Why cryptocurrencies crashed – and what happens next Business

More than $300bn (£246bn) has been wiped off the total value of all cryptocurrencies in circulation as investors panic over the collapse of two of the biggest crypto tokens, while regulators are increasingly watching the market, which was worth nearly $3 trillion at its peak.

What happens to cryptocurrency?

The collapse of the cryptocurrency market mainly concerns two interconnected cryptocurrencies: Terra, or UST, and Luna.

UST is an algorithmic stablecoin. A stablecoin, unlike a cryptocurrency such as Bitcoin which fluctuates wildly, is supposed to have a fixed value, in this case $1.

It’s in the algorithmic part that it gets complicated. While most stablecoins are backed by currency reserves, much like money in a bank account is backed by savings, algorithmic stablecoins are meant to be backed by complicated trading protocols.

This brings us to the second cryptocurrency, Luna. The price of Luna fluctuates, but the software behind Terra stipulates that at any time, a coin can be exchanged for a dollar of Luna.

If Luna is worth 10 cents, UST can still be exchanged for 10 Luna. If Luna is worth $100, UST can be exchanged for one hundredth of Luna, and so on.

In theory, this works as long as Luna has value, even residual. In practice, this is not the case. Terra’s value slowly crashed from $1 to $0.1282. Luna went from over $60 to $0.000 in 1986. A flurry of sales, perhaps triggered by a deliberate attempt to drive down its price, saw confidence in the programming behind Terra plummet, and its software was unable to keep up.

So why are other cryptocurrencies falling?

Cryptocurrency has been compared to digital gold, a way to stave off inflation and a criminal’s best friend. Day to day, however, it runs on trust. The values ​​of Bitcoin and other coins are as much a factor of investor belief as any technical consideration.

So while Terra and Luna’s fall in value may seem isolated, it has significantly shaken confidence in other coins. On Thursday, Bitcoin fell to an 18-month low as $200 billion was wiped off the market value of all cryptocurrencies.

The Luna Foundation Guard, which operates the Terra network, has large reserves of Bitcoin and is expected to sell them in an effort to support the value of Luna and Terra.

However, on Friday the market rallied even as Terra and Luna slumped further, suggesting that investors have not lost faith in the broader cryptocurrency realm.

Will regulators intervene?

Perhaps. Janet Yellen, the US Treasury Secretary, said the fall of Terra demonstrated the need for better regulation and that the US government was preparing a report on the matter.

“It just illustrates that this is a fast growing product and there are financial stability risks and we need a proper framework,” she said.

Cryptocurrency regulation has proven difficult, but governments might be able to give a stamp of approval to those they deem more trustworthy or put pressure on regulated exchanges where the crypto is bought and sold.

Tether, a reserve-backed stablecoin, has faced its own government scrutiny. Last year, the New York attorney general reached a settlement with cryptocurrency companies, saying Tether’s claim to be entirely backed by reserves was false.

Is it a financial crisis?

Probably not. It’s been called a Lehman Brothers moment for crypto, but if so, it’s unlikely to extend beyond crypto.

The total value of all cryptocurrencies is $1.3 trillion, and while $300 billion has been dropped from the figure, it’s hardly systemic. By comparison, Facebook’s parent company Meta lost $230 billion in a single day in February.

Yellen said the crypto does not pose “a real threat to financial stability”, although the more the system develops, the more systemic it could become.

“The links between crypto markets and regulated financial markets remain weak,” Fitch Ratings said. “We expect this to limit the potential for crypto market volatility to spread and cause broader financial instability.”

Will banks and finance companies be affected?

Major financial institutions have pushed further into cryptocurrencies in recent months, particularly on behalf of clients who wanted to benefit from rising cryptocurrency prices. The Bank of England has asked banks to describe their exposure to the space as it reviews the sector.

Fitch said that “many regulated financial entities have increased their exposure to cryptocurrencies, defi [decentralised finance] and other forms of digital finance over the past few months, and some… could be affected if crypto market volatility becomes severe.

While research suggests that 55 of the world’s top 100 banks have some degree of exposure, most banks are believed to have relatively little investment in cryptocurrencies.

A greater risk could be for consumer-facing businesses that allow retail investors to trade cryptocurrencies. These include UK banking app Revolut, investment app Robinhood and PayPal, which has been boosted by allowing users to trade bitcoins.

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This notice was published: 2022-05-16 12:45:07

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