The 2008-style cryptocurrency crash could affect real markets

Cryptocurrency started in 2009 with idealistic dreams of a new economy built on liberal principles and freedom from the fiat currency system that had just collapsed. But in 2022, cryptocurrency trading revolves around the dollar. And the 2008 financial crisis has just been repeated in absurd microcosm.

In the lead-up to the 2008 financial crisis, the economy was heating up. The companies were making huge amounts of money and had to put it somewhere. There was a huge demand for safe, dollar-equivalent assets, which reduced supplies of Treasurys and other ultra-stable assets. Financial engineers have put together “safe” dollar equivalent products to meet demand — backed by assets like real estate, real estate-backed securities, or bets on real estate-backed securities. This worked until the housing market experienced the slightest downturn, at which point the series of leveraged bets fizzled out and threatened to take the broader economy with them.

The same pattern has just happened in cryptocurrencies – except that there is no asset as strong as the housing at the bottom of it. Cryptocurrency traders operate entirely in US dollars. Regular cryptocurrencies are known to be volatile – bitcoin regularly goes up or down 10 percent per day, making speed critical. So the industry created “stablecoins”: blockchain tokens worth exactly one dollar that can be traded as stable dollar equivalents on the blockchain, without having to wait for banks. As an added bonus, stablecoins provide their users with all that tedious routine of financial regulation, complying with anti-money laundering laws, or being a well-known and named entity with a bank account.

Cryptocurrency started in 2009 with idealistic dreams of a new economy built on liberal principles and freedom from the fiat currency system that had just collapsed. But in 2022, cryptocurrency trading revolves around the dollar. And the 2008 financial crisis has just been repeated in absurd microcosm.

In the lead-up to the 2008 financial crisis, the economy was heating up. The companies were making huge amounts of money and had to put it somewhere. There was a huge demand for safe, dollar-equivalent assets, which reduced supplies of Treasurys and other ultra-stable assets. Financial engineers have put together “safe” dollar equivalent products to meet demand — backed by assets like real estate, real estate-backed securities, or bets on real estate-backed securities. This worked until the housing market experienced the slightest downturn, at which point the series of leveraged bets fizzled out and threatened to take the broader economy with them.

The same pattern has just happened in cryptocurrencies – except that there is no asset as strong as the housing at the bottom of it. Cryptocurrency traders operate entirely in US dollars. Regular cryptocurrencies are known to be volatile – bitcoin regularly goes up or down 10 percent per day, making speed critical. So the industry created “stablecoins”: blockchain tokens worth exactly one dollar that can be traded as stable dollar equivalents on the blockchain, without having to wait for banks. As an added bonus, stablecoins provide their users with all that tedious routine of financial regulation, complying with anti-money laundering laws, or being a well-known and named entity with a bank account.

The obvious way to operate a stablecoin is to keep a backup reserve: each coin represents a dollar held in the bank. Unfortunately, it turns out that many stablecoins claiming to support the dollar have not been fully supported. None of the reserve-backed stablecoins were properly audited; Issuers only provide quick testimonials, where finances are treated for a moment as if it were a permanent supply. For example, one of the most notable stablecoins, iFinex tether, borrowed funds one morning after a one-shot certificate to appear backed, before returning the funds the next day.

The other way to operate a stablecoin is to make an “arithmetic” stablecoin. This supports the supposedly stable dollar tokens with volatile crypto reserves. Issuers claim that the algorithm can maintain a stable price, whatever the reserve does, and keep the value of the stablecoin at one dollar. The problem is that you cannot guarantee stability against an unstable support; Nothing will protect you from an entire market crash. Every algorithmic stablecoin has so far failed to maintain its peg. Algorithmic stablecoins work until they don’t work.

Stable coins are a modern form of unruly banks in the 19th century, which issued questionable paper dollars backed by questionable reserves. This led to the National Currency Act of 1863, which established the Office of the Comptroller of Currency and took over the power of commercial banks to issue banknotes. At the very least, stablecoins should be regulated like banks. But all cryptocurrencies are a less powerful version of the current systems and have any advantage only as long as they get away with not being properly regulated.

But there is still a huge demand in the cryptocurrency trading markets for dollar-equivalent stablecoins and for the “dollar” symbol that can be pumped in ridiculous amounts. Then something came to fill this niche. Do Kwon launched Terraform Labs TerraUSD (UST) in September 2020. UST had issued 18 billion tokens – supposedly worth $18 billion – by May 2022.

