Crypto Crash and a LUNAr Eclipse

Near the start of the pandemic, cryptocurrencies* skyrocketed in value as speculators sought rapid returns. According to CoinMarketCap, in late February 2020, the total crypto market capitalization was approximately $250 billion. This reached a peak of nearly $2.9 trillion in November 2021. Since then, crypto has been on a downward spiral, losing approximately $1.6 trillion in market value in just over six months. As with other risk assets, investors in crypto have pulled back in the face of record high inflation, rising interest rates, and increased global and domestic economic uncertainty. Currently, the market capitalization of the crypto market is sitting at approximately $1.3 trillion with nearly $400 billion wiped out since the start of May following worrisome broad market news and a crypto market specific meltdown.

*Need a refresher on crypto terminology? View our Digital Economy Glossary.

Macroeconomic News Results in Broad De-Risking

The crypto markets, like many asset classes, have been rattled by stagnating global growth and geopolitical unrest largely spurring from the Ukraine-Russia conflict. As measured by GDP, the U.S. economy shrank in the first quarter of 2022, reflecting the first pullback since the start of the pandemic in early 2020. In addition, in response to decades-high inflation and a strong labor market, the Federal Reserve (“Fed”) has steadily increased interest rates and is scaling back on its $9 trillion balance sheet. All of these factors lead to increased uncertainty and ultimately volatility in asset prices.

According to Zoltan Pozsar, the global head of Credit Suisse’s short-term interest rate strategy, “volatility is like napalm for risk assets,” with all of the aforementioned events introducing volatility into financial markets. Risk assets, such as equities, high-yield bonds, and cryptocurrencies, have greater uncertainty associated with expected return. This uncertainty stems from higher volatility in the underlying assets prices in reaction to news and market conditions.

Is this a Crypto Bubble Burst?

As noted earlier, the crypto market skyrocketed at the start of the pandemic, growing more than 10x in market cap between February 2020 and November 2021. However, skeptics have suggested the market is experiencing a bubble. A market bubble represents an event in which a market experiences a rapid rise in the price of assets that is not justified by fundamentals and is subsequently followed by a sharp decline in prices once irrational enthusiasm subsides.

Outside of cryptocurrency reacting to broad macroeconomic news, cryptocurrencies have experienced multiple market specific events. For example, Coinbase, the largest cryptocurrency exchange, declined substantially in value following disappointing quarterly results, Bitcoin ("BTC") has recently plunged to its lowest levels since 2020, and hundreds of billions in value was wiped out of the crypto markets following a stablecoin crash last week.

Approximately $400 billion has been wiped from crypto markets since the start of May, resulting in the worst reset in crypto markets since BTC plummeted 80% back in 2018 and leading many to question whether the crypto bubble is finally beginning to pop and deflate. However, unlike in 2018, the effects are now felt more broadly. There are significantly more people and institutions holding the cryptocurrencies now than in 2018. According to an NYT article, in 2022, nearly 16% of Americans own some cryptocurrency, significantly up from the 1% that held some in 2015. Institutions, such as large banks and hedge funds, have also upped their holdings of crypto, with some using leverage (i.e., debt) to further bolster their bets in the space.

The Collapse of Terra

Last week, the world watched as the crypto markets were rattled with a staggering $18 billion stablecoin meltdown. As a reminder, a stablecoin is a where the value of the digital asset is derived from an underlying asset (e.g., U.S. Dollar (“USD”)) and are designed to provide a value that does not fluctuate, contrasting the high volatility of many traditional cryptocurrencies. Several stablecoins, such as TerraUSD ("UST") and Tether (“USDT”) are pegged to the USD using either collateralized or algorithmic systems.

