Why cryptocurrencies crashed – what happens next

Terra Luna caused the meltdown, but all cryptocurrency has been erased now that $300 billion has been spent

In the past week, the total value of all cryptocurrencies in circulation has fallen by more than $300bn (£246bn). This was due to panicked investors following the collapse of two major crypto tokens. Regulators are increasing their surveillance of the market, which was valued at almost $3 trillion at its peak.

What’s the deal?

This week’s cryptocurrency market meltdown primarily involves two interlinked cryptocurrencies, Terra or UST and Luna.

UST is an algorithmic stablecoin. A stablecoin is not like a cryptocurrency like Bitcoin, which fluctuates rapidly, but it has a fixed value, in this instance $1.

This is the tricky part. Stablecoins are generally backed by currency reserves. This is similar to how money in a bank account can be backed up by savings. However, algorithmic stablecoins may be supported by complex trading protocols.

This brings us to Luna, the second cryptocurrency. Luna’s value fluctuates, but Terra’s software stipulates that one coin can be converted for one dollar of Luna.

UST can be traded for 10 Luna if Luna is worth 10 Cents. If Luna is $100, UST can always be traded for one-hundredth Luna.

This works theoretically as long as Luna has any residual value. It hasn’t worked in practice. Terra’s value has gradually fallen this week from $1 to $0.16. Luna’s value has dropped from $60 to $0.0000379. The wave of selling that began to lower Terra’s price may have been an intentional attempt to reduce its value. However, Terra’s software has not been able to keep up with the falling confidence in its programming.

So, why is the price of other cryptocurrencies dropping?

Cryptocurrency is often compared to digital gold. It can be used to avoid inflation and it is a criminal’s best friend. It is a matter of confidence. Investors’ faith in Bitcoin and other coins is just as important as any technical consideration.

Even though the plunge in Terra and Luna’s value may seem to be isolated, it has had a dramatic impact on confidence in other coins. Bitcoin dropped to its lowest point in 18 months on Thursday as $200bn was taken off the market value.

The Terra Network Guard of the Luna Foundation Guard has large Bitcoin reserves and is expected to dispose of them to help support Terra and Luna’s value.

The market rebounded on Friday even though Terra and Luna continued to slump, suggesting that investors still have faith in cryptocurrency.

Will regulators step in?

Possibly. Janet Yellen (the US Treasury Secretary) stated this week that Terra’s fall demonstrated the need to improve regulation and that the US government was preparing a study on the matter.

She stated that “that simply illustrates that it is a rapidly expanding product and that there may be risks to financial stability, and we need a structure that’s appropriate.”

Although it has been difficult to regulate cryptocurrency, governments may be able to give approval to people they consider more trustworthy or put pressure on exchanges that allow crypto to be bought and sold.

Tether, a stablecoin that is backed by reserves, was subject to government scrutiny. The New York Attorney General reached an agreement with cryptocurrency companies last year, stating that Tether’s claims to be fully backed up by reserves were untrue.

Is this a financial crisis?

Most likely not. It has been called a Lehman Brothers moment in crypto, but it is unlikely that it will continue beyond crypto.

The total value of all cryptocurrencies is $1.3 trillion. While $300bn was taken off this figure over the past week, it’s not a systemic reduction. Comparatively, Meta, Facebook’s parent company, lost $230bn in value within a single day in February.

Yellen stated that crypto was not a threat to financial stability, although it is possible for the system to become more systemic as the system grows.

Fitch Ratings stated Thursday that “links between crypto markets regulated financial markets are still weak.” “We anticipate this will limit the potential for volatility in crypto markets to spill over into wider financial instability.”

Banks and finance companies will be affected.
In recent months, major financial institutions have increased their investment in cryptocurrency, especially for clients who want to take advantage of rising prices. As it examines the sector, the Bank of England asked banks to describe their exposure.

Fitch stated that many regulated financial entities increased their exposure to cryptocurrency, defi [decentralised financing] and other forms in recent months. Some… could be affected should crypto market volatility become severe.

Research suggests that 55 of the top 100 banks in the world have some exposure to cryptocurrency, but most banks are not exposed to cryptocurrency investments.

Consumer-facing businesses that let retail investors trade cryptocurrency may be at greater risk. These include the British banking app Revolut and Robinhood, as well as PayPal. Users can trade Bitcoin.

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