Stock Markets have been Crushed. And Cryptos are falling even harder. Before you get swayed by all the negative sentiments, here is an important story that you need to read.
Like several asset classes, Crypto too is an asset class. To add to this, it is a new asset class, so the volatility is inherently higher. Which is absolutely normal if you compare it with initial period of stock market.
2] Recently, Terra-Luna, which is a Crypto asset, got crushed by 97%. And, people seem to be losing faith without understanding the context of the problem. So here is a super simplified version.
3] In the ecosystem of Cryptocurrencies & Blockchain, Terra-Luna is: – An Ecosystem. That comprises of a blockchain, native token. – And, it is pegged to the TerraUSD or UST (which is an algorithmic stable-coin)
4] Just a quick explainer on Stable-coins:
- You see Cryptos are volatile. For example, if you use one of the most trusted Cryptos (Bitcoin), it can change in value quite rapidly.
- Using Stable-Coins (Eg. USDT, USDC, UST), they can change their Bitcoin to a Stable-Coin.
- This is similar to you changing your “US Dollar” to a Gold ETF (if you believe that gold is more stable than USD) But, not all Stable-Coins are the same: USDT, USDC function like gold. These are non-algo driven Stable-coins.
- To issue 1 USDT, technically the firm issuing that USDT/USDC needs to put one pegged asset as a reserve. A pegged asset could be anything: gold, bitcoin, USD etc. USDT & USDC two biggest Stablecoins are US Dollar pegged.
- Another category of stablecoins are called Algorithmic stablecoins. In simple words, they don’t depend on manual actions of buying an underlying peg. But, are rather driven by a smart contract (a computer code– to buy/sell the peg).
4] So back to Terra-Luna: – The Terra-Luna ecosystem is pegged to UST (which is an algorithmic stable coins). – A point to be noted that Algorithmic stable projects have not usually succeeded in the past (eg. Titan and Iron Finance).
Why is Terra – Luna Falling ?
5] The way Terra-Luna ecosystem works is this:
a. In the Terra-Luna ecosystem the goal is to maintain a peg between Luna and UST (1:1 peg).
b. The smart contract essentially tracks supply and demand of UST and LUNA.
c. If price of UST > 1$, people can sell Luna to the Blockchain (Terra). This is then converted to UST. Since the supply rises, the prices falls.
d. If UST decreases in price, UST holders are offered to convert their UST into LUNA coins. And the prices go up.
e. But if a situation arises where no one wants to exchange Luna or UST, then it becomes a problem. f. This can happen for a wide range of reasons [eg. sudden price fall of UST or Luna; arbitrage opportunities etc].
On 9th May, UST fell to $0.68. This was triggered due to market sell off in Cryptos. At this stage, the investors neither wanted Luna or UST. The peg arbitrage further worsened the problem.
6] Now the folks managing Terra-Luna is trying to build back up the investor confidence by re-pegging it to alternate assets (Eg. Bitcoin), but seem to be losing the race.
7] The major problem now is that the winning advantage for Terra-Luna was that it was winning in the algo driven Stablecoin ecosystem. But, given the fact this model has somewhat failed (and given previous failures of algo stablecoins, the investors are going to be skeptical.
8] Does this mean that the entire Crypto ecosystem has failed? The answer is no. The likely outcome is that: Stablecoins now are likely to be more regulated. And, this is not bad.
9] In short if you are an investor, you should do your due-diligence before investing. The rules remain simple: a. Invest, if you truly see fundamental value on a project. b. And, be diversified within and across asset classes.
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