Why did Terra and Bitcoin crash and are cryptocurrencies rebounding now?

Huge losses resulted in billions being wiped off the value of digital tokens

The value of investors' holdings in Bitcoin and Terra rapidly diminished this week. Getty

“Meltdown”, “turmoil”, “financial disaster”. It has been quite a week for the world of cryptocurrencies as markets plummeted and the value of investors' holdings in digital assets such as Bitcoin and Terra rapidly diminished.

Bitcoin was set for a record losing streak while Terra, a stablecoin, collapsed to close to zero on Thursday.

But what happened? Why did the crash occur and is it now over?

What happened to Terra?

Stablecoins, which are pegged to the value of traditional assets such as the US dollar, are usually popular in times of turmoil. They are key elements of the cryptocurrency market and traders park funds in these assets as they move in and out of other digital tokens.

However, Terra slipped below its 1:1 peg to the dollar this week, as global stock markets fell amid rising interest rates and high inflation.

Terra's value is derived by algorithmic processes and it is linked to another paired token called Luna.

Luna fell by more than 94 per cent on Wednesday to almost zero, compared with a high of $119.51, and the blockchain behind both coins twice stopped processing new transactions.

The blockchain’s validators unveiled a software update designed to help avoid attacks on the network.

The largest stablecoin, Tether, also diverged from its 1:1 peg, although marginally.

“The Terra incident is causing an industry-based panic as [it] is the world’s third-biggest stablecoin that couldn’t hold its promise to maintain a stable value in terms of US dollars,” Ipek Ozkardeskaya, a senior analyst with Swissquote Bank, said on Thursday.

“The Terra-USD peg is mostly based on the belief that one could always exchange Luna to guarantee a $1 peg for Terra. But, apparently, that belief is not working any more, and trust is a foremost ingredient in cryptocurrencies' success. So, the level of stress in other cryptocurrencies is mounting.”

Fitch Ratings said that in the case of Terra, the backing entity’s cryptocurrency reserve was not sufficiently large to serve as a source of stability when its algorithmic peg mechanism came under speculative pressure.

“We expect recent developments to lead to increased calls for regulation of stablecoins,” the rating agency said in a note.

How is Bitcoin faring?

The world's largest cryptocurrency has been struggling, too. Bitcoin was at a 16-month low of about $25,400 on Thursday. While it rose close to $30,000 on Friday, it is still way below the $40,000 level it was at a week ago and about 60 per cent below record peaks reached in November.

“Bitcoin has rebounded from $25,424 but this won’t last if risk appetite does not stabilise soon,” said Edward Moya, senior market analyst at Oanda.

“Bitcoin is still vulnerable to one last plunge that could coincide with a stock market sell-off, before many crypto investors feel the bottom is in place.

How is Bitcoin's plunge affecting El Salvador?

It became the world’s first government to make Bitcoin legal tender in September. The idea was to draw more people into the financial system and make it cheaper to send remittances.

However, after the government spent about $105 million buying more than 2,300 Bitcoins, the value is now at about $66m.

The losses are equal to the cash-strapped nation’s next interest payment to bondholders, Bloomberg reported.

Will cryptocurrencies rebound?

Sentiment was generally improving on Friday morning.

“The dust seems to be settling in cryptocurrencies,” Ms Ozkardeskaya said.

“Terra and Luna are now worth almost nothing and probably won’t regain investors’ confidence, and Tether had a mini crash to 0.95, but it recovered fast before things got serious,” she said.

“Bitcoin returned past the $30,000 [level], which is a sign that confidence in the broader sector may not have been damaged as much as we first feared.”

However, analysts also believe that further declines are in store for cryptocurrencies.

“I don't think the worst is over,” said Scottie Siu, investment director of Axion Global Asset Management, a Hong Kong-based company that runs a cryptocurrency index fund.

“I think there is more downside in the coming days. What we need to see is the open interest collapse a lot more, so the speculators are really out of it and that is when I think the market will stabilise.”

How is Hollywood actor Matt Damon involved?

The actor is being criticised across social media for an advertisement he starred in for Crypto.com in October last year.

The advert ran under the tagline “Fortune Favours the Brave”. Mr Damon's financial advice is not looking too sharp right now.