Terra Crash... 'Fed Warning' Concerns Over Stablecoin-Induced Financial Shock

[Image source=Reuters Yonhap News]

[Asia Economy Reporter Jeong Hyunjin] On the 11th (local time), the collapse of the stablecoin TerraUSD (UST) and the cryptocurrency Luna has been compared to the Lehman Brothers crisis during the 2008 global financial crisis because the decentralized experiment has encountered difficulties, potentially leading to a collapse of investor confidence in cryptocurrencies themselves.

The market is on high alert for the ripple effects on the entire cryptocurrency sector as vulnerabilities in financial soundness have come to the forefront. With the cryptocurrency market rapidly expanding recently due to institutional investors' interest, there is a possibility that the turmoil in the crypto market could spread to the broader financial market.

How Does the ‘Kimchi Coin’ That Caused the Chaos Work?

Terra and Luna are classified as domestic cryptocurrencies, so-called ‘Kimchi Coins.’ Although Terraform Labs, the issuer of these two cryptocurrencies, is headquartered in Singapore, the coins are considered Korean because the blockchain company is led by a Korean CEO. Terra's market capitalization soared to $18 billion (approximately 23.1 trillion KRW), ranking it third among stablecoins at one point, and Luna reached the $110 range as recently as last month, placing it within the top 10 cryptocurrencies by market capitalization.

Unlike other stablecoins such as Tether or USDC, Terra does not use cash or government bonds as collateral but applies an algorithmic model supported by Luna to maintain its value. When Terra's price falls, investors deposit Terra with Terraform Labs and receive Luna worth $1 in return, adjusting Terra's circulation through arbitrage to keep its price pegged at $1.

The problem is that recent U.S. interest rate hikes and stock market crashes affected the cryptocurrency market, and once Terra started to fall, Luna also plummeted. Foreign media report that the two coins then entered a ‘death spiral’ where their prices fell simultaneously. Cryptocurrency exchange mgnr analyzed, "The algorithm's safety is a kind of trust game, and once that trust collapses, the game is over." Bloomberg News explained, "Comparisons to the 2008 financial crisis have begun," adding, "Features of shadow banking (financial institutions not subject to soundness regulations), such as extremely high leverage and a circular mechanism of biting and being bitten, can be easily found in the Terra ecosystem."

Institutional Influx into Cryptocurrency Market... Will the Financial Sector Face Wider Impact?

Cryptocurrency exchanges have taken measures to prevent the spread of the fallout. Domestic cryptocurrency exchanges have consecutively designated Luna as a cautionary investment item. Upbit announced the day before, "Luna is a project that aims to peg UST to $1 through a currency supply adjustment algorithm, but it is judged that the pegging process is not functioning properly," and designated it as a cautionary item. Bithumb and Korbit also designated Luna as a cautionary investment item for the same reason.

Crypto evaluation and disclosure platform Xangle also downgraded Luna's rating to ‘BB,’ citing emerging doubts about Terra's sustainability. Nevertheless, the collapse of Terra and Luna impacted other cryptocurrencies. On the same day, Bitcoin's price fell below the $30,000 mark. Cryptocurrencies related to DeFi (decentralized finance) projects such as Avalanche (down 30%), Solana (down 20%), and Aave (down 24%) also plummeted simultaneously.

The securities industry pointed out that the recent collapse of Terra and Luna will lead to a short-term contraction in the cryptocurrency market beyond stablecoins. Ha Daehun, a researcher at SK Securities, said, "The collapse of TerraUSD will raise questions about the soundness of deposit-backed stablecoins," adding, "With inflationary pressures and heightened tensions, the cryptocurrency market is likely to face liquidity reduction pressures due to stablecoin regulations," suggesting the possibility of short-term contraction.

As the cryptocurrency market staggers, the market is watching whether the impact will spread to the broader financial market. According to foreign media, the cryptocurrency market currently holds a value of $1.5 trillion. Last November, when Bitcoin prices peaked, the market expanded to $3 trillion but has since halved due to the U.S. tightening monetary policy and high inflation. However, with large banks, hedge funds, and other institutional investors entering the cryptocurrency market, more than half of investors in the fourth quarter of last year were institutional investors, according to U.S. cryptocurrency exchange Coinbase.

Fed and Yellen Warn... Regulation Expected Soon

This incident is likely to lead to regulations on stablecoins. U.S. Treasury Secretary Janet Yellen emphasized the risks of stablecoins last month and again recently, mentioning the need for regulation. The U.S. Federal Reserve (Fed) also pointed out operational vulnerabilities and lack of transparency in its recent ‘Financial Stability Report,’ stating that "stablecoins are exposed to liquidity risks."

On the same day, U.S. Senate Banking Committee member Pat Toomey (Republican) said, "This incident could be a big problem for consumers who lost money and the fallout will spread," emphasizing the need for regulation of stablecoins. Senate Banking Committee Chairman Sherrod Brown said, "What this means is that we should be pessimistic about the entire (cryptocurrency) sector."

This content was produced with the assistance of AI translation services.