Cryptocurrency’s 2008-Style Crash Could Affect Real Markets

Cryptocurrency started in 2009 with idealistic dreams of a new economy built on libertarian principles and freedom from the fiat currency system that had just crashed. But in 2022, cryptocurrency trading will be all about the dollars. And the 2008 financial crisis has just repeated in absurd miniature.

In the lead-up to the 2008 financial crisis, the economy was running hot. Companies were making stupendous amounts of money and had to put it somewhere. There was such a huge demand for safe dollar-equivalent assets that supplies of Treasurys and other such superstable assets were running low. Financial engineers synthesized “safe” dollar-equivalent products to meet the demand—backed by assets such as real estate, or by securities backed by real estate, or by bets on securities backed by real estate. This worked until the housing market had the slightest downturn, at which point the chain of leveraged bets unwound and threatened to take the wider economy with them.

The same pattern has just taken place in crypto—except without any asset as solid as housing at the bottom of it. Cryptocurrency traders work entirely in US dollars. Ordinary cryptocurrencies are notoriously volatile—bitcoin regularly goes up or down 10 percent in a day, making speed crucial. So the industry created “stablecoins”: blockchain tokens worth precisely one dollar that can be traded as stable dollar-equivalents at the speed of the blockchain, without the need to wait for banks. As an added bonus, stablecoins save their users all that tedious red tape of financial regulation, compliance with anti-money-laundering laws, or being a known and named entity with a bank account.

Cryptocurrency started in 2009 with idealistic dreams of a new economy built on libertarian principles and freedom from the fiat currency system that had just crashed. But in 2022, cryptocurrency trading will be all about the dollars. And the 2008 financial crisis has just repeated in absurd miniature.

In the lead-up to the 2008 financial crisis, the economy was running hot. Companies were making stupendous amounts of money and had to put it somewhere. There was such a huge demand for safe dollar-equivalent assets that supplies of Treasurys and other such superstable assets were running low. Financial engineers synthesized “safe” dollar-equivalent products to meet the demand—backed by assets such as real estate, or by securities backed by real estate, or by bets on securities backed by real estate. This worked until the housing market had the slightest downturn, at which point the chain of leveraged bets unwound and threatened to take the wider economy with them.

The same pattern has just taken place in crypto—except without any asset as solid as housing at the bottom of it. Cryptocurrency traders work entirely in US dollars. Ordinary cryptocurrencies are notoriously volatile—bitcoin regularly goes up or down 10 percent in a day, making speed crucial. So the industry created “stablecoins”: blockchain tokens worth precisely one dollar that can be traded as stable dollar-equivalents at the speed of the blockchain, without the need to wait for banks. As an added bonus, stablecoins save their users all that tedious red tape of financial regulation, compliance with anti-money-laundering laws, or being a known and named entity with a bank account.

The obvious way to run a stablecoin is with a backing reserve: Each coin represents a dollar held in a bank. Unfortunately, many stablecoins claiming dollar backing have turned out not to be fully backed. None of the reserve-backed stablecoins has ever been properly audited; the issuers present only snapshot attestations, where a single moment’s finances are treated as if they were a permanent supply. For instance, one of the most prominent stablecoins, iFinex’s tether, borrowed money on the morning of one snapshot attestation to appear backed, before returning the money the next day.

The other way to run a stablecoin is to do an “algorithmic” stablecoin. This backs the supposedly stable dollar tokens with reserves of volatile cryptocurrencies. The issuers claim that an algorithm can maintain a stable price, whatever the reserve does, and keep the stablecoin’s value at one dollar. The trouble is that you can’t guarantee stability against an unstable backing; nothing will protect you against the whole market going down. Every algorithmic stablecoin thus far has failed to maintain its peg. Algorithmic stablecoins work until they don’t.

Stablecoins are a modern form of the wildcat banks of the 1800s, which issued dubious paper dollars backed with questionable reserves. These led to the National Currency Act of 1863, establishing the Office of the Comptroller of the Currency and taking away the power of commercial banks to issue paper notes. At the very least, stablecoins need to be as regulated as banks are. But all of cryptocurrency is a less robust version of existing systems and has any advantage only as long as it gets away without being properly regulated.

But there remains a huge demand in the crypto-trading markets for dollar-equivalent stablecoins and for a “dollar” token that could be pumped out in ridiculous quantities. Then something came along to fill that niche. Do Kwon of Terraform Labs launched TerraUSD (UST) in September 2020. UST had achieved an issuance of 18 billion tokens—supposedly worth $18 billion—by May 2022.

