect on the industry reminiscent of the 2008 Lehmen Brothers crisis.
Like Terra, the Lehman Brothers had cleverly leveraged on a growing market to make a fortune — in their case, the growing U.S housing bubble. As the real estate market grew, so did its capital market revenue and by 2007, the company announced 4.2 billion in net income and $19.3 billion in revenue. Its stock price in February that year reached $86.18 per share, giving it a market capitalization of nearly $60 billion.
The cause of its downfall is also arguably similar: A lack of liquidity.
Lehman’s business model required it to raise billions of dollars everyday and it was heavily reliant on short-term funding deals known as repurchase agreements. However it has also invested heavily in the high-risk subprime mortgage sector, where defaults on subprime mortgages were rising and investor confidence was low.
By 2008, it had $639 billion in assets, but these were difficult to sell. Cash flow problems forced Lehman to file for bankruptcy. In turn, money market funds with loans issued by Lehman were unable to maintain their net asset value, kicking off the same vicious cycle of investors fleeing and price falling.
Surviving the aftershocks
In both cases, it was almost as if liquidity across the economy dried up overnight — sending the markets into crisis. Lehman’s bankruptcy arguably brought the economy into the Great Recession, with unemployment more than doubling to 10 percent. Similarly, since Terra’s collapse, layoffs have spread across the blockchain industry, with at least seven firms reporting reduced workforce numbers.
Undoubtedly, both traditional and crypto investors will need time to patch the losses from the latest crash, and if the 2008 crisis — which lasted around 18 months — is anything to go by, it is likely that the crypto market will not bounce back quickly.
Crypto-credibility questioned by HODLERS
After all, just as the Lehman crisis eroded the faith in financial institutions, so the Terra crash has diminished faith in the legitimacy of the crypto industry.
It also does not help that while the Lehman Brothers vanished from the investment banking sphere, Terra lives on. It has released Luna 2.0, a new version of its failed cryptocurrency on exchanges like Bybit, Kucoin and Huobi, a move couched as providing restitution and propelling recovery of the crypto sector.
The problem is that this comes in spite of the company facing various legal suits and mass resignation and allegations of Terraform Labs moving $4.8 million worth of assets through a shell company — all of which continues to eat into its credibility; and despite all the “red flags”, shilling of Luna 2.0 continue to soar, giving false hope to those who’ve already lost a fortune investing in their project.
Hope on the horizon
Nonetheless, in the middle of difficulty lies opportunity.
As Brett Harrison, Head of FTX.US aptly put it in an interview with CoinDesk: “There was no lack of transparency [in what Terra offered] and everyone understood there was risk in the asset itself. I mean, to be able to offer a 20% yield on a token, that sort of very high yield doesn’t come without risks.”
“So much capital has moved into the private equity space in crypto,” he continued. “There are a lot of teams that are building and creating new infrastructure, building out new projects, and we’re probably going to see a lot of that investment come back over time.”
So what does this mean for crypto-HODLERs?
Likely, that the DeFi space will continue to grow — only this time with a clearer scope of crypto regulations in the future to avoid the situation from recurring.
Ultimately, there is hope for the comeback of the bulls market, and opportunities for those buying into the dip to convert the bear economy into a bear stash. But the need is to tread with caution!
Disclaimer: It’s my personal insight on the current market trend which should not be considered as financial advice.
