The rocky road of cryptocurrencies

During May, the floor fell out of the cryptocurrency markets with many losing their life savings. You can question why they had their life savings invested in cryptocurrencies in the first place, but what made the price fall so far, so fast? The answer is a combination of things, the core of which is a currency called Terra (LUNA) that is meant to be a stablecoin. Stablecoins are backed by real assets, such as real US dollars, and are meant to be therefore much more, well, stable. How did Terra become unstable? More importantly, having peaked at $120 per coin in April, how could it lose 98 percent of its value in under 24 hours (May 11).

Basically, because there was a downturn in all crypto during April and May, but more importantly because Terra is not the same as other stablecoins which are backed by real assets. This is because Terra was issued as an algorithmic stablecoin. Unlike others, this means that is uses blockchain technology to print money using smart contracts, similar to the way Ethereum’s smart contracts work. The aim of the algorithm is to ensure that Terra’s value remained at USD$1 per coin.

The thing is that the smart contracts can only be executed whilst the currency had the belief of investors and investors started withdrawing funds. The knock-on effect was that the algorithm could no longer execute contracts to maintain parity with the USD, and the price dropped to 70 cents and then 20 cents. In other words, the more people withdrew funds that harder it became for the algorithms to keep the coin stable.

The stabiliser at this point is meant to be the LUNA token. When Terra dips below USD$1, it can be swapped for LUNA tokens (at a small profit). In theory, that's meant to keep the value of both stable.

The thing is that people lost faith in LUNA tokens exactly at the same time as withdrawing money from Terra. The price of the "sister" token dropped from about $US86 at the start of this week, to just 0.003 US cents on Friday 13th.

This meant LUNA crashed at the same time as Terra in a “death spiral”.  Essentially, investors rushed to liquidate their digital assets quicker than the “algorithmic stabiliser” could deal with it.

This has raised questions amongst all crypto watchers. Specifically: how could a cryptocurrency using the technologies that are meant to create stability, drop from a market cap of $40 billion to $500 million overnight and, if that’s the case, could that happen bitcoin and others? Is this market just a massive Ponzi scheme, or does it have substance?

For the financial community, I am sure many will be sitting with a smug smile on their face. The Germans call it schadenfreude. I call it a sucker punch for those who don’t investigate the markets well, and do not understand the risks. If you invested your life savings in a system you don’t understand, it is no wonder you lost that money. Equally, why are you investing your life savings in something you don’t understand? Markets have risk. They go up and down. Only invest what you are prepared to lose. That’s something the financiers understand well.

Does this mean a flight to safety, the rise of CBDCs and the end of bitcoin?

No. It is just another bump on the rocky road to creating decentralised finance (DeFi). Many have never experienced these bumps, but they occur often. The website 99bitcoins.com tracks the media predictions of its expected doom, and there have been many since 2010. And yet, the idea still lives. Why? Because there is a friction between national government issued coins and networked coins. It’s quite hard to send cash over the internet and, with the four-pillar model of cards or the percentage-plus costs of intermediaries, it makes absolute sense to try to move to a networked system that is fast and free. That’s what DeFi is trying to achieve.

So, it won’t end here. I’m very aware of the faults and virtues of both systems – fiat currencies and cryptocurrencies – and believe the end-game will be a hybrid model of CBDCs, stablecoins and cryptocurrencies. The issue with Terra was not the structural faults of these systems; it was the structural faults of Terra and the fact that too many people believe these currencies are all about HODLing (keeping them as an investment) instead of what currencies are really about, which is allowing the exchange of value to buy and sell products and services.

That’s where the real fault lies, and it’s nothing to do with a Ponzi scheme. It’s all about creating currencies that work for value exchange in a networked world.