The Cryptocurrency World is in Crisis, This is Why

The cryptocurrency world is in crisis and this is not new. Veterans of the space will have seen similar events before but each of the previous doomsday events had consequences that affected the industry for years, and this event will be no different.

First, some background. Bitcoin and other cryptocurrencies were already having a tough time this year. That is largely attributed by mainstream media outlets to falling stock markets, increased interest rates, and global insecurity, and those likely have played a factor. But it also follows a pattern Bitcoin has been following from its inception - it explodes rapidly and then contracts slowly.

From October to December 2013, bitcoin increased in price from roughly $130 to a peak of $1,151. It then contracted over the next two years, hitting a low of $178 in January 2015. It took almost three years for bitcoin to hit its next peak, reaching over $19,000 in December 2017.

However, it then contracted for a year, bottoming out at $3,236 in December 2018. That lasted until bitcoin’s most recent skyrocketing when it topped $67,566 in November 2021 and since then, the pattern has continued, with bitcoin mostly losing value.

Bitcoin was already on a path of contraction when events over the last few days sent the entire industry into free fall. Bitcoin currently sits at $29,644, its lowest level since December 2020.

What makes this drop different from most - but not all - previous drops is that it coincides with a crash of a mostly but not entirely unrelated cryptocurrency, and that is creating uncertainty and doubt in the industry.

The culprit, in this case, is a popular cryptocurrency coin and ecosystem known as LUNA. LUNA is one of those coins that come with a bevy of industry buzzwords: decentralized finance (DeFi), non-fungible tokens (NFTs), Web3, and Distributed Autonomous Organizations (DAO).

If you don’t know what that means that isn’t important for the scope of this article, what is important is that LUNA, like the more popular ethereum, is more of an interconnected ecosystem of dozens of projects powered by cryptocurrency rather than just a cryptocurrency. Stablecoins were a big part of LUNA’s system.

Stablecoins are a relatively new - as in a few years - addition to the cryptocurrency space. They use various means, either financial backing or algorithmic trading, to keep the price of a cryptocurrency pegged to a fiat currency like the US Dollar. This has been a great help to cryptocurrency investors, giving them a haven for their funds during bear markets without having to incur the fees, or time, it takes to switch between fiat and cryptocurrencies. The most popular stablecoin in LUNA is TerraUSD, better known by its ticker symbol, UST.

Unlike USDC and USDT, two other popular stablecoins who use assets to maintain their peg, UST is algorithmic, not unlike early attempts at stablecoins such as NuBits, and was maintained by LUNA’s creators Terra.

The idea is that whenever UST goes above $1, users are able to trade $1 worth of LUNA for 1 UST, which, since its price is above $1, would be a “risk-free” investment for them. Conversely, if the price of UST goes below $1, users can trade the coin for $1 worth of LUNA. In theory, this should keep UST at $1 because whichever way it goes, there should be buyers and sellers on both sides, using the opportunity to pocket some quick cash, pushing the price in the right direction.

This system worked from late 2020, until a few days ago when it didn’t. On Sunday, UST dropped below $0.80 and it has yet to recover. By Wednesday morning, it dropped as low as $0.27 and at press time, it sits at $0.70.

LUNA’s other stablecoins, attached to other fiat currencies like the Yuan and Euro, are similarly down.

There are a lot of unknowns at this point in the story. What seems likely is that a big investor decided to unload their UST holdings and the LUNA algorithm was unable to deal with it.

With the formerly stablecoin dropping, more and more investors would be incentivized to trade that $0.80, $0.75, $0.70 UST for $1 in LUNA, but as UST failed the stabilize, uncertainty arose around LUNA itself, causing investors in that token to flee to cryptocurrencies like bitcoin and ethereum or even out of cryptocurrency altogether. This would have created a dual downward pressure on both coins, making UST’s return to its peg continuously more difficult. LUNA, which was as high as $116 earlier this year, sits at $1.08 at the time of this writing.

The aforementioned NuBits used a similar system. It had a companion coin named NuCoin which was intended to be the investment coin that enabled NuBits to remain stable. But once NuCoin lost its popularity, it was unable to maintain NuBits’ peg.

Theories abound about who the 'big investor' was, what their motivations may have been, or if they existed at all. All we do know is that UST lost its peg and according to a recent report from CoinDesk, its creator may have been the anonymous creator of Basis Cash, a short-lived and failed stablecoin that never reached parity with the US dollar as intended.

How all this affects the larger cryptocurrency market is multifold. First, UST was massive, with a market cap valued at $15 billion before the crash. Assuming Terra was an honest actor in all of this, it is likely, though not confirmed, that Terra would have used their assets to buy LUNA in an attempt to keep that token’s price high. That means an untold amount of other cryptocurrencies flowing into one most investors were fleeing.

More significantly, is panic selling across the board. If a popular stablecoin drops, investors aren’t likely to put that into another stablecoin or a cryptocurrency known for volatility, they are likely to move their holdings back into fiat. There are also concerns that this event will encourage lawmakers, already pushing for regulations of cryptocurrencies to further regulate them, with a focus on stablecoins.

And that, most likely, will be the lasting legacy of the LUNA debacle. Bitcoin will recover like it has many times in the past. The 2013/2014 crash was preceded by the collapse of the Mt.Gox exchange, which was by far the largest cryptocurrency exchange at the time.

Bitcoin was sent to the desert for years after that event but it eventually recovered and dwarfed its previous high. But that led to regulations of cryptocurrency exchanges in most countries with a significant cryptocurrency presence. LUNA may die, and regulators may take a look at the other stablecoins, but bitcoin will continue on, eventually.