Cryptos – Mother of all bubbles?

The crypto markets saw the worst fall since their inception, losing over USD 500 billion all in a matter of a week. Stablecoins were isolated as one of the major reasons for this collapse of the market. What started in 2009 as a dream for a new economy has now led to one of the biggest crashes since 2008.

One question that we are all asking ourselves is, “Shouldn’t we have seen this coming?”
In hindsight, it all looks predictable but several warning signs were pointing towards a completely irrational and absurd investor behaviour but were completely ignored in this frenzy. 

Some warnings signs were when dogecoin surged more than 10,000% to become the fourth most valuable cryptocurrency ahead of Elon Musk hosting SNL or when electric vehicle startup Rivian was worth more than USD 110 billion without generating a dollar of revenue or when NFT platform OpenSea raised money at a valuation of USD13.3 billion —more than the value of American Airlines.
Maybe now we can all sit back and notice this warning sign – a sign of an impending bubble, waiting to get burst. 

What happened this time?

Cryptos are not strangers to volatility so then what went wrong this time? 
The fourth-largest stablecoin, TerraUSD or UST which is the US Dollar stablecoin of the Terraform Labs got stuck in a death spiral last week. It traded as low as USD 0.30 and has been trading at USD 0.53 now, which is a far cry from its fair value of USD 1. Luna the other currency which can be exchanged for Terra was at $2.20 down by almost 93% during the last 24 hours and 97% in the last week. 
The algorithm that tied the two coins together basically said that 1 Luna can be exchanged for 1 Terra and vice versa, but this was under the assumption that both will be valued above USD 1. 
Why did this become such a big deal, pulling all the crypto brothers and sisters with it? To understand that, let us first know about the biggest villain in this story, STABLECOINS

What is a stable coin?

The purpose of designing a stable coin was to protect this particular cryptocurrency from the volatility associated with digital assets. 
Stable coins are pegged to fiat currency and are pegged in a 1:1 rato with the national currency. Eg: 1 table coin is equivalent to 1 USD.
Stable coins have a market cap of about USD 170 billion and Tether is the largest stable coin with a valuation of USD 80 billion.
They had recently become very popular and had been used by cryptocurrency traders as a hedge against a spike in bitcoin prices and as a store of value for idle cash without changing it into fiat currency. They were being used increasingly to facilitate leveraged trading in other cryptocurrencies according to the US Federal Reserve.

How does stablecoin work?

There are two main types of stable coins operating in the market: those coins which are backed by reserves made of assets, such as fiat currency, bonds, commercial paper, or even other crypto tokens, and those which are algorithmic. 

Major stablecoins like the Tether, USD Coin and Binance USD are backed by assets and hold a dollar-denominated exchange rate of 1:1. Whether there are enough reserves to back these coins in circulation is a different discussion altogether. 
Meanwhile, the TerraUSD is an algorithmic stable coin which implies that it does not have reserves. Instead, its value was supposed to be maintained by a rather complex mechanism involving swapping TerraUSD coins for a free-floating cryptocurrency called Luna to control supply. TerraUSD’s value was pegged to Luna which itself had no real value apart from the fact that it can be exchanged for Terra. 

Is that what you call stable!

Now, that the value of both these coins is diminished it is seen that the mechanism that was supposed to balance supply is very similar to the crisis of 2008 when CDOs backed by subprime mortgages were sold despite knowing that the underlying asset can fail. The only difference being the loans in 2008 was backed by real estate and the cryptocurrencies are backed by illiquid tokens.

Another bubble brewing?

This crash is a grim reminder of the 2008 financial crisis when the sale of structured products which were backed by subprime mortgages lost value leading to the loss of billions of wealth and jobs. These loans were bad loans with a very low chance of repayment and were issued freely without much thought and packaged into structured products and were used as collateral to issue bigger loans.
Similarly in the crypto market, most of these coins have no underlying assets and some of them who do are very secretive about the asset classes which back them. The amount of regulation on these currencies is minimal and this has resulted in mass circulation as they offer the benefit of unparalleled gains. What started as a craze for coders and artists has now become a full-blown investment that people do not understand. Millions of people have exposure to this and have lost a significant amount of money.

Is there a bottom?

While Luna and Terra are coming up with a plan to counter this loss and restore the equilibrium, the faith in these cryptocurrencies seems to be fading. Regulators now see stable coins as a risk to financial stability and are now trying to establish rules to control and monitor them across the globe.
The Fed says that these coins are particularly risky because during a stressed market the assets that these stablecoins are backed by become illiquid or lose too much value, resulting in a run on these stablecoins. Such runs spill over to the traditional markets and create stress on the underlying assets disturbing the financial system. 

Cryptocurrency is based on fiction, the money and the value are fictional. The endgame of these traders seems to be to make cryptocurrency systemic and leave the government with a heap of leveraged investments as the holder of last resort. It was done once in 2008 and by the looks of it will be repeated soon.
Is there a bottom in sight? Well, yes! When you finally agree with your father’s age-old financial advice!