Let me explain the current crypto crash in TerraUSD / Luna in very simple terms and why all cryptocurrencies are in free fall.
I am neither an investor nor a trader in Bitcoin or any cryptocurrency. However, being in the market and having a technology background, I can understand the recent crash in the crypto world. So let me try to explain the current free fall in the cryptocurrencies.
Again, I am not recommending anyone to invest in crypto. It is the opposite. I am still warning people to invest in crypto and have been doing the same since 2017 on my blog.
Still, I think there is a lot to learn for me, so I am sharing my view of what I believe is the reason for a recent crypto crash.
Further, I think the crash has just begun. When every tom dick and harry start a coin of its own, there has to be a burst. Please listen to this clip of Mohnish Pabrai.
He compares and explains the past automotive bubble of the 1920s, the Dotcom bubble of the 2000s and now crypto.
What Was Luna?
A couple of weeks ago, Luna, a cryptocurrency by Terra Blockchain, was one of the hottest coins. It was gaining popularity because it was stabilised using an algorithm, one of the few stablecoins (We will come to stable coins later).
And we will see how the reason for its being stable made it the most vulnerable.
Before the crash, it had reached a maximum of 4th most valuable cryptocurrency.
Now, the value of Luna is zero, and it has been delisted from crypto exchanges. All those who hold Luna that isn’t worth a dime.
What is stablecoin?
First, let’s understand the concept of stability for coins or money.
Let me explain this with a hypothetical example of the Indian Rupee.
RBI prints money. We know there are 15 lakh crores of printed money from demonetisation. Now it may be a little higher, but any number is good enough for us to understand the stability of a currency or coin.
Assume I get hold of all the cash that RBI prints, and I visit the RBI headquarter and ask for gold (or an alternative currency).
Because RBI doesn’t have what I am asking for, the value of the Indian Rupee will fall because there is a considerable supply but no demand.
So as an Individual, it may be tough to execute, but there can be countries (Pakistan or China) that can target a crash of the Indian financial system.
So, RBI has stabilised the Indian Rupee by having a demand for its rupee from individuals, reserves of foreign currencies, gold etc.
Depending on how RBI calculates the max attack the Indian rupee can see, they keep a reserve.
So, out of 15 Lakh Crore, RBI says we will keep 5 Lakh Crore. But, again, this is not actual data but to help you understand the concept of stabilising the currency.
So now, Pakistan or China may not try to devalue the Indian currency because they know RBI has a reserve to the extent that they can get hold of the maximum cash.
How Was Luna as a Stable Coin Different?
To make any coin (or, for that matter, currency) stable, the concept is to have a reserve of an alternate asset.
We are an equity investor. So to make shares stable and avoid a hostile takeover, a promoter has to have a 51% stake in the company.
If the promoter holds only 49% of the company and 51% of my shares are available for trading, it can be a candidate for a hostile takeover.
However, if I can borrow money to buy the 2% in the company, the hostile takeover option goes out of the window.
Similarly, as a promoter, my stake is only 40%, but if I can arrange money for the 11% stake in the company, the hostile takeover option goes out of the window.
I know my guidelines if I want to make my company safe from hostile takeovers.
If I want to make a coin stable, I have to look for the maximum amount of coins an individual, a company or a government can acquire and need an alternate asset to stabilise it, much like RBI.
So, Terra Foundation, the organisation behind Luna cryptocurrency, was to do the same task.
However, Luna was not backed by an alternate asset but USD equivalent currency, which they termed TerraUSD or $UST.
The value of UST has to remain equal to $1.
The algorithm, in very brief, was such that if the value of UST increases, the demand of LUNA will bring it back to $1. Similarly, if the UST decreases, the supply of LUNA will get it back to $1.
Other stable coins have other assets like Gold, Bitcoin, and USD (the actual currency) in some ratios to provide stability.
What Caused TerraUSD / Luna to Crash
Now we know the stable coin TerraUSD / Luna was different.
In straightforward terms, if the value of TerraUSD increases, the demand for LUNA will bring it back to $1. Similarly, if the TerraUSD decreases, the supply of LUNA will get it back to $1.
Now, there was a massive supply of TerraUSD, which caused a vast supply of Luna, and it fell 99% in a matter of two days.
The other side of the equation is that someone had LUNA coins to the extent that when they dumped everything in the market, the TerraUSD could not provide them with enough money, and the price kept falling.
Much similar to the example I explained, if someone has too much of the printed INR Rupees and demands an alternate asset for it.
Why does Cryptocurrency have Stability Issues?
Let’s understand the instability of the cryptocurrency market itself and why the crash was inevitable.
Let’s say you are buying 1 Bitcoin in one of the largest brokers in India, which is WazirX.
So deposit the amount (which is in Lakhs) into your account in WazirX (or, for that matter, any broker).
I am not questioning the broker here but the process and the entire cryptocurrency market.
So what makes your broker do a transaction in the international market and purchase a Bitcoin for you?
And how do you verify that they have purchased the coin for you? What if they don’t and show you that you own 1 Bitcoin in your broker account.
Understand from Indian Shares
Let’s say my broker is Upstox. If I buy a share, I expect a contract note from the exchange to verify that I am a shareholder in a so and so company.
If there is no contract note, my broker can skip the actual purchase and only theoretically show that I own the shares in my account.
Another option can be that they purchase the share later on the same day at lower than the price they offered it to me.
Don’t you think it’s possible without a contract note where I can verify every aspect of my order?
Back to Cryptocurrency
Indian crypto market always had a premium to the International market, and I couldn’t understand why but they always were like that.
So Indian brokers always had a premium price for Cryptocurrency.
Further, I had called once to WazirX and enquired what makes you purchase an actual bitcoin for me. They told me you could transfer the coins to your blockchain wallet.
If you want to verify if you have an actual bitcoin, you must request the transfer of coins into your blockchain wallet.
So when I asked some of my relatives and friends who have an account in WazirX, they knew nothing about the wallet.
And those who know they don’t transfer into the wallet and keep it in the WazirX account.
Typically, this is what a trader’s tendency is.
Crypto crashed, and so if the broker didn’t purchase the coin for you, they could make a lot of money because they now need to pay you less.
I am not saying WazirX did it, but what I am pointing out is that it is possible.
What if the market of crypto skyrocketed?
Many brokers may have to declare bankruptcy like TerraUSD / LUNA.
If you are or were investing in cryptocurrency, either coin owners or the brokers make money.
You can make money if you own the coin in your blockchain wallet, and the price of the coin increases.
And to be honest, most of us even don’t know what a blockchain wallet is or how it looks.
It is time to learn this new technology and see it evolve. It has the power to change the way we see the world of currency, but that doesn’t mean you need to invest in them and burn your fingers.
Unless you have lost money in the Crypto crash, there is a positive way to look at it. Experts estimate that $800 billion of wealth has been wiped from the cryptocurrency market. So, it should help reduce Inflation worldwide.