The Crypto Crash Explained

The past decade saw a lot of success for cryptocurrency. Crypto investors viewed digital currencies as a strong alternative to fiat currencies, like the dollar. Buying Bitcoin and Ethereum helped some investors amass fortunes. Excitement for decentralized finance grew and new crypto companies sprang up every day.

Then came the crash. Values for major coins dropped rapidly. Within days, billions of dollars were lost.

So, what happened? And what does it mean for us as investors?

What caused the crypto crash?

You don't need to understand crypto to understand the crash, but it might be helpful to learn more about a token called Luna (LUNA) and its sister token, TerraUSD (UST).

Part one: A brief history of Terra

Terra Labs created UST as a stablecoin, or a coin pegged to the value of a fiat currency. Terra pegged UST to the value of the U.S. Dollar (USD). This means that the value of one UST token held stable at $1, even as the USD fluctuated.

Usually, crypto companies back their stablecoins with hard assets, such as cash or gold. But with UST, Terra took a different approach. They created LUNA as a sister coin designed to help UST maintain a stable value. At any point, users could exchange LUNA tokens for UST tokens (or vice versa) with no transaction fees at a guaranteed value of $1. For example, if LUNA's value rose above $1, a user could exchange $1 worth of UST for the more valuable token.

This helped UST remain pegged to the Dollar in an interesting way. Whenever a user exchanged their token, it would burn the token they exchanged in order to mint the new token they received. This means that, if they exchanged a LUNA token for a UST token, that LUNA token would be destroyed forever. Then, a new UST token would be created for them to own.

By destroying old coins and minting new coins, they controlled their tokens' rarity. Whenever UST's value rose above $1, many users would burn their LUNA tokens to mint new UST tokens. By creating new USTs, they'd decrease its rarity and help devalue the token back down to $1. If it ever dipped below $1, users would burn their tokens, increase their rarity, and raise their value.

Part two: A series of unfortunate events

Because Terra Labs lacked the hard assets to back up their coin, they purchased large amounts of Bitcoin. Their Bitcoin cache was valued in the billions. If they ever needed to stabilize UST's value, they could sell some of their bitcoin to reinvest and keep it pegged to the Dollar. This unwittingly linked Terra's success and stability to Bitcoin's value.

Unfortunately, high inflation and rising interest rates affected the stock market. Confidence in crypto dropped. UST's value dropped below $1 multiple times within a few days. As investors sought more stable assets, the Bitcoin network experienced a selloff that saw Bitcoin's value drop—and with it, the value of Terra's Bitcoin cache. To stabilize their coin, Terra was forced to sell billions worth of Bitcoin at a fraction of their original value.

They could not successfully stabilize their tokens themselves. Selling their Bitcoin only contributed to the selloff, and confidence in crypto continued to plummet. It was a massive confluence of unfortunate circumstances. Within a matter of days, an unstoppable downward spiral had begun. And the crypto market still has yet to recover.

What does a crypto crash mean for investors?

For many investors, the crypto crash was a startling return to reality. For those who either haven't invested in crypto or were lucky enough to avoid major losses, we can find value in the lessons learned from the crash itself. There are two primary lessons we can take from this experience:

Lesson one: Ignore the hype

We often advise investors to go against the herd. Crypto's successes made that understandably difficult. For the past several years, the crypto market experienced a long bullish period. The price of Bitcoin and other cryptocurrencies hit all-time highs—and so did investor confidence. For some, these bullish views on crypto made investing in it feel safer and less risky. The hype brought in a lot of new, inexperienced investors who bought large amounts of crypto. Even some experienced investors saw the undeniable success of major cryptocurrencies as something of a safe bet.

Unfortunately, safe bets in investing are few and far between. Bull markets eventually become bear markets. And that brings us to our next lesson:

Lesson two: Treat crypto like any other investment

The higher the risk, the higher the reward. For many years, the cryptocurrency market offered unusually high rewards. Hidden behind that, either ignored or unknown by many investors, was the risk that came with it. And like those rewards, the risks were also unusually high.

If you want to invest in crypto, find a strategy that helps lower that risk. Treat crypto investments as you would any other investment. Do your research to find which coin(s) fits your investment strategy. Make it part of a diverse portfolio. Take your time, dip your toes in the water, and invest slowly. Regularly reassess where your investment stands, then make adjustments. Use dollar-cost averaging and other strategies you might use for any other asset.

The Future of Crypto

It's hard to predict what the future might bring for crypto. The long-term effects of the crash are still to be seen. The most likely outcome is more regulation over the crypto market. Many officials in the U.S. and other countries are currently figuring out how to regulate crypto markets in a way that helps make them safer for investors. These talks are still in the preliminary stages, so the future is uncertain.

Until then, we have to rely on our knowledge, experience, and instincts to guide us.

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