TerraUSD, a stablecoin that is meant to remain pegged to the US dollar, sunk well below its intended value last week, pushing major cryptocurrencies including bitcoin and ether to their lowest levels in months.
An algorithmic stablecoin, TerraUSD uses its sister token Luna to maintain its peg. The two currencies are meant to be swapped in order to reduce or increase the supply of TerraUSD and theoretically bring it back to a value of US$1.
However, TerraUSD lost its dollar peg last week and fell below 10 cents, while Luna dropped to a fraction of a cent from a high of over US$100 in early April. Both have subsequently been delisted from a range of crypto exchanges including the largest by trading volume, Binance.
“The failure of Terra’s peg has sent shocks through the decentralised finance (defi) sector,” Fitch Ratings said in a note last week.
“There could be significant negative repercussions for cryptocurrencies and digital finance if investors lose confidence in stablecoins. The latter play an important role in catalysing the crypto ecosystem more broadly, by providing a stable link to fiat-currency financial markets.”
AMP chief economist Dr Shane Oliver explained that stablecoins were popular because they allowed crypto traders to trade without having to leave the crypto world, sharing some similarities to money market funds in traditional investment markets.
“But TerraUSD depended on faith in Luna and this was weakened after a series of large withdrawals,” he added.
Alongside falls for the major cryptocurrencies, the world’s largest stablecoin, Tether, also fell to a low of US$0.95. The reserve-backed stablecoin then moved back close to US$1 as the wider crypto market also started to recover.
“Notwithstanding short-term bounces, as with shares further downside is a risk if falls feed on themselves and the speculative mania unwinds leading to yet another 80 per cent top to bottom fall. Or buy and HODL may kick in again,” Dr Oliver suggested.
“With little in the way of fundamental value it's hard to know which way it goes.”
Dr Oliver noted that cryptocurrencies have recently been behaving like a high beta version of shares.
“Like tech stocks, they benefited immensely from easy money and ultra low interest rates and bond yields,” he said.
“So now that easy money is being reversed they are suffering along with tech stocks albeit more so as there was far more hot air involved in cryptos.”
eToro global markets strategist Ben Laidler argued that extreme sell-offs were not new to the crypto market.
“We have seen such situations in the past, and the market could well rebound quickly or slowly (or not at all),” he said.
“Global retail investor ownership of crypto is already big, broad, and resilient to volatility, per our Retail Investor Beat survey. A focus now is whether institutional investors, who have been slowly building positions in this new asset class, take advantage of current price weakness to step up their involvement."
Looking ahead, Dr Oliver said that a crypto crash may have a more lasting impact and affect the ability of cryptocurrencies to attract more investors.
“For the broader financial system and economy a crypto crash poses a risk (particularly if the cash and other US dollar assets supposedly backing stablecoins like Tether have to be sold) but it's unlikely to be another sub-prime crisis,” Dr Oliver added.
“Banking system exposure to crypto is limited and the exposure of the wider investing public is still small (contrary to various surveys claiming the contrary – but which seem more aimed at marketing interest in cryptos). Demand for Lamborghinis may suffer a set back though.”
According to Fitch Ratings, the risk of crypto volatility causing wider instability would be limited due to the weak link between crypto markets and regulated financial markets.
“However, many regulated financial entities have increased their exposure to cryptocurrencies, defi and other forms of digital finance in recent months, and some Fitch-rated issuers could be affected if crypto market volatility becomes severe,” the firm said.
“There is also a risk of an impact on the real economy, for example through negative wealth effects if crypto-asset values fall steeply. Nonetheless, we view the risks to Fitch-rated issuers and real economic activity as being generally very low.”