Why Did the Crypto Market Crash?

Red charts in the morning, an investor’s warning. Why did the crypto market crash over two days in May? On the morning of May 8, 2022, a lot of cryptocurrency investors woke up to their crypto portfolios deep in the red with heavy losses. The night before, a single trade sent a pair of coins into a complete downward spiral. Shockwaves ripped through the market, Bitcoin dropped 25%, and the altcoins tanked. Crypto holders blew up social media and chat rooms to ask “why is crypto crashing?” TerraUSD (UST), a popular stable coin, lost its peg to the US Dollar. What happened next was a vicious cycle that took Terra (LUNA) down with it. And it rocked the entire market. Here’s what triggered the crypto market crash, and why it’s not just a crypto problem. 

Why the crypto market crashed: a stable coin sets the stage

TerraUSD (UST) was a stable coin designed to offer crypto investors some relief from price volatility. A stable coin is designed to represent the same value per coin as the real-world currency it’s pegged to. In the case of TerraUSD (UST), its value was pegged to the US Dollar to keep the price relatively constant. 

Stable coins like UST are popular because they create a quick and easy way to get money from the real world into the digital world. You can spend $200 US and know you’re getting $200 worth of UST, minus trading fees of course. From there, you can purchase other cryptocurrencies with your UST without having to do mental math to figure out how much crypto you’re getting for your digital buck. Stable coins are also commonly used as a store of value to park profits or hold capital until you decide whether to enter a trade or cash out into real money.

Better yet, you can stake some stable coins and earn passive income. In the world of crypto, staking is similar to purchasing a Guaranteed Investment Certificate (GIC) to earn better interest on your cash. Unlike a guaranteed investment certificate (GIC), however, the returns on crypto staking are disproportionately large and don’t exist anywhere else in the real world. And that was the basis of UST’s appeal; you could stake it and beat the bank. Many investors bought large positions of UST, staked it, and banked on that sexy 20% yield. 

Was TerraUSD vulnerable by design? 

TerraUSD (UST) was a top 10 stable coin thanks in large part to its own lending, borrowing, and savings platform called Anchor Protocol. Arguably, the only reason to buy and hold UST was to earn 20% interest by staking it on Anchor. But as a stable coin pegged to the US Dollar, its value had to stay relatively constant. So it had a sister coin, Terra (LUNA), to help stabilize the price, and you could make money holding that one too. 

Some other popular stable coins use real money in real bank accounts to back their value, those are called collateralized stable coins. But UST was an algorithmic stable coin, so it had no such reserves. Instead, UST was linked to LUNA to keep its price pegged to the US Dollar. A complicated math program, called an algorithm, automatically minted and burned each coin as needed whenever the two were traded. Sounds complicated, right? It worked like this:

For every one UST purchased, $1 worth of LUNA was destroyed, aka burned. With less LUNA in circulation, the price of LUNA goes up. For every one UST sold, $1 worth of LUNA was created, aka minted. With more LUNA in circulation, the price of LUNA would go down. Are you still with me? Buy UST and LUNA price goes up. Sell UST and LUNA price goes down. Got it? Good. So what was the point of this mint-and-burn mechanism? 

Why crypto crashed: a weird way to peg a stable coin

One word: arbitrage. Stable coins are generally stable, hence the name. But their prices can fluctuate by a cent or two, depending on what’s happening in the market. Investors particularly loved UST because no matter what the price was, they could exchange one UST for $1 worth of LUNA. Here’s why they loved it:

If the price of UST fell against the US Dollar and dropped to say, $0.95 for example, you could swap it for $1 worth of LUNA and profit $0.05 in the process. It’s called arbitrage, and it wasn’t an accident. The opportunity to make easy money on a simple swap was the mechanism that would push UST back to parity with the US Dollar. 

That’s because selling UST for LUNA would increase the price of UST by reducing its supply. And it would lower the price of LUNA by increasing the supply. Savvy investors would exploit any UST price fluctuation and the trading activity of each coin would close the gap until UST was worth $1 again. The founder, Do Kwon, also held Bitcoin in a reserve in case things ever got really ugly. More on that later. 