Terra created two tokens, UST and Luna, out of thin air, unsupported by anything else. UST is the stablecoin, and Luna floats freely. If floor cabinets exceed $1, more floor cabinets will be created by burning $1 luna for each new floor cabinets. If the ground tank drops below $1, the ground tanks are burned and a luna is created. The main driver of demand for terrestrial treasuries is their lending to Terra’s Anchor Protocol, a separate system, for use by cryptocurrency traders. Anchor pays 20% interest on earth treasury deposits, paid in earth treasury currencies. If there are not enough borrowers for the lenders, Terra backs interest, which is ultimately paid out from the company’s venture capital financing.

You might ask why floor cabinets or luna are worth anything in the first place, given that they were created by terra. But the crypto bubble was so full of illogical exuberance that a token created yesterday could claim to be worth something that only exists, and you can pay people in your fake token.

Floor cabinets or Luna aren’t really priced in dollars; It is priced in other illiquid currencies, which is priced in other illiquid currencies, which is priced in Ether (the original currency of the Ethereum blockchain), which is priced in dollars. There has never been $18 billion in dollars, or even Ether. There is only a long and double slate of purported pricing for two open ended assets. Every time you see a major claim to billions of dollars in cryptocurrency, these are by no means achievable dollars – there is no real liquidity in the market. But the market accepted this hardly backed currency as being worth a dollar because faith would allow traders to make money for some time.

On Saturday, May 7, $14 billion was deposited into Angkor. At around 10 PM UTC, someone withdrew $500 million in several cryptocurrencies from Anchor. This left about $300 million of cash to cover UST 14 billion. Bearers withdrew $3.8 billion immediately from Anchor. This brought UST down from $1.00 to $0.987. Luna fell 10 percent. UST was also sold from decentralized finance exchange Curve and crypto exchange Binance.

On Sunday, May 8, Terra renewed the liquidity of its ground tanks during the day. Terra Reserve released $1.5 billion in bitcoins to defend the price of underground treasuries. This did not restore investor confidence. On Monday, May 9, the terrestrial reservoir at deposit in Anchor fell to $9 billion. The ANC token for Luna and Anchor has also fallen. The ground tank dropped to $0.65.

The bitcoins in reserve have been enough to affect the price of bitcoin itself – there is very little actual dollar liquidity in the bitcoin markets, and moderate selling can severely impact the bitcoin price. Bitcoin has already fallen from $39,000 to below $36,000 today Thursday May 5coinciding with the decline of the Nasdaq Index – real investors get rid of their foolishness before anything else. The bitcoin price rose from $35,857 on May 7 to $29,735 in the morning of May 10 and $25,500 in the morning of May 12. Confidence has been shaken, and the rest of the cryptocurrency market has fallen in tandem with Bitcoin. Even the price of the stock market on the cryptocurrency exchange Coinbase has fallen. Just as in the 2008 financial crisis, the collapse of an over-indebted dollar equivalent product seriously destabilized the entire market.

The crash affected not only foolish professional traders – cryptocurrency has real victims. Times are tough, and many ordinary people who don’t remember 2008 are desperate and see cryptocurrency as the only way out. When UST crashed, Terra’s Reddit forum was filled with desperate messages, and moderators pinned suicide hotline numbers to the top of the forum.

There is a lot of pain, but the real danger is contagion from cryptocurrency to the broader economy. US regulators have always been concerned about stablecoins. The Trump administration established rules to mitigate money laundering risks from stablecoins in December 2020. The President’s Working Group on Financial Markets warned in December 2021 that “the mere possibility of a stablecoin not performing as expected could lead to a “run” on that stablecoin.” …operating under strained market conditions may have the potential to amplify a shock to the economy and financial system.”

The Federal Reserve’s May 2022 Financial Stability Report compared the risks of stable currencies with those of the money market funds that played a critical role in the 2008 crash. The day after the Earthquakes collapse, Treasury Secretary Janet Yellen reported to the Senate Financial Stability Oversight Council and reported Earth treasury as an example of potential issues with stablecoins.

The cryptocurrency industry has constantly tried to make its way into the corners of the economy that have systemic risks. The Department of Labor warned financial advisors and other trustees in March that their licenses could be at risk if they put cryptocurrency into their 401(k) retirement plans. Fidelity Investments is still trying to put cryptocurrency into its 401(k) product for employers anyway. Department of Labor Senators Elizabeth Warren and Tina Smith asked Fidelity to explain why it offers such incredibly risky assets as long-term retirement plans, as well as the company’s conflict of interest in promoting an investment in which it has such a strong position.

Cryptocurrency trading is approaching millions and claimed billions. These numbers are fantasies based on imagination, with a much smaller – but still real – amount of actual money at the bottom. The entrances to the real dollars are narrow and not penetrated significantly yet. But this is not due to a lack of effort from the crypto world, whose end seems to be to regularize cryptocurrency and leave the government as a last resort when teetering piles of leverage fall. You succeeded in 2008, after all.