One shiny premise of DeFi, or decentralized finance—a catch-all term for cryptocurrencies and blockchain projects related to the exchange of value—is that by spreading out and automating operations, and removing power from middlemen like banks, it can offer a system more resilient to global forces, able to survive events like war and economic downturns that pummel traditional markets. Some industry insiders have even suggested crypto could be a good investing bet to ride out a potential recession.
Now in our current precarious financial climate, with the traditional market slipping dramatically and Big Tech stocks plummeting, that theory of resilience is getting a real-life road test. And the results are not great.
Bitcoin has taken its own nosedive in the past few weeks, while Ethereum and others have dipped as well. As “Web2” tech companies like Amazon and Netflix watch their stock drop, Coinbase, one of the top three crypto exchange platforms, and Robinhood, which supports crypto trading, have seen theirs falling right alongside. Even popular proof-of-stake network Solana has seen its coin drop in value by about 80% since its all-time high in November. But the big crash came last week, when the major algorithmic stablecoin TerraUSD (UST) tanked dramatically. A $100 stake in UST last Monday was worth just $18 by Sunday morning; that much in its sister token, Luna, is worth pennies now.
Stablecoins, as the name suggests, are designed to be the rocks of the crypto ecosystem, pegged sturdily to real-world assets like the dollar. Exchanges use stablecoins to even out the volatility of other coins, and crypto investors may favor them as a safer bet to park money. They have served their function pretty well so far, although questions around consumer safety and their potential for illicit activity have certainly caught the attention of regulators.
Algorithmic stablecoins, however, are different. They are a DeFi experiment that aren't pegged to fiat money and don't hold collateral assets to stabilize their value. Instead, they are usually supported by a second token, in a push-me-pull-you math equation. Terra, for example, balances variations in the stablecoin’s value by increasing or decreasing the supply of Luna tokens through incentives; investors can profit off these exchanges, which keeps them—in theory—trading tokens in the amounts the algorithm predicts they will. But much of this is magical thinking.
Well before the Terra crash, algorithmic stablecoins were generally understood to be much less stable than regular ones. Even Sam Bankman-Fried, CEO of the crypto exchange FTX and a notable “crypto billionaire,” argued on Twitter last week that the two types of stablecoins are so distinct from both a functional and risk perspective that “[r]eally, we shouldn’t use the same word for all these things.”
So why pursue algorithmic stablecoins at all? Because they were supposed to be the DeFi holy grail: a stable unit of value that self-corrects independently and elegantly, like water naturally finding its own level. They appeal to Bitcoin purists because algorithmic stablecoins aim to avoid what regular stablecoins like Tether and USDC rely on to function: a tie to the real world and traditional markets. They operate on code alone—besides, of course, the human traders the system presumes will act in a predictable way. If algorithmic stablecoins perform as promised, they could demonstrate that code is the future of finance, lending new credibility to the crypto worldview.
For a while, it looked as if Terra’s experiment might just work. In February, Terra closed a multimillion-dollar sponsorship deal with the Washington Nationals. Just over two months ago, in March, its blockchain—the seventh most valuable in the world at the time—became the number two staked network, unseating Ethereum. But on Monday, May 9, things went off course. Someone may have pushed UST’s value to start dropping by acting against the algorithm’s predictions. Then the coin crashed to well below the $1 value it was designed to maintain, fueled by very human, fear-driven “bank runs.”
When UST reached $0.37 on Thursday, the company that manages it, Terraform Labs, even made the last-resort call to temporarily stop transactions on its network to protect against further decline and then froze them once more overnight—preventing any token holders from taking what little they had left and running. Since the network restarted, Terra’s UST has continued to fluctuate well under $0.50; Luna hovers just above zero.
Each company in the crypto ecosystem has its own explanation for why it’s faltering. Coinbase’s much-anticipated new NFT marketplace had an underwhelming launch at the end of April, which may have put off investors and hurt its stock price. The Luna Foundation Guard, the nonprofit that supports Terraform Labs, had stockpiled $3.5 billion in Bitcoin by early May and then seemed to sell off a chunk of its stash in order stay afloat as the price of UST began to dip; both actions could have helped contribute to drops in Bitcoin’s value. Some Terra/Luna supporters even accused BlackRock and Citadel of intentionally manipulating the market to force UST to crash—a rumor vicious enough to prompt the companies to respond, asserting that they had no hand in the event. Then there’s the question of management. CoinDesk reported that the CEO of Terraform Labs was also behind a previous failed algorithmic experiment; maybe his leadership was another hole in the stablecoin’s boat.
But all these faulty pieces add up to an experimental system that is vulnerable to the same market trends as traditional finance—only without strict regulation and strong guardrails. The price tag of last week’s wild ride tallied up to some $270 billion in crypto assets lost. Even the non-algorithmic powerhouse stablecoin Tether briefly ducked below its $1 peg last week, indicating that standard stablecoins may not be immune to volatility. And the impact of all this activity likely doesn’t end at crypto’s border.
With banks launching crypto products and non-algorithmic stablecoins relying on the paper dollar to keep them steady, the crypto industry is clearly “tethered” to the rest of the financial market in multiple ways; the question now is if the plummeting coins will drag down traditional stocks in return. In January, Paul Krugman predicted in the New York Times that crypto assets may be the new subprime mortgages—bad eggs that have the power to spoil the whole market. This week, individual crypto investors claimed to have lost their life savings already. There may be more pain in store.
But even as social media fills up with mocking memes and skeptical news outlets label this the start of a crypto “winter”—a term used when technologies undergo a prolonged period of public disinterest and lack of innovation—crypto executives and investors are not just betting the crypto ecosystem will return to its glory days. They are planning for it. Even the word “winter” implies there will be a spring for the believers who can wait it out.
On Wednesday, Terra founder Do Kwon tweeted a threaded letter to the Terra community, describing his plan to resuscitate the stablecoin and assuring that it would turn around. “Short-term stumbles do not define what you can accomplish,” he wrote. “It’s how you respond that matters.” Coinbase founder Brian Armstrong is also claiming a full-throttle focus on the future as the company’s stock tipped back up on Thursday after losing half its value. In an internal memo that Armstrong made public, he wrote, “Volatility is inevitable. We can’t control it, but we do plan for it … I just know that we will make it through to the other side, and we come out stronger than ever if we focus on what matters: building.”
Many crypto believers are buckled in for the journey. The prevailing philosophy of Web3 enthusiasts is HODL: “Hold on for dear life.” That is both for the good of the crypto community and to preserve the value of one’s own holdings through a dip. Some “Lunatics,” as Terra/Luna fans and owners call themselves, are in fact holding on tight. Do Kwon’s plan to nurse Terra back to health means burning a huge quantity of Terra tokens, costing Terra and Luna owners significant value. As of Sunday, more than 60