UST and Terra (“LUNA”) were created in 2018 by Singapore-based Terraform Labs, with UST serving as an algorithmic stablecoin and LUNA used to help stabilize UST prices. Unlike collateralized stablecoins, which hold cash and other assets in reserves to back the pegged token, UST relied on complex code and LUNA to stabilize its peg to the USD. It is this algorithmic function that led to the collapse of LUNA and UST last week. The Terra protocol is set to destroy and create new units of UST and LUNA to adjust. In theory, if the UST price fell below $1, it would be taken out of circulation and exchanged for LUNA, reducing the supply of UST and thereby increasing the value (or price) of the now scarcer UST.

Leading up to the start of last week, UST had a total circulating supply of approximately $18 billion. Of this, roughly 75% or $14 billion, were deposited on Anchor – a platform offering up to 20% yields (i.e., returns) to investors who would lend UST on its platform. Critics questioned the sustainability of such high yields, and leading into Monday, May 9, 2022, many investors began to pull their UST deposits on anchor and attempt to sell them on the open market. This led to a flood of UST available on the market, causing major selling pressure, and a break in the $1 peg of UST. The pressure led to significant drops in both UST and LUNA, increasing panic and fear in market participants, and causing a ‘bank run’-esque escape from the tokens.

The collapse has been a bloodbath for investors. On May 16, LUNA is trading at approximately $0.0002, which is down more than 99.99% YTD, and reflecting an enormous decline from the token’s all-time high price of more than $116 in April 2022. In addition, UST has not regained its dollar peg, and is currently trading around $0.12 compared to the targeted peg of $1. Nearly all its $18 billion has been wiped from the market in the span of a week.

Note: Tether ("USDT"), the third largest crypto by market capitalization and the largest stablecoin, briefly lost its $1 peg and fell to $0.95 on May 12 before returning to $1. Unlike UST, Tether is a collateralized stablecoin, backed by cash and other traditional assets.

Is This All Bad?

Some have likened the busting of the crypto market to the bursting of the Tech bubble in the early 2000s, when nearly $5 trillion was wiped out of the equity market. Following speculation and investor enthusiasm for internet start-ups, the NASDAQ fell more than 75% between March 2000 and October 2002. The NASDAQ’s crash effects reverberated throughout the economy, wiping out retail investors and pulling down business investment until the U.S. ended up in a brief recession.

At the end of 2000, one estimate puts the total market capitalization of US Equities at roughly $15 trillion, suggesting the $5 trillion loss in value wiped out roughly one-third the total equity market. In comparison, crypto markets have experienced a drawdown in value wiping out more than 50% of the total crypto market value since the peak in November 2021. While the magnitude in dollars lost is smaller than that lost during the Tech bubble, given the increased prevalence of crypto assets in retail investors portfolios it could have similar reverberating negative effects.

With crypto becoming a mainstream asset class since the start of the pandemic, the recent crypto crash is expected to have broader effects than the crash in 2018. With a greater number of retail investors holding crypto, the recent collapse of UST and LUNA have renewed the urgency to regulate stablecoins and the broader digital asset classes. While it remains to be seen whether the recent drop in market value represents the popping of a crypto asset bubble, the market correction could ultimately provide some relief to hot inflation and reduce the need for the Fed to make use aggressive “shock therapy” policy to combat rapidly rising prices.

Sources

Global Cryptocurrency Market Charts | CoinMarketCap

Cryptocurrencies Melt Down in a ‘Perfect Storm’ of Fear and Panic - The New York Times (nytimes.com)

$1 Trillion Crypto Meltdown—Huge Crash Wipes Out The Price Of Bitcoin, Ethereum, BNB, XRP, Cardano, Solana, Terra’s Luna And Avalanche (forbes.com)

The Dotcom Bubble Burst (2000) (internationalbanker.com)

Bitcoin (BTC) price plunges to $30,000, hits lowest level since January (cnbc.com)

Bitcoin (BTC) price falls after Tesla stops car purchases with crypto (cnbc.com)

Coinbase (COIN) earnings Q1 2022 (cnbc.com)

The LUNA and UST Crash Explained in 5 Charts (coindesk.com)