Crypto: rise in institutional interest

In May 2022, cryptocurrency (or crypto) experienced a massive loss of value due to Terra’s crash. As a result, retail investors have exited their positions, and various jurisdictions are considering increasing regulation on the crypto industry.

Despite this, financial institutions have been increasing their investments into crypto.

The debacle surrounding the rapid and spectacular failure of FTX was, unfortunately, not isolated, and part of a series of failures which beset the cryptocurrency industry in 2022. Cryptocurrency’s rapid loss of value has been widely publicized: between November 2021 and June 2022, the value of Bitcoin fell by 70%, from approximately US$68,000 to US$20,000. This steep decline was largely due to a tightening monetary policy around the world, but was severely exacerbated by the failure of the Terra stablecoin, alternatively known as TerraUSD or UST.

A stablecoin is a digital cryptocurrency asset whose price is pegged to another financial instrument, typically a traditional asset class, such as a currency or a commodity. One of the most widely used stablecoin is Tether (also known as USDT), which is pegged to the US dollar.

Stablecoins are not issued by a cryptocurrency exchange, but they have to maintain reserve assets of the pegged currency as collateral, mitigating against the inherent volatility of conventional cryptocurrencies as a medium of exchange.

As a stablecoin, Terra took a different approach: it was pegged to the US dollar, but not backed by reserve assets of that currency. Instead, Terra was linked algorithmically to a sister token, Luna, whose price was set by the market. Luna served as the primary backing asset for Terra, and UST targeted a consistent value of US$1 by enabling users to exchange it for US$1 of Luna. Users could sell UST for Luna when UST prices rose above US$1, and could buy UST at a discount when prices fell below US$1.

In theory, Terra was supposed to remain stable, while Luna served as a volatility buffer. This approach also created arbitrage incentives for traders to maintain the value of UST at, or close to, US$1.

In May 2022, this Terra-Luna system was severely disrupted. It is still not fully known what precipitated the initial slump in UST demand, but in early May, a large amount of UST was withdrawn from a decentralized exchange.

In particular, an unknown user exchanged approximately US$84 million worth of UST for another cryptocurrency. These large movements set off a cascade of UST withdrawals, which eventually led to its depegging from the US dollar.

The UST-Luna linkage meant these large UST withdrawals led to a rapid increase in the supply of Luna, resulting in a parallel rapid drop in the latter’s price. Since cryptocurrency traders relied extensively on UST as a medium of exchange for other cryptocurrencies, Terra’s nosedive quickly accelerated into an outright market-wide crash.

Eventually, the collapse of Luna and UST led to cryptocurrency traders fielding a loss of approximately US$18 billion in May 2022 alone.

By July 2022, the global crypto assets industry had lost 70 percent of its value within 6 months, while the value of crypto assets had fallen from US$3 trillion (November 2021) to US$1.3 trillion (July 2022).

Since Q4 2020, the KPMG Financial Performance Index (FPI) has been tracking a steady decline in crypto firms: between Q4 2020 and Q4 2021 (from 94.3 out of 100 to 76.0) the falling FPI scores are consistent with the worsening debt position of the industry. Therefore, FPI analysis could potentially have served as a predictive indicator of the then-impending distress.