It wasn’t the only one. Ethereum, another star crypto currency, lost 24% over the weekend, while an index tracking the top 100 crypto currencies dropped as much as 17%, its lowest levels since December 2020. The generalized collapse was so brutal that Celsius, a crypto lender, halted both withdrawals and transfers, citing extreme market conditions. Just as alarming was the collapse in the price of Terra last month, a stablecoin meant to remain pegged to the dollar. The drop erased $41bn in value. What do these extreme swings – and the forces behind them – tell us about crypto as an asset class?

The first lesson is that while crypto is nominally beyond the control of central banks and governments and not technically eroded by inflation, it is not independent of the real economy either. Policy decisions will impact crypto prices. This was evident before the current market volatility. In early 2021, for instance, Bitcoin’s price crashed when the Chinese government said it was going to regulate crypto more closely. The price of Bitcoin has also followed that of the tech sector very closely in recent months.

The second lesson is that algorithm-based stablecoins are not always fit for purpose. As evidenced by Terra, some are vulnerable to speculative attacks when under-collateralized. TerraUSD used a Bitcoin reserve to support its dollar peg, for example, but reserves had to be sold off to fend off a speculative attack on the currency, triggering the catastrophic fall in value.

To be fair, neither the Terra crash nor the Bitcoin drop mark the end of stablecoins or crypto as a broader asset class. Some stablecoins are backed by real assets like gold, oil, and real estate, so the problem may be specific to algorithm-based models, and more specifically those relying on valuations of other crypto assets.

Mainstream institutions do see value in stablecoins as an instrument in the broader digital finance ecosystem. Some, like the Pax Dollar and Gemini Dollar, are formally regulated. More broadly, banks are already channeling billions of dollars through blockchain-based financial infrastructures and governments from Ecuador to Australia are leading research and pilots into virtual central bank currencies. The rapid rise of the metaverse, meanwhile, will act as a strong demand base for cryptocurrencies.

Regulators might put the brakes on, however. While the Terra collapse had limited impact on the financial system despite the tremendous economic loss (Lehman Brothers was worth $60bn when it collapsed, compared to Terra’s $40bn), stablecoins’ stellar 14-fold growth in market size (from $11bn to $160bn today) is leading some to worry about contagion risk in the future. Both the UK and the US central banks have notably called to proactively explore the implications of stablecoins on the real financial system.

If there is one lesson of the 2008-2009 financial crisis, it is how a financial instrument in one part of the market can ricochet through the global economy. Terra could be the warning shot needed to get stablecoins on to safer ground. It might come during a crypto winter.

A Crypto Winter is Coming