Where to start?

Last week we saw one of the all-time crypto meltdowns. In seven days, the total value of all cryptos fell by 36 per cent. Bitcoin dropped 33 per cent (though it has since stabilised, at around $30,000). And a once-mighty coin called terra dropped 99.9 per cent, from a market cap of $30 billion to $45 million. It currently trades at a little over $1.3 billion.

A drop of 36 per cent in seven days is not unheard of in crypto. But a 99.9 per cent drop, in a currency that had once been one of the ten biggest — that’s new.

Terra is itself a new type of crypto. On its website, it describes itself as “a public blockchain protocol deploying a suite of algorithmic decentralized stablecoins which underpin a thriving ecosystem that brings DeFi to the masses.” 

The idea here is that terra is a stablecoin, which is a bit different from an ordinary crypto. A normal crypto bounces around in value, gaining or losing five per cent in a day. A stablecoin’s value is meant to be stable. One terra coin is meant to be worth one dollar, always and forever. 

Stablecoins are useful because they help crypto investors swap cryptos for something closely-related to cash — and swapping $100,000 worth of bitcoin for real cash can be a pain in the neck. There are money laundering checks and other hoops to jump through. Stablecoins, by comparison, are easy to trade.

The biggest stablecoin is tether. Tether is valued at $1. For every tether coin in circulation, tether promises to own one real dollar, or something close to it. If the price of tether drops below $1, Tether the company sells some of its dollar assets and buys tethers, and the $1 peg is maintained (that’s the official story, anyway — more on this later).

A new variety of crypto

Terra is a whole other story. It’s an “algorithmic stablecoin”. What this means is that it’s a stablecoin, in that it’s meant to trade at $1 per terra. But unlike tether, it isn’t backed by real assets like cash and bills and bonds. Instead, it’s backed by another crypto coin. 

The way it works is, the terra people made two coins. One coin was a normal crypto, which they called luna. The other one was the stablecoin — terra. The stablecoin’s stability came from the promise that people could automatically (algorithmically) exchange one terra for $1 worth of luna. The algorithm would automatically create as many lunas as were needed to swap for $1 worth of terras. 

Ok, you might ask, but why would one luna be worth anything? This is a good question, and one you could ask of any cryptocurrency. But as of the beginning of May, luna was worth about $30 billion, so the question was moot.  Here’s how the billionaire crypto evangelist Mike Novogratz felt about it in January:

Terra was stable because it was backed by luna. But the real trick here is that terra was in fact supporting luna; that is, the algorithmic stablecoin element was a cool gimmick that allowed luna to stand out from the other coins and got people to buy it. 

Remember, it promised “a suite of algorithmic decentralized stablecoins which underpin a thriving ecosystem that brings DeFi to the masses.” This was a nonsense statement, but the algorithmic stablecoin element gave it a vague plausibility. Plus, there were signs of terra supporting other uses. A coin called anchor was built using the terra protocol, offering a 19.5 per cent yield. 

All cryptos are confidence tricks, but terra was a confidence trick upon another confidence trick. Its dollar peg was backed by luna, whose value came from its role in the terra dollar peg. 

The two coins supported each other. That worked on the way up, as the terra ecosystem climbed past $50 billion in value, between luna, terra, anchor, and its many other coins.

But on the way down, things worked against terra. People started doubting luna, so they sold terra. Terra automatically printed more luna which depressed the luna price, which caused more selling of luna. The algorithm was furiously minting fresh luna, but it couldn’t keep pace with the amount of selling going on. People sold more terras because luna was falling. In seven days, the ecosystem went from being worth more than $50 billion to be worth less than $2 billion. Luna went to $45 million. 

It’s easy to get lost in the weeds, but this is a simple story. People needed coins that were worth $1, so terra came along telling them it had created a coin worth $1. The mechanism for pegging the thing at $1 was to back the coin with a highly volatile crypto asset. It worked for a while — because why not, this is crypto we’re talking about — but then people lost faith in the coin’s backing, and the whole thing fell apart.

This is an important event for two reasons. One, the numbers are big. Around €700 billion was wiped off the value of cryptocurrencies in the last fortnight. That’s around as big as Tesla, Berkshire Hathaway or Facebook. And the terra ecosystem was worth around as much as Ford, General Motors, Dow Chemical, or Uber. Now it’s all gone.

Second, the collapse has shaken the whole crypto system. During the good times, the terra people bought a couple of billion in bitcoin to help support the value of terra (this was an interesting move, since the whole point of terra is that its algorithmically backed). They sold them last week to support the price — to no avail — which helped pull down the rest of the market. 

Now, there’s an allegation that the terra people used their reserves, not to support their coin’s price, but to bail out insiders. According to Luna Foundation Guard, which looks after terra’s reserves, holders of $2.7 billion worth of terras were able to sell them for bitcoin at close to face value on May 9 and 10 last week, at a time when terra was trading for as little as ¢60 on the dollar. 

Crypto is a confidence trick, so it’s very much not good for crypto when everyone simultaneously loses confidence in a high profile coin and loses all their money. A smaller algorithmic stablecoin called DEI broke its peg this week, and is now trading at ¢56. 

The big one would be tether. As the founder of dogecoin Bill Markus said, “If Tether dies, it’s all over, friends.” Though tether claims to be fully backed by high-quality liquid assets, there are questions over exactly what it owns, where it owns them, and whether it owns them at all — New York Attorney General Leititia James accused it of lying over its stated reserves. Last week, tether broke its peg momentarily, before snapping back to $1.

The whole fiasco has been terrible for crypto. €700 billion has gone up in smoke. But looking on the bright side, it’s been a stress test, and the industry seems to have survived it.