Alongside the crash in technology stocks, cryptocurrencies have been tumbling dramatically. And, as has happened in every previous financial crash, the meltdown has exposed some once-hyped investments as total nonsense.
While the Nasdaq Composite stock market index has lost 29 percent since its record high last November, the price of bitcoin and rival cryptocurrency Ethereum have both dropped about 60 percent since their all-time peaks that same month.
That sounds pretty bad, but it’s hardly the end of crypto. Rather, the current crash has exposed a few highly touted innovations as risky disasters that could lead to some total wipeouts. As Warren Buffett says: “Only when the tide goes out do you discover who’s been swimming naked.”
In the 1990s, Wall Street’s financial engineers invented the leveraged inverse floating rate note to profit from falling interest rates. It got killed in 1994 when the Federal Reserve raised rates. In the 2000s, the banking industry’s collateralized debt obligation, or CDO, supposedly turned low-quality mortgages into AAA-rated gold. It blew up when defaults spiked in 2007.
And in 2022, meet the top candidate for financial innovation disaster of the year: the cryptocurrency market’s “algorithmic stablecoins.”
As with the earlier financially engineered disasters, the algorithmic stablecoin evolved from some good ideas (which are still working properly).
Cognizant that bitcoin’s volatile price made it difficult to rely on for conducting financial transactions, some companies, including Boston-based Circle Internet Financial, had an idea for a digital currency whose price would be more stable, hence the term stablecoin.
In the case of Circle, the company keeps $1 of actual US currency and assets like US government debt in reserve accounts audited by accounting firm Grant Thornton to back each $1 USD Coin, or USDC, it issues. At the end of March, Circle’s reserve accounts had $51.4 billion of assets to back the $51.4 billion of USDC it had issued, the accounting firm reported.
Others in the crypto market decided there might be a shortcut to issuing a stablecoin without the expense and hassle of maintaining a one-to-one ratio of ordinary assets in reserve. Thus was born the algorithmic stablecoin.
Here’s how South Korea-based Terraform Labs’ stablecoin worked, for example. The company issued a digital coin called Terra at a set price of $1 and a second digital currency called Luna, whose price could fluctuate based on demand. But the key to the system was that whenever Terra’s price started to slip, people could trade in one Terra and receive $1 worth of Luna.
While crypto markets were booming, the system worked well and Luna’s price rose as high as $119. So any time Terra slipped, people exchanged it and received a fraction of a Luna worth $1. That arbitrage opportunity maintained confidence that one Terra would always be worth $1.
Then crypto prices started crashing, including Luna’s. Terraform Labs had to issue more and more Luna in an effort to maintain the $1 ratio.
Just like when famed hedge fund manager George Soros shorted the British pound in 1992 and undermined confidence in that currency, the sinking price of Luna undermined confidence in Terra. On May 9, Terra slipped below $1, sinking as low as 30 cents on Wednesday.
The dip spooked investors in all kinds of smaller cryptocurrencies and projects, Nate Maddrey, head of research at Coin Metrics in Boston, said. Terra’s “swift collapse has had a ripple effect throughout crypto ... dragging many other small-cap cryptocurrencies down with it,” he said.
Meanwhile, Circle’s USDC remained steady at a price of $1. That gave Circle cofounder and chief executive Jeremy Allaire a chance to crow about his better mousetrap.
“We have gone out of our way for four years to operate a fully reserved, regulated model for dollar digital currencies that’s stood the test of time,” Allaire said. “How we’ve run USDC should be a model for how to do this in a way that supports innovation and protects consumers.”
Terraform Labs chief executive Do Kwon also created a second mechanism to support the value of Terra at $1. He built a nonprofit foundation that acquired and borrowed stronger cryptocurrencies like bitcoin. The strategy was to use those assets to buy Luna and shore up its price and the price of Terra.
That effort helped slightly boost Terra from its low of under 30 cents per coin, but on Thursday it was still trading at only about 40 cents. And Luna? It’s under 2 cents per coin, down 99.98 percent from its high. The value of all Luna outstanding, which was more than $40 billion a few weeks ago, is now worth less than $50 million.
As with past financial crashes, if an investment sounds too good to be true, it probably is.