… and what it could mean for their future

Gavin Brown, Richard Whittle, and Stuart Mills

IF YOU had invested R10 000 in the cryptocurrency Luna on 1 May 2022 (when the unit price was R1 238.96, you might have been quietly confident you’d made a sensible bet.  But Luna’s value has since fallen drastically—at the time of writing (21 May 2022), that R10 000 is worth one cent.

Luna was by no means the only victim during the week ended 13 May 2022  week where cryptocurrencies as a whole were down 30%.  Some have recovered to a certain extent, but this still represents an aggregate seven-day loss of over US$500 million (£8 billion), prompting existential questions about the future of the market.

This crash was possibly triggered by a financial “attack” on the stablecoin Terra (UST), which is supposed to match the US dollar but is presently trading at just 7 US cents.  Its partner coin, Luna, subsequently collapsed.

An attack of this kind is extremely complex, and involves placing multiple trades in the crypto market in an attempt to trigger certain effects—which can provide the “attacker” with significant gains.  In this case these trades caused Terra to fall, which in turn brought its partner coin Luna down too.  Once this was noticed, it caused panic—which, in turn, sparked market withdrawals, which then caused further panic.  Some (but not all) stablecoins rely to a large extent on perception and confidence—and once this is shaken, big falls can come into effect.

Crucially, the recent major falls in cryptocurrencies have called into question just how stable these stablecoins really are.  After all, they are designed to have practically zero volatility by maintaining a ‘peg’ to some other underlying asset (see box below).

Yet the effects seen recently have spilt over in to the whole crypto space, to create single day losses akin to (or arguably worse than) a “Black Wednesday” for crypto (Black Wednesday was the day in 1992 when speculators forced a collapse in the value of the pound).

Even the leading stablecoin Tether lost its peg, down to 95 cents on the dollar, perhaps demonstrating the need for regulation.  For if stablecoins aren’t stable, then where is crypto’s safe space?

 

Crypto confidence

How investors respond will be key to the future of cryptocurrencies.  We have already seen panic and despair, with some comparing this crash to a traditional run on the banks.  But with bank runs, customers tend to be worried that their bank will be unable to give them their money, rather than worrying that their money has become worthless.

A more accurate comparison is with stock market crashes, where investors worry that the stocks and shares they hold may soon be worthless.  And so far, reaction to this crypto crash suggests that a large section of crypto holders view their investments in a similar way.

Notwithstanding historical price volatility, there is a basic assumption often seen in investor behaviour: That the asset price will increase, and will keep on doing so.  In this scenario, the investor doesn’t want to miss out.  They see the asset rising, consider it a ‘sure thing’, and then invest.  Frequently buoyed by initial successes, the investor may then put in more.  Combine this with social media and the fear of missing out on “inevitable” gains, and the investments continue.

Put simply, many will have invested in cryptocurrencies because they believed it would make them richer.  This belief has no doubt been shaken.

However, another motivation for investing in cryptocurrencies may be a belief in their transformational nature—the idea that cryptocurrencies will eventually replace traditional forms of financial exchange.

For these investors, any increase in the value of a cryptocurrency is a demonstration of the increasing power of cryptocurrency over traditional money.  But likewise, a significant decline in the value of crypto is not simply a monetary loss—it is an ideological one.  At the same time though, this ideological stance creates an investor group far less likely to sell in the face of any sharp fall—and it is this group which may yet provide hope for the sector.

In established stock market crashes, we talk of a return to ‘fundamental value’.  The fundamental value of crypto is frequently assumed to be zero.  However, perhaps there is at least some fundamental value which is based on belief.

The size of the investor pool who own cryptocurrency because they believe in its long-term future, and the promise of a new money, may determine that fundamental value of crypto.  Indeed, if we consider cryptocurrency investors as different groups with different motivations, we can better understand the behaviours we are seeing.

Investors can perhaps take solace that we may have seen the worst of this crash, and that better times may be ahead—but as any financial adviser will tell you, in crypto as in any other market, nothing is guaranteed.

Gavin Brown is an associate professor in financial technology at the University of Liverpool.  Richard Whittle is a Capabilities in Academic Policy Engagement (CAPE) policy fellow at University College, London.  Stuart Mills is a fellow of behavioural science at the London School of Economics and Political Science.

This article is republished from The Conversation under a Creative Commons Attribution-NoDerivatives (version 4.0 International) license.

 

What is a stablecoin?

 

STABLECOINS ARE cryptocurrencies, the value of which is pegged (or tied) to that of another currency, commodity, or financial instrument.  They aim to provide an alternative to the high volatility of the most popular cryptocurrencies, including Bitcoin (BTC), which has made such investments less suitable for wide use in transactions.

Understanding stablecoins

Though Bitcoin remains the most popular cryptocurrency, it tends to suffer from high volatility in its price, or exchange rate.  For instance, Bitcoin’s price rose from an intraday low barely above US$ 4 000 in March 2020 to nearly US$ 65 000 in April 2021—only to plunge almost 50% over the following two months.

Intraday swings can also be wild; the cryptocurrency often moves more than 10% in the span of a few hours.

All this volatility can be great for traders, but it turns routine transactions like purchases into a risky speculation for the buyer and seller.  Investors holding cryptocurrencies for long-term appreciation don’t want to become famous for paying 10 000 Bitcoins for two pizzas.  Meanwhile, most merchants don’t want to end up taking a loss if the price of a cryptocurrency plunges after they get paid in it.

To serve as a medium of exchange, a currency that’s not legal tender must remain relatively stable, assuring those who accept it that it will retain purchasing power in the short term.  Among traditional fiat currencies, daily moves of even 1% in forex trading are relatively rare.

As the name implies, stablecoins aim to address this problem by promising to hold the value of the cryptocurrency steady in a variety of ways.

 

Fiat-collaterised stablecoins

Some would argue that stablecoins are a solution in search of a problem, given the wide availability and acceptance of currencies such as the US dollar.  Many cryptocurrency adherents, on the other hand, believe that the future belongs to digital tender not controlled by central banks.

Fiat-collateralized stablecoins maintain a reserve of a fiat currency (or currencies) as collateral, assuring the stablecoin’s value.  Other forms of collateral can include precious metals like gold or silver, as well as commodities like crude oil, but most fiat-collateralised stablecoins have reserves of US dollars.

Such reserves are maintained by independent custodians, and are regularly audited.  Tether (USDT) and TrueUSD (TUSD) are popular stablecoins backed by US dollar reserves, and denominated at parity to the dollar.  As of May 2022, Tether (USDT) was the third-largest cryptocurrency by market capitalisation, worth more than US$83 billion (R1.341 trillion).

Source: Investopedia (https://www.investopedia.com/terms/s/stablecoin.asp).  Accessed on 21 May 2022.

 

Editor’s note

Bloomberg reported on 11 May 2022 that the algorithmic stablecoin Terra (the subject of this article) lost it’s 1-to-1 peg to the US dollar, trading for as little as US$ 0.31 when trade opened on the morning of 12 May 2022.  At the time this issue of Personal Finance was being compiled (21 May 2022), its latest closing price stood at just US 0.07.