Investors are taking stock of last week’s collapse of the Terra stablecoin, and its repercussions on the entire cryptocurrency market.

The Korean-managed Terraform Labs shuttered its Terra blockchain platform after the price of its Terra USD stablecoin and cryptocurrency Luna lost almost all their value, wiping out billions of dollars of funds and rattling the global crypto market.

If anything, the crisis has highlighted the ample warnings issued by regulators on the risks involved in investing in what many consider an emerging asset class.

In Singapore, where Terraform Labs is registered, the Monetary Authority of Singapore ( MAS ) has sought to dampen interest in crypto trading. As early as January 2022, it issued guidelines to discourage cryptocurrency trading service providers from placing any form of advertising or promotional materials in public areas, including any type of promotional materials or advertisements in places such as public transport and related venues, public websites, and both broadcast and print media outlets. They can only advertise or market on their corporate websites, mobile apps or their own official social media accounts.

In Thailand, a ban on the use of digital assets such as crypto tokens for payment of goods and services took effect from April 1. However, the country’s Securities and Exchange Commission has said the trading of digital assets for investment purposes is still allowed.

Algorithmic system

The Terra crisis happened after the company’s custom-built algorithmic system supporting the stablecoin collapsed. Terraform Labs had developed a smart-contract algorithmic system designed to maintain a dollar peg by incentivizing its crypto holders with high yields to arbitrage between its Terra USD stablecoin ( UST ) and Luna crypto coin.

However, a combination of withdrawals of hundreds of millions of dollars from Anchor, a platform that supported the Terra USD stablecoin, set in motion a run on the Terra and Luna tokens, breaking the Terra USD stablecoin’s peg to the dollar. And when that system broke down, the price of Luna subsequently collapsed.

Terra Labs’ Luna coin traded at US$0.005 on May 12 with a market capitalization of US$56 million, down 99.8% from US$28 billion the previous week. Before the collapse, Terra USD was the third-largest stablecoin in the world with a market cap of around US$18 billion.

The failure forced crypto exchanges to delist the Terra USD and Luna from their platforms with investors losing almost all the value of their investments in the stablecoin and token.

It remains to be seen whether efforts to boost the UST back to its previous highs will be successful.

Terraform Labs was founded in 2018 by South Koreans Do Kwon and Daniel Shin. Shin is no longer associated with Terraform Labs.

In December 2019 the then blockchain payment startup Terra incorporated a business unit in Singapore to set up its Southeast Asia hub with ambitious plans to expand in the region.

The company said at the time it planned to grow its onshore network in the region through strategic partnerships with local businesses including e-commerce platforms Carousell and Qoo10, and to officially launch its stablecoin.

After the turmoil in the crypto markets broke out last week, however, Terraform Labs CEO Do Kwon fled his home and asked for police protection, fearing for his safety, according to local media sources.

Not so stable

As its name implies, a stablecoin is a form of digital asset that is supposed to have a stable value as it is pegged to a fiat currency or another financial instrument.

Tether and USD Coin are among the biggest and well-established stablecoins, claiming to be backed 100% by cash reserves, liquid assets, and other investments. That linkage, however, was tested during the Terra USD and Luna crisis with Tether dropping to US$0.95 on May 12.

The Terra USD is an algorithmic stablecoin, which seeks to maintain price stability though an algorithmic formula that is supposed to control supply.

Critics of the digital assets claim the only true stablecoin would be a government-backed cryptocurrency as there is no altruistic obligation or incentive for independent stablecoin providers to hold deposits or reserves or remain solvent.

Industry insiders, meanwhile, say that the Luna and Terra USD debacle will be a painful and expensive lesson for crypto investors as it has exposed the instability of the fragile algorithm-based stablecoin structure.

Commenting on the fallout, Chen Zhuling, founder and chief executive officer of RockX, a Singapore-based institutional gateway to crypto finance and blockchains, says: “There are mixed reactions currently. We're seeing huge trading volumes of Luna within the past couple of days, suggesting that investors are interested in the opportunity of buying low. However, others are still concerned about the extensive fall of a top 10 cryptocurrency.”

 “It is unlikely we have seen the bottom, since the crypto market is yet to absorb and process the full aftermath of UST depegging. The macroeconomic outlook for cryptocurrencies is also full of volatility and uncertainty,” Chen tells The Asset. “Regulators will certainly scrutinize crypto assets, especially stablecoins, further following these recent events.”

Benjamin Stani, director of business development at Matrixport, one of Asia’s fastest-growing digital asset financial services platforms, remarks: “In my opinion, we still have not seen the full implications from the Luna fallout yet. It's unlikely that any major institution may be too adversely affected, ruling out systemic risk.”

“Volatility has also spiked after the move but then also quickly retraced, albeit with off-peak trading levels still elevated. It's hard to say if we have seen a bottoming yet but, overall, I would say regulatory action and other macroeconomic factors will set the agenda.” Stani adds. “Some regulatory action may likely result but we hope there will be a clear differentiation between algorithmic stablecoins [backed by other crypto assets] and fully asset-collateralized stablecoins.”

Volatile markets

The Terra USD and Luna downfall came amid a period of volatility in the crypto markets following the Federal Reserve’s interest rate hike of 50 basis points in early May.

The global crypto market was also jolted by the shockwaves from the Terra Labs calamity with the price of tokens plunging. Two prominent cryptocurrencies typified the rout: bitcoin dropped below US$25,000, its lowest value since December 2020, while ethereum lost more than 20% of its value.

Crypto trading exchange Coinbase suffered a double hit with its shares falling by almost 25% after reporting lower-than-expected first-quarter revenues and a fall in monthly users on May 10, followed by the news of the Terra USD collapse.

This latest surge of volatility in the crypto markets has led to calls for tighter regulation with US Treasury Secretary Janet Yellen saying that the US needs a regulatory framework to guard against the risks surrounding stablecoins and cryptocurrencies.

Regulators in other jurisdictions are also likely to take a stricter stance on cryptocurrencies and digital tokens to protect the interest of investors and prevent contagion in the broader financial markets.