May 18, 2022

The Crypto Crash

39 minutes

In this episode of Understanding Crypto, Paul Abercrombie and James Burtt explore the intricacies of the UST/Luna crypto crash, highlighting the geopolitical and crypto-specific influences. They provide a systematic breakdown of the events leading up to UST devaluation and the subsequent death spiral. They explain why investors have started to sell off their crypto assets and why there is more anti-stablecoin sentiment and calls for regulation in the crypto market.

Geopolitical Influences

Paul gives a brief overview of the digital landscape before the crash, explaining the functions of the US Terra stable coin and its 25% devaluation. He highlights the major global geopolitical issues. "We are in a massive Covid hangover," Paul says while exploring the ways in which China’s zero-free policy has messed up global supply chains, subsequently increasing prices internationally. This, coupled with the World Bank’s decision to initiate economic stimulus measures in an attempt to rejuvenate the economy, has led to inflation. The current dip is a result of anti-inflationary measures which are rooted in the ideology that the only remedy to curb inflation is to raise interest rates. The Federal Reserve’s decision to increase the base rate by 0.5% was as predictable as investors' decision to "liquefy... sell... get rid of UST," Paul says. This, coupled with media forecasts of an impending recession, is making investors nervous, causing them to sell their crypto assets. [Listen from 4:09]

Luna and UST

In an attempt to demystify the crash, James provides a systematic breakdown of the events leading to the UST devaluation. He begins by exploring the relationship between Luna, a burn mint token which is the native currency of Terra and UST. The function of the burn mint token is to replace the traditional dollar in the digital marketplace. He points out that a token is generated as the mechanism for creating and liquidating crypto assets. As such, it becomes the governance token or major currency of a specific blockchain. "So it's a bit like our own creator coin that we have,” James points out. “Rally is the burn mint token of our Winner's Club token…In order to buy our currency, you've got to buy Rally. " Likewise, in Terra, cash is first exchanged for Luna burn mint tokens, which are in turn exchanged for USTs and vice versa. So when UST loses its peg, they create more Luna, similar to "printing money and inflation in the real world". [Listen from: 9:35]

Anchor

Both James and Paul agree that one of the major causes of the crash was the Luna Foundation Guard’s (LFG) decision to decrease Anchor’s (Terra’s high interest savings account) interest rate from 20% to 4%. This singular act caused the liquidation of over 2 billion USTs within two days. Consequently, "the liquidity pools are going to run out," Paul highlights, "which just kept the price tumbling out of control, both the prices of UST and Luna, because the same effect was happening everywhere." LFG’s injection of $1.5 billion worth of Bitcoin to provide liquidity in Luna and UST to prop up the market was a temporary fix but shortly after that came "the death spiral". The compounded effects of these decisions have caused "investors to start looking at crypto assets generally and starting to spark a sort of sell off across all digital assets, just because of market uncertainty." [Listen from 14:07]

The unstable "stablecoin"

The current crypto crash has strengthened the anti-stablecoin sentiment. Paul explores these concerns, stating that the UST "stable coin is controlled by a central entity which is the Luna Foundation Guard, not a decentralized organization". He questions, "Who's in charge of the liquidity?" Who provides the reserves? Is it backed by the dollar really? Is there a pool of dollar reserves? " Paul predicts that, "The result of this is going to be regulation big time in stablecoins and across other digital assets regulation around retail investors." Interestingly, though Web3's main tenet is decentralization, the current crash is a good argument for some measure of regulation, especially after the rapid rate of capitulation. As crypto asset owners, James and Paul both discuss the ways in which the crash has affected The Winners Club (TWC) coin on Rally. They tell listeners, “You just have to ride out, stay calm, keep calm and carry on". Current and potential investors should understand that crypto is here for the long term, despite frequent fluctuations in the market. [Listen from 23:50]

Key Takeaways