5 min read

Unstable

Unstable
Photo by Benjamin Voros / Unsplash

Recently, a top 10 cryptocurrency protocol, Terra/Luna went to zero, sending shockwaves through the broader industry as almost $40bn was wiped from existence.

As a brief overview, Terra (UST) was the third largest stablecoin, algorithmically pegged to the USD through its sister token Luna.

The core proposition was that one UST could always be redeemed for $1 worth of Luna. The (now obvious) risk with such a system is that it is requires Luna to have value. When investors lose faith in Luna and/or UST, the whole system collapses.

The peg worked like this: as Terra traded above $1, users would mint new Terra by burning Luna, thereby increasing the supply of Terra and reducing its price. If Terra traded below $1, users would burn their Terra and redeem $1 worth of Luna, thereby reducing the supply of Terra and increasing its price back to the $1 peg.

As the Terra peg began to break, there was simultaneously a loss of faith in the Luna cryptocurrency, which led to a 'death spiral' with both Terra and Luna rapidly losing value as people tried to sell out.

The full breakdown of the Terra crash is well documented. I'd prefer to discuss the implications it has for the crypto industry.

1/ Adoption

Institutional Investors

Late last year, crypto finally began to draw in some considerable institutional investment, which large global investment banks and asset managers beginning to provide crypto-backed products to their clients, and establishing dedicated crypto and digital assets strategy teams.

This is positive because sophisticated actors are often beneficial for market efficiency. Rather than trading purely on narratives and price action, it supports a shift towards fundamental valuation. Institutional players also bring considerable amounts of trading volume to the space, which improves liquidity and price discovery for cryptocurrencies. This promotes more efficient crypto markets.

As inflation has run rampant and stock markets have taken a beating, institutional players have naturally been the first to pivot away from higher risk investments, including tech growth stocks and cryptocurrencies.

Although institutional investors are becoming increasingly familiar with the space, this event will not bode well for continuing adoption among large wealth managers, especially those with stricter investment mandates.

Retail Investors

40% of bitcoin investors are now underwater as Bitcoin is nearly 55% down from its November peak. And being down 55% probably looks good through the eyes of anybody holding altcoins...

As the hype cycle of crypto reached its full force late last year, retail investors piled into several crypto assets in hopes that the good times would continue rolling. Unfortunately, they have not.

The challenge with retail investors is that they often don't fully understand the cryptocurrency ecosystem. Everybody flouts the importance of 'onboarding' the next generation of crypto users, but forgets that the ecosystem is incredibly complex. Most people aren't financially literate, never mind a completely new system which is going to reshape the financial system.

Further, valuations of these assets are based on hype and narratives rather than fundamental analysis or value-accretive events within a given cryptocurrency protocol, or the industry more generally. We will reach a stage of adoption where these assets trade closer to a 'fundamental valuation', but we're not quite there yet.

The markets for these assets are smart, but they're nowhere near as efficient as the traditional financial system. This doesn't worry me for now, but there's no doubt that sophisticated participants are necessary in the long-term.

People who were on the fence about investing in cryptocurrencies will now shy away, and that is completely understandable and justifiable in the given environment.

But it doesn't change the fact that our money is eroding in value each and every day. It doesn't change the fact that inflation is running rampant, and that the economy will pay the price for the excessive stimulus of the prior two years.

This is not simply a matter of investment in crypto. Everyday people will also defer learning about crypto until the next hype cycle or bull market, leading to even slower adoption.

2/ Regulation

Regulators are currently in the phase of drafting regulation and consulting with industry participants to draft frameworks guiding the future of cryptocurrencies, both domestically and offshore.

While there has always been debate between industry participants hoping for more developer-friendly regulation and members of government who believe cryptocurrencies are a scam, I truly believed that we were moving towards a supportive and developer-friendly regulatory environment. Regulators understand that the industry is attracting the world's best talent, and that a crypto-friendly regulatory environment has substantial benefits to local economies.

However, when $40bn is wiped from existence in the span of a few days, it's highly likely that regulation is going to be much more heavy handed. This will slow the development and the adoption of cryptocurrencies globally, and increase barriers to entry for aspiring cryptocurrency developers hoping to build in the space.

I can't emphasise enough how damaging this is. Stagnating the development of the cryptocurrency industry means that everyday people continue to lose out.

Crypto is our first step towards offering an 'opt-out' from traditional finance, as a means of reforming traditional finance

I am a believer that the overwhelming support for cryptocurrencies is a clear indicator of the shortcomings of traditional financial institutions. It is an opportunity to increase transparency and responsibility in a system which continues to be a black box.

While I do not believe that crypto will replace traditional financial institutions, I believe the ecosystem has provided an impetus for change. Traditional institutions will be forced to increase transparency, take greater responsibility for their mistakes, and offer products and services in a more open and customer-first format.

3/ The Bright Light

Despite slower adoption and harsher regulation in the wake of this event, it's not all doom and gloom for cryptocurrencies. The market has demonstrated resilience indicating to me that sentiment and belief in the industry is still strong.

It is also a fantastic reminder of the risks associated with crypto investments, and the importance of due diligence and sense-checking rather than simply YOLOing into a hyped up asset.

The reality is that crypto is a multi-trillion dollar industry, and is becoming more and more integrated with global financial markets. It is no longer a matter of 'what happens in crypto stays in crypto'.

As more everyday people begin to invest their hard-earned money on crypto protocols, the broader economy and financial system becomes increasingly dependent on the stability of cryptocurrencies. It is simply too big to fail.

The solution is blaringly obvious. We need clear regulation and education within the cryptocurrency space. Without it, these events will continue to occurs, and everyday people will be left holding the bag.

It feels like the past year of crypto media has included calls for clarity from regulators, from those within the crypto ecosystem, but also from those in traditional financial institutions.

I am hopeful that regulators do not use this as an excuse to shut down the growth of the industry in Australia. However, there is no doubt that we need protections for investors, and legal liability for harmful actors.

Regulation becomes more and more necessary as each day passes.