Why cryptocurrencies crashed – and what happens next

More than $300bn (£246bn) has been wiped off the total value of all cryptocurrencies in circulation in the last week as investors panic over the collapse of two of the biggest crypto tokens, while regulators are increasingly monitoring the market, which was worth almost $3 trillion at its peak.

What is going on?

This week’s cryptocurrency market meltdown primarily concerns two interlinked cryptocurrencies: Terra, or UST, and Luna.

UST is a so-called algorithmic stablecoin. A stablecoin, unlike a cryptocurrency such as Bitcoin that fluctuates wildly, is supposed to have a set value, in this case $1.

The algorithmic part is where it gets more complicated. While most stablecoins are backed by currency reserves, similar to the way that money in a bank account is backed by savings, algorithmic stablecoins are supposedly propped up by complicated trading protocols.

That brings us to the second cryptocurrency, Luna. Luna’s price does fluctuate, but the software behind Terra stipulates that at any time, one coin can be exchanged for one dollar’s worth of Luna.

If Luna is worth 10 cents, UST can always be traded for 10 Luna. If Luna is worth $100, UST can be traded for one hundredth of a Luna, and so on.

In theory, this works as long as Luna has any value, however residual. In practice, it has not. Terra’s value has slowly collapsed this week, from $1 to $0.16. Luna has fallen from more than $60 to $0.0000379. A wave of selling, perhaps started by a deliberate attempt to drive down its price, has seen confidence in the programming behind Terra collapse, and its software has not been able to keep up.

So why are other cryptocurrencies falling?

Cryptocurrency has been compared to digital gold, a way to avoid inflation, and a criminal’s best friend. Day to day, however, it runs on confidence. The values of Bitcoin and other coins is as much a factor of investors’ belief as any technical consideration.

So even if the slump in the value of Terra and Luna might seem isolated, they have dramatically knocked confidence in other coins. On Thursday, Bitcoin fell to its lowest level for 18 months as $200bn was wiped off the market value of all cryptocurrencies.

The Luna Foundation Guard, which runs the Terra network, has substantial Bitcoin reserves, and has been expected to sell them off in a bid to support the value of Luna and Terra.

However, on Friday, the market recovered even as Terra and Luna slumped further, suggesting that investors have not lost confidence in the wider cryptocurrency realm.

Are regulators going to step in?

Possibly. Janet Yellen, the US Treasury Secretary, said this week that Terra’s drop demonstrated the need for better regulation and that the US government was preparing a report on the matter.

“That simply illustrates that this is a rapidly growing product and that there are risks to financial stability and we need a framework that’s appropriate,” she said.

Regulating cryptocurrency has proved difficult, but governments might be able to give a stamp of approval to those it considers to be more trustworthy or apply pressure on the regulated exchanges where crypto is bought and sold.

Tether, a stablecoin backed by reserves, has faced its own government scrutiny. New York’s attorney general last year reached a settlement with cryptocurrency companies, saying that Tether’s claim to be fully backed by reserves was false.

Is this a financial crisis?

Probably not. This has been called a Lehman Brothers moment for crypto, but if that is the case, it is unlikely to extend beyond crypto.

The total value of all cryptocurrencies stands at $1.3 trillion, and while $300bn has been knocked off the figure in the last week, it is hardly systemic. As a comparison, Facebook’s parent company Meta lost $230bn in value in one day in February.

Yellen said that crypto did not constitute “a real threat to financial stability”, although the more the system grows, the more systemic it could become. 

“Links between crypto markets and regulated financial markets remain weak,” Fitch Ratings said on Thursday. “We expect this to limit the potential for crypto market volatility to spill over and cause wider financial instability.”

Will banks and finance companies be affected?

Major financial institutions have pushed further into cryptocurrencies in recent months, particularly on behalf of clients who have wanted to benefit from rising cryptocurrency prices. The Bank of England has asked banks to outline their exposure to the space as it looks into the sector.

Fitch said that “many regulated financial entities have increased their exposure to cryptocurrencies, defi [decentralised finance] and other forms of digital finance in recent months, and some… could be affected if crypto market volatility becomes severe.”

While research suggests 55 of the world’s top 100 banks have some degree of exposure, most banks are believed to have relatively little in cryptocurrency investments.

A greater risk might be to consumer-facing companies that allow retail investors to trade cryptocurrency. These include British banking app Revolut, the investing app Robinhood and PayPal, which has been boosted by letting users trade Bitcoin.