Monetary Policy

What the Hell Just Happened With Crypto?

Last week, the price of bitcoin fell to lows not seen since 2020 while a prominent stablecoin collapsed. Does this mean it was all a Ponzi scheme?


The cryptocurrency world took a beating last week. The price of bitcoin fell to lows not seen since 2020; Coinbase, the largest cryptocurrency exchange, saw its stock plummet; and a prominent "stablecoin" called Terra, along with its associated cryptocurrency, Luna, collapsed.

In response, crypto naysayers took to Twitter to dance on bitcoin's grave, and subreddits that had once been filled with celebrations of booming crypto portfolios were soon filled with people posting numbers for suicide hotlines and desperate personal stories about lost fortunes.

Some of the downturn in the crypto market can be explained by the fact that cryptocurrencies now closely track the stock market, and so the same global factors that battered the S&P 500 and Dow Jones Industrial Average also battered bitcoin: another month of high inflation, the Federal Reserve hiking interest rates, slow economic growth, and supply chain disruptions stemming from Russia's war against Ukraine and China's zero-COVID policy.

But it's impossible to understand what's happening with bitcoin without understanding the role of Terra's collapse and what it might say (or not) about stablecoins, which are integral to the cryptocurrency ecosystem.

As the name suggests, stablecoins are non-volatile digital currencies that are pegged to the dollar. This peg is ostensibly "backed by reserves like dollars, U.S. Treasury bonds or other traditional assets," reported The New York Times last week. That peg simply means that if you use one U.S. dollar to buy one stablecoin on Monday, you can expect that on Friday, that stablecoin can still be redeemed for one dollar. Using stablecoins like USDC (USD Coin) and USDT (Tether) allows investors to move into and out of cryptocurrency positions more quickly.

However, one popular stablecoin turned out to not be so stable: Terra, which the Times notes was "based on an algorithm that encourages traders to maintain its value," lost nearly all of its value last week after its supportive sister currency Luna dropped to 23 cents in value. (More on the technical side of the Terra collapse here.) The loss of Terra's peg meant that Terra holders could not redeem their tokens for U.S. dollars on a 1:1 basis, which is the primary function of stablecoins.

Terra losing its peg not only erased the wealth of Terra investors, but also led to another stablecoin, Tether, briefly losing its dollar peg and falling to 94.55 cents before recovering. It also likely drove many bitcoin investors to cash out for fear that Terra's collapse indicated a systemic problem that might spread to other parts of the crypto space.

Whether the Terra incident is a harbinger of collapses to come depends on who you ask. "Really we shouldn't use the same word for all of these things," tweeted Sam Bankman-Fried, CEO of FTX, a prominent crypto exchange, on May 12. "What we call 'algorithmic stablecoins' aren't really stable in the same way that fiat backed stablecoins are. They're more like structured products, and they need upside if they want to justify the risk."

The fact that Terra holders went all in regardless of the risk is what worries Jon Stokes, founder of Ars Technica and a major web3 watcher. "With the Terra-Luna pairing, there was an ecosystem there," he tells Reason. "It wasn't just a stablecoin that people were using on [decentralized exchanges] to swap in and out of USD; there was an ecosystem of DeFi products…that were built on top of this."

Because Terra was more than just a stablecoin, "what has imploded is not an asset solely, but a whole corner of web3," Stokes says. Plus, Terra and the associated protocol, Anchor, "had some amount of V.C. imprimatur." There were big names and big money behind Terra, which raises the question of whether retail investors are safe following the lead of venture capital firms and other institutional investors, who can afford bigger losses. 

What's more, Stokes notes that there has always been skepticism around Terra specifically because it was backed by volatile assets. However, Stokes says he's also skeptical of supposedly safer stablecoins. "There are plenty of those kinds of things that are out there; I suspect we will see more such implosions in the coming weeks and months," he says. "I think [Tether] is vulnerable to a bank run."

However, another way to look at Terra's collapse is a successful stress test of Tether, which quickly recovered its 1:1 peg with the U.S. dollar. That's what Nic Carter, general partner at Castle Island Ventures and founder of Coin Metrics, took away from the last two weeks, when Tether processed over $7 billion in redemptions. "If Tether had no reserves, they wouldn't be able to do that," says Carter. "What this shows is the mechanism worked as intended." He adds that while many of crypto's critics are "indiscriminate" and "think everything is a scam," some things really are "Ponzi-like" or "Ponzi-adjacent"; Carter says that Terra qualifies. 

As to why bitcoin is tracking stocks so closely, Carter says it's investors trying to manage risk in their portfolios during less-than-ideal times. "Bitcoin is a great asset to liquidate, it sells 24/7, globally, everywhere," he notes.

And eventually, we may start to talk about stocks following crypto, rather than the other way around. "My guess is that…if crypto prices crash there will not be a ton of contagion in the rest of the financial system," writes columnist Matt Levine at Bloomberg Opinion. "But I think it is, at this point, debatable. Crypto has at least started to work its way into the real financial system. Some traditional investors also own crypto; if their crypto goes down they might have to sell regular stuff. Some public companies are exposed to crypto (because they are crypto exchanges, because they have levered crypto holdings, etc.), so your boring old index fund might go down when crypto goes down." The existence of ripple effects would prove crypto's success, in a way, argues Levine.

Despite current volatility in the crypto space, its fundamental promise holds up: It remains a competitor to central banks, adds Carter. "It's very unambiguous to me that bitcoin, in particular, and then stablecoins are very useful for financial and monetary freedom."