Terra created two tokens, UST and luna, out of thin air, not backed by anything else. UST is the stablecoin, and luna floats freely. If UST goes above one dollar, more UST is created by burning a dollar’s worth of luna for each new UST. If UST goes below one dollar, UST is burned and luna is created. The main engine of demand for UST is to lend it to Terra’s Anchor Protocol, a separate system, for cryptocurrency traders to use. Anchor pays 20 percent interest on UST deposits, paid in UST tokens. If there aren’t enough borrowers for the lenders, Terra subsidizes the interest, which is ultimately paid from the company’s venture capital funding.

You might be asking why either UST or luna is worth anything in the first place, given they were created ex nihilo by Terra. But the cryptocurrency bubble has been so full of irrational exuberance that a token created yesterday can claim to be worth something just for existing, and you can pay people in your made-up token.

Neither UST nor luna is really priced in dollars; they’re priced in other illiquid tokens, which are priced in other illiquid tokens, which are priced in ethers (the native currency of the ethereum blockchain), which are priced in dollars. There was never $18 billion in dollars, or even in ethers. There is only a long, multiply leveraged chain of alleged pricing for two made-up assets. Every time you see a headline claim of billions of dollars in cryptocurrency, those are not in any way actual realizable dollars—there’s no real market liquidity. But the market accepted this barely backed coin as being worth a dollar because the belief would let traders make money for a time.

On Saturday, May 7, 14 billion UST was on deposit in Anchor. At approximately 10 pm UTC, someone withdrew $500 million in various cryptos from Anchor. This left about $300 million of cryptocurrency liquidity to cover the 14 billion UST. Holders promptly withdrew 3.8 billion UST from Anchor. This knocked UST from $1.00 down to $0.987. Luna fell 10 percent. UST was also sold from the Curve decentralized finance exchange and the Binance cryptocurrency exchange.

On Sunday, May 8, Terra replenished UST liquidity through the day. Terra’s reserve released $1.5 billion in bitcoins to defend the price of UST. This didn’t restore investor confidence; on Monday, May 9, UST on deposit at Anchor went down to 9 billion UST. Luna and Anchor’s ANC token also plummeted. UST went down to $0.65.

The bitcoins in the reserve were sufficient to affect the price of bitcoin itself—there’s very little actual-dollar liquidity in the bitcoin markets, and a moderate sale can strongly affect bitcoin’s price. Bitcoin had already dipped from $39,000 to below $36,000 on Thursday 5 Mayin step with NASDAQ dipping—real investors dump frivolities before anything else. Bitcoin went from $35,857 on May 7 to $29,735 on the morning of May 10 and $25,500 by the morning of May 12. Confidence was shaken, and the rest of the cryptocurrency market went down in step with bitcoin. Even the stock market price of the Coinbase cryptocurrency exchange plummeted. Just as in the 2008 financial crisis, the crash of an overleveraged dollar-equivalent product had seriously shaken the entire market.

The crash didn’t just affect foolish professional traders—cryptocurrency has real victims. Times are tough, and a lot of ordinary people who don’t remember 2008 are desperate and see cryptocurrency as their only way out. When UST crashed, the Terra forum on Reddit filled with despairing messages, and moderators pinned suicide hotline numbers to the top of the forum.

Plenty of pain is out there, but the real danger is contagion from cryptocurrency to the wider economy. US regulators have long worried about stablecoins. The Trump administration made rules to mitigate the money-laundering risk from stablecoins in December 2020. The President’s Working Group on Financial Markets cautioned in December 2021 that “the mere prospect of a stablecoin not performing as expected could result in a ‘run’ on that stablecoin. … A run occurring under strained market conditions may have the potential to amplify a shock to the economy and the financial system.”

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

The cryptocurrency industry has persistently tried to worm its way into systemically risky corners of the economy. The Labor Department warned financial advisors and other fiduciaries this March that their licenses may be at risk if they put cryptocurrency into 401(k) retirement plans. Fidelity Investments is still attempting to put cryptocurrencies into its 401(k) product for employers anyway. The Labor Department and Sens. Elizabeth Warren and Tina Smith have asked Fidelity to explain why it is offering such incredibly risky assets as long-term retirement plans, as well as the company’s conflict of interest in promoting an investment it has such a strong position in.

Cryptocurrency trading throws around alleged millions and billions. Those numbers are fictions built on fictions, with a much smaller—but still real—amount of actual money at the bottom. The gateways to genuine dollars are narrow and have yet to be significantly breached. But that’s not for lack of effort from the cryptocurrency world, whose endgame appears to be to make cryptocurrency systemic and leave the government as the bag-holder of last resort when the tottering heaps of leverage fall down. It worked in 2008, after all.

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