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18 May 2022

What the Terra crash means for the future of crypto

The stablecoin’s spectacular implosion won’t destroy the cryptocurrency market – but it could give it a political edge.

By Bruno Maçães

It’s been a historic period in the crypto world. On 12 May, Terra – the third-largest stablecoin and one of the biggest blockchains – collapsed, erasing more than $41bn in value in what was one of the largest single-asset financial events in history. For comparison, Lehman Brothers was worth $60bn when it collapsed in 2008.

What was Terra? The crucial thing to know is that the Terra blockchain created a form of cryptocurrency that was meant to stay permanently pegged to the US dollar. Stablecoins are important in the world of crypto because they allow investors to move in and out of a stable unit of value without having to exchange their crypto assets for actual fiat currency, such as US dollars. So, if an investor thinks that Bitcoin will decline in value, they can exit their position by buying a stablecoin and return to Bitcoin when the price is right.

The problem with stablecoins is similar to the problem with currency pegs in general – where one currency’s exchange rate is tied to the value of another, more stable currency. If investors stop believing the value of the peg can be maintained, they will sell their currency, and the subsequent pressure on others to do the same will undermine any attempt to defend its value. There was little the Terra authorities could do because the coin was backed not by a central bank, or even solid assets, but by market forces.

[See also: Why we need to end the crypto Wild West – by Tulip Siddiq MP]

The system was supposed to work owing to the existence of arbitrageurs – investors who target market inefficiencies, and whose activities tend to have a stabilising effect on prices. Arbitrageurs moving between two of Terra’s coins – UST and Luna – would in theory steady their values, like two planets permanently balanced by gravity. But when these investors lost faith in the Terra system it crashed. Bitcoin suffered. Ethereum suffered. Following the Terra crash, cryptocurrencies lost more than $200bn in less than 24 hours. Many retail investors lost all their savings.

Those who mock crypto or remain indifferent should reconsider their views. Crypto is reaching the point where it may well trigger a global financial crisis when the next Terra-like crash happens.

The damage seems to have been contained. That a financial crisis of this scale took place on the blockchain in full public view was somewhat exhilarating. Everyone could watch it happen in real time and decide accordingly. This was no eurozone crisis where only a few could view the relevant data and Goldman Sachs and others could use their access privileges to gain from the turmoil. Rather than sharpening their knives, regulators might want to turn to crypto markets as a source of lessons about transparency.

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There is another reason to check your schadenfreude. Crypto may well be the canary in the coal mine. To fight inflation, the US Federal Reserve raised interest rates, which sent crypto markets tumbling, but the Nasdaq Stock Market in New York City is also under pressure. Even Amazon’s share price is down more than 30 per cent since the start of the year and Alphabet, Google’s parent company, is down around 20 per cent. Easy money is being sucked out of the financial system. There is a lot of easy money in crypto, but where does it stop? With another squeeze from the US Federal Reserve expected soon, the damage and pain may spread far and wide.

Over the past few years crypto has become a kind of Nasdaq on steroids, the riskiest and most speculative of tech stocks where people flock in search of fame and fortune. For some, this development was a radical betrayal of the crypto promise. True believers do not think of crypto as an investment or even as a technology. They think of it as a new way to organise the economy, society and the state.

[See also: Why the Bitcoin crash won’t halt the growth in crypto assets]

It is now possible to imagine a great schism in the crypto world. Some will continue to regard it as a market for exciting new technologies. They may accept greater public regulation if that means access to larger sources of capital. Slowly, crypto might start to change the way finance works. Smart contracts will replace human decision in many economic areas, but the political energy of crypto will be lost or tamed in the process.

A large part of the crypto space will never reconcile itself with this outcome. For the true revolutionaries, Terra’s implosion showed crypto is not going far enough. Stablecoins still look to fiat currencies as their model and so suffer from the same flaws the US dollar and its peers have always exhibited. They are tools of power, ways to control wealth and channel it in certain directions. Crypto utopians picture a world where mathematical truth becomes the overriding political authority. If this sounds like Platonism, it’s because it is Platonism. But there is a reason Platonism continues to attract us. Behind the notion of an immutable blockchain lies the dream of the unmediated rule of truth over society.

We saw it on 12 May. There was real anger in the crypto world and many complained of foul play from the establishment. Perhaps a hedge fund had launched an attack against Terra. After all, many famous investors have spent the past year or two proclaiming that crypto needs to be destroyed. Warren Buffett called Bitcoin “rat poison”. It is unlikely that crypto believers will lose faith. They may lose their savings, but as a result the movement will gain a political edge it has lacked so far. A sense of danger and vulnerability will turn crypto into a leading political movement – Platonism for the people – and one sharing very little with existing creeds.

[See also: “If you want to democratise the economy, you will need the state”]

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This article appears in the 18 May 2022 issue of the New Statesman, Putin vs Nato