Explained: Why the Luna Crash Raised Questions About the Stability of Crypto Assets

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The brutal crash of Luna, the sister cryptocurrency of Terra Algorithmic Stablecoinwhich rendered it nearly worthless, sent shockwaves throughout the cryptocurrency market, with experts comparing the crypto market crash to be as severe as the Great Financial Crisis of 2008. The collapse of these stablecoins, considered relatively safer investment bets in the crypto space, has also prompted regulators and authorities to call for tougher laws governing these financial assets.

What happened?

Stablecoins are tokens pegged to the value of a government-backed currency, such as the US dollar, or commodities such as gold or silver. Tether (USDT) and USD Coin (USDC) are the two main stablecoins. The value proposition of these tokens is that they largely trade around $1 per token, giving investors some security in highly volatile market situations.

TerraUSD, or UST, is different from Tether in that it is not backed by fiat currency or other commodities, but instead relies on a complex mix of code and a sister token called luna to stabilize its price. Terra is called an algorithmic stablecoin, which means that its value is not determined by financial collateral in traditional markets but by lines of complex computer code.

In order to maintain its peg to the dollar, Terra’s algorithm, which is a well-defined set of instructions, encourages investors to take advantage of price changes between Terra and its sister token Luna, which means that the UST is highly dependent of the Luna token. Simply put, this means that on paper, if Terra’s price falls below $1, traders can “burn” the coin, or permanently remove it from circulation in exchange for the Luna cryptocurrency, and vice versa. , if Terra’s value exceeds $1, investors can burn Luna and create new Terra, making gains in the process and keeping the coin’s value close to a dollar.

Last week, after the UST fell from $1 to around $0.45, this led to enormous selling pressure on Luna, which caused the coin to lose almost all of its value. This means that Luna has fallen to a few decimal cents from its peak of over $110 per token, meaning investors have lost almost all of their wealth to the cryptocurrency. Estimates suggest the token wiped $40 billion from investors’ pockets — a big fall from grace for a cryptocurrency that was considered one of the top ten tokens before the crash.

What is the short term impact of the crash?

The severe crash could deplete investor confidence in the crypto market. As investors lost almost all the value of their investments in Terra and Luna, exchanges, including Indian ones like WazirX and CoinDCX, pulled the currencies from their platforms so new investors wouldn’t end up buying them. The crash also caused repercussions for the crypto market, which fell more than 16% on Thursday. Bitcoin, the most popular cryptocurrency, saw its value fall below $27,000 amid the crypto market bloodbath, its lowest since December 2020. However, since then it has shown warm signs of stability.

What does this mean in the big picture?

Regulators could step in to tighten standards around stablecoin investments. Gary Gensler, chairman of the U.S. Securities and Exchange Commission, who previously likened stablecoins to poker chips, renewed his calls for regulation of the crypto asset class. Amid the Terra and Luna crash, she said, “I think it just illustrates that this is a rapidly growing product and there are risks to financial stability.” According to a WSJ report, US Treasury Secretary Janet Yellen has reiterated her calls for the US Congress to allow regulation of stablecoins. Commenting on Terra’s developments, Yellen said: “I think it just illustrates that this is a rapidly growing product and there are risks to financial stability. We really need a coherent federal framework”. The report notes that a Treasury-led group of regulators last year recommended that Congress draft legislation that would regulate stablecoin issuers in the same way as banks.

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