The cryptocurrency crisis has gone from bad to worse as LUNA, the native token of the Terra (LUNC 7.67%) blockchain, lost over 99% of its value in less than a week. This stunning collapse has dragged down the entire market -- which is now down 41% year to date to $1.3 trillion. That said, these near-term challenges probably won't destroy the industry and may turn into a buying opportunity when volatility subsides.
What is Terra/LUNA?
Terra is a blockchain designed to facilitate stablecoins, which are cryptocurrencies pegged to real-world currencies like the U.S. dollar or the euro. It comprises two types of assets: Terra, its portfolio of stablecoins, and LUNA, the tradeable token designed to absorb the volatility of the stablecoins. Terra's stablecoins are not backed by real-world money. Instead, they rely on complex algorithms and arbitrage.
For example, if the peg of Terra's dollar stablecoin, TerraUSD, goes above $1.00, LUNA holders are allowed to burn $1.00 worth of LUNA to mint a Terra, profiting from the difference and causing inflation to bring the price back down to the peg. The process also works in reverse: If TerraUSD falls below $1.00, users can burn TerraUSD for $1.00 worth of LUNA, deflating the supply to meet demand.
What went wrong?
Terra Luna provided an excellent way for investors to bet on the growing popularity of stablecoins, and it quickly grew to a market cap of $28 billion, making it the eighth-largest cryptocurrency by May 1, 2022. But on May 9, TerraUSD lost its peg to the dollar after a series of major withdrawals, and its arbitrage mechanism failed to solve the problem. Instead of supporting TerraUSD, LUNA was overwhelmed by the volatility, sending its market cap down 99% to just over $230 million at the time of writing.
The crash has infected the wider industry
Terra looks unlikely to survive this crisis because trust has been broken. And the situation has infected the wider crypto industry, with top assets like Bitcoin and Ethereum down 13% and 20%, respectively, in the last five days as investors fear they could be at risk for a similar meltdown. The good news is that Terra's structure is an anomaly. And most other cryptocurrencies operate in a completely different model.
For example, Bitcoin's value is based on supply and demand -- with no complex pegs or arbitrage mechanisms. Even other stablecoins such as Tether (which is backed by cash and equivalents) have maintained their pegs despite the panic.
I'm not giving up on crypto
Crypto is facing a confidence crisis. But investors shouldn't jump ship. After the dust settles, this could turn into an opportunity to scoop up quality assets at rock-bottom prices. The cryptocurrency industry has a track record of recovering from its declines. And Terra's business model is fundamentally different from other large blockchains.