It was an ingenious way to get people to buy and hold UST. Not only could you basically print money for yourself with 20% returns in Anchor Protocol, you could also stack gains with LUNA too. Plus, you had peace of mind knowing your stable coin wouldn’t lose value despite market volatility. Before the crypto market crash, over 72% of UST’s entire circulating supply was held in Anchor Protocol; roughly $14 billion USD. 

Crypto market crash and greed

But if a 20% return seems unsustainable, it is. The only way to keep paying that rate is to keep bringing in new stakers. So Anchor announced it would start reducing the rate of return in a phased rollback. 

Some people began withdrawing and selling their UST in search of better staking opportunities because for some reason even a lower double-digit return wasn’t good enough. Stakers were pissed-off with UST.

Many people now speculate the interest rate rollback and the shift in sentiment caught the attention of a crypto short-trader. One with big bags and bigger balls. While nothing is confirmed, there is enough evidence to suggest what happened next was a planned attack stolen right out of 1992. Yes, more on that later as well.  

A single trade triggered the crypto market crash

On May 7th, all hell broke loose when a single trade was so big it basically broke the market. Late that night, over $2 billion worth of UST was withdrawn from Anchor Protocol. Many have reason to believe someone shorted UST, because immediately after that withdrawal, $84 million worth of UST was sold and the price dipped below $1. The sale also triggered $84 million worth of new LUNA to mint and flood the market, which lowered its price too.

But at that time of night, trade volume is low because people are sleeping so there isn’t as much liquidity for trading. Trades in a low liquidity environment have a bigger, more immediate impact on crypto prices. It also meant there weren’t as many arbitrage traders around. Remember, no matter the price of UST, you can swap it for $1 worth of LUNA. Arbitrage and the mint-and-burn scheme should have put upward pressure on UST, but they didn’t. The offending UST sale was just too big and there wasn’t enough trade volume to compensate. 

Cue the “bank run” on Anchor Protocol. Stakers got spooked and started withdrawing their UST from Anchor and selling it. The next morning, people woke up to see the price of their UST had dropped, so they started panic selling in droves. When they did, massive amounts of fresh LUNA were minted, flooding the market and tanking its price even further. Within a day, UST lost its peg and dropped from $0.99 to about $0.90. Crisis mode activated. The market had a collective panic attack, triggering a vicious cycle that drove UST and LUNA through the crust of the earth.

What happened next was an actual death spiral into Hades. Chaos erupted on the Terra network. There were so many people trying to sell their UST and LUNA before prices bottomed out that the network crashed and eventually shut down. Other exchanges halted trading, which prevented holders from dumping their coins to stop the bleeding, which scared all crypto holders across the broader market. 

By May 16th, the price of TerraUSD (UST) dropped 99% from $0.99 to a low of $0.09. Its sister coin, Terra (LUNA), basically dropped 100% from roughly $80 to just $0.00018; literally a fraction of a penny. Needless to say, there are a lot of really stressed out, traumatized UST/LUNA holders right now. Real people lost real money with real-world consequences. The pain is palpable.    

How did the crypto market crash affect the price of Bitcoin? 

Let’s circle back to those Bitcoin reserves. You know, in case things got ugly? TerraUSD founder, Do Kwon, created a Bitcoin reserve to help restore parity should UST ever drop too far below $1 US. He could sell Bitcoin and buy UST until the price recovered. And that’s exactly what he did, sort of. 

As both UST and LUNA fell, Kwon drained the $3 billion Bitcoin reserve and transferred it to at least two major crypto exchanges. From there, the trail goes dark. We can’t see if the Bitcoin was sold, loaned out, or moved to a private wallet. So what did Kwon do with all that Bitcoin? We don’t know for sure. 

On Twitter, he claims the plan is to lend Bitcoin over the counter (OTC) to market makers, which are liquidity pools that facilitate trading. What we do know is that the price of Bitcoin dropped about 25% during the carnage. Draining the Bitcoin reserve likely impacted the price of Bitcoin, but the carnage was enough on its own to scare enough crypto holders into selling whatever they had, triggering a crypto market crash. 

