The equivalent of a digital global financial crisis has been unfolding in real time over recent weeks with a meltdown of a string of cryptocurrencies and stablecoins designed to back them melting down.
The crash marks the violent end to the bubble for the currencies that only exist in cyberspace that saw hundreds of billions of dollars in value vaporise.But this won’t mark the last we are likely to see of virtual currencies.Names such as bitcoin and ethereum and the project of stablecoins designed to smooth out volatility will remake themselves.
The shakeout is significant, but the future of digital currencies are still evolving and fast.The biggest impact for now is the collapse will give ammunition for regulators and central bankers to push back on adopting digital currencies.Australia’s Reserve Bank for one has been one watching the rise of digital currencies but has been cautious about a real world application.It sees the adoption of some sort of digital currency over time, but one that will mostly be used between big investors or banks for secure transfer of funds.
For most Australians the meltdown over the past two weeks might as well be as significant as online game Fortnite shutting down – which is not very.But for those one-in-three active investors that are estimated to be exposed to more than $2bn in crypto assets in Australia it means a lot.
Bitcoin, the best known crypto, has fallen 26 per cent from the start of this month to a year low of $US28,900.
Ethereum, also popular among Australians, is down 40 per cent to $US1,170.Both are down more than 60 per cent from their peak in November.
For some time the correlation of cryptocurrencies was difficult to pin down, but their rise and fall can be traced back to central banks turning on and then preparing to turn off the liquidity tap.
An example of this, the Shiba Inu digital token, which doesn’t have any useful function saw its market capitalisation peak last November at $US26bn.Today the collective value of the tokens are $US6.3bn.
Lehman Moment
The “Lehman Brothers” moment for the crypto world was the implosion of TerraUST stablecoin that ran on a Terra blockchain that also was linked to the digital currency Luna.
Terra was designed to be stable, maintaining a peg to the US dollar by a highly complicated algorithm and trading alliance with Luna that at its most basic could turn supply on and off.This was the virtual world’s equivalent of a bank providing backing for the Luna.
But the value of Luna imploded from around $100 to just a fraction of a cent following a hedge attack that had the algorithm responding by minting trillions of Luna tokens which sucked in the TerraUST peg along with it, causing more than $US40bn be annihilated in just days.TerraUST is currently trading at 2 US cents, a long way from the $US1 it is meant to be linked to.
A reboot of TerraUST with new Luna tokens this weekend also stalled.After debuting at $17.80 on Saturday it had lost more than 70 per cent of its value just 12 hours later.
The assumption that this is the end of stablecoin assumes that all stablecoins are equal.Similar to global currencies, not all are equal with different central banks having different ability to back their respective currencies.The key was Terra/Luna had hopelessly misjudged its algorithm would protect it from the market rather than planning for robustness.
For Will Remor the head of risk at rival stablecoin project MakerDAO the lessons of recent weeks have been clear.
MakerDAO’s DAI currency built up a reserve of cryptocurrencies, or “overcollateralising” to ensure – like currencies in the real world – have adequate financial backing.
Stablecoins play a role in removing volatility of cryptocurrencies.Through the collapse, DAI which is capitalised at $6.6bn was one of a few stablecoins that increased in value.Today it retains its $US peg which it is used to back crypto currencies lodged by customers.
This is similar behaviour to the real world where customers of a stressed bank will put their funds with a lender with a stronger balance sheet.Renor says the way Luna worked by reducing supply was effectively using “the same side of the balance sheet” to regulate its value.
“Essentially, you’re playing with liability only.
There is no nothing on the asset side,” he says.
“My hope is that regulators will take the time to understand how the different stablecoins actually work and not pull everything to the same basket and try to regulate that in a new way,” he says.
He says the events of recent weeks will deliver a big shake out among stablecoins.But it has also shown that events that happen outside trading of bitcoin or ethereum “can be systemically important for the market”.
‘Risks’
The nation’s powerful Council of Financial Regulators which is backed by the Reserve Bank and bank regulator APRA called out the volatility in the crypto markets at their regular board meeting last week.
Specifically, they narrowed in on the stablecoins that had collapsed in value.
“The events highlighted some of the risks associated with stablecoins that regulators internationally are seeking to address,” they said in minutes made available after the meeting.
The Council of Financial Regulators has a review underway around digital payments and whether they can be used more broadly in the payments system.It comes amid a broader review by the Treasury department to bring cryptocurrencies in from the cold .This includes the prospect of licensing local crypto exchanges and demanding they have enough assets to back their operations.
A landmark speech by the RBA’s head of payments policy Tony Richards late last year said it is important that a suitable regulatory framework is developed around stablecoins.“If stablecoins are intended to be safe payment instruments and serve as alternatives to other forms of money, it is important for consumer protection and financial stability that they are appropriately regulated,” he said.
David Inderias of Fresh Supply Co.
David Inderias whose Fresh Supply Co business is building a payments infrastructure around blockchain says the situation of recent weeks is more like the tech crash of 2000.
“And this is actually a good thing ….and out of the ashes comes a maturity in terms of let’s learn let’s not be arrogant.Let’s learn from financial markets.Let’s learn about collateralisation.Let’s be a little bit conservative,” he tells The Australian.
“It’s good for the whole industry, because it’s the survival of the fittest fundamentals that allowed us to move on from the tech crash of 2000”.
Originally published as ‘Survival of fittest’ out of crypto collapse.