A crypto whale copied this traditional investor

If the unregulated free-for-all is off-putting, I have news for you. It started on Wall Street. What happened with UST and LUNA is not just a crypto problem. Traditional financial markets are susceptible too. 

Hop in the Delorean, we’re going back to 1992. The whole UST debacle copied the tactic George Soros used against the Great British Pound. He went down in history as the guy who “broke the Bank of England,” and made the most money ever on a single trade. How? It’s a long story but an interesting one.

How the traditional market inspired the crypto market crash 

England entered into an agreement called the Exchange Rate Mechanism (ERM) to peg the Great British Pound (GBP) to the German Deutschmark. But England was experiencing a high rate of inflation at the time, about 3x higher than Germany’s, which was devaluing England’s currency. It was hard to keep up with the Deutschmark. To maintain parity, they needed to prop up the price. So the Bank of England increased interest rates to make bonds more attractive and started using its own foreign currency reserves to buy the GBP.

Then a recession hit England, but they couldn’t lower interest rates to stimulate the economy or it would devalue the GBP and break the peg. So they were forced to keep buying up their own currency at the same time negative financial news out of Europe started to shift market sentiment.  

Soros saw the writing on the wall and knew it was unsustainable. Along with a few others, he bet against the GPB with a trading move called a short position; selling the GBP at the current price, promising to buy it back at some point in the future. He knew the GBP was over-valued, so a short-trade was just a risky and roundabout way to buy low, sell high, and pocket the difference. Soros took a massive $10 billion short position against the GBP, which spooked other traders and immediately weakened it.  

That triggered panic and the market started unloading GBP, but the Bank of England could not buy up the supply fast enough to stabilize the price, nor could they afford to or they’d literally run out of reserves. The GBP cratered by 20% forcing the Bank of England to exit the ERM agreement. 

The crypto market crash: new market, old game

Soros made a $1 billion profit on his short-trade, while the Bank of England lost over £3 billion. Now, a single crypto whale annihilated UST and LUNA. But it’s not a one-off move from 30 years ago. 

All financial markets have weaknesses, from computer models to big players that can tip the scales, and opportunists looking to get rich quick. There was Black Monday in 1987, the 2008 financial crisis, not to mention multi-billion dollar schemes like those of Charles Ponzi and Bernie Madoff. Insider trading is an ongoing problem and the reason Martha Stewart went to jail. Then there are companies who intentionally defraud investors like Enron and WorldCom.  

Is the crypto market crash the end for Bitcoin? 

Someone pulled the pin on UST and LUNA. The explosion sent shrapnel ripping through the market, but Bitcoin probably didn’t sustain any fatal injuries. Yes, the crypto market is weakening, but so is every other financial market right now. The decline makes sense given the current economic climate, and so do the more dramatic highs and lows with how new and unregulated digital assets are. 

The birth of the internet created a tech bubble in the 90s that eventually burst and triggered a bear market. Now, the economy runs online. I won’t pretend crypto is just as risky as the stock market. It’s actually more risky because it’s still in its infancy and under-regulated. Of course, there are regulated cryptocurrency exchanges and governments are looking at the best ways to regulate crypto. Some countries are even adopting Bitcoin as legal tender. Just as the internet caught on and tech matured, digital assets are on their way there too. We just don’t know which projects will thrive and which ones will die off because no one has a crystal ball. 

And just like the stock market, Bitcoin has survived major crashes and big scandals. It’s going to take a lot more than an unstable coin to kill the notorious BTC. The point is not to accept scammers and manipulators as par for the course. The point is that wherever there is an Achilles heel, someone will kick at it. There are incredible opportunities in crypto, but there is also risk and you need to manage it appropriately. 

This crypto market crash taught us 4 critical lessons: 

1. Never invest more than you can afford to lose
2. Don’t be greedy
3. Regulation is not the enemy, and 
4. Risk management is the most important part of any investing strategy, no matter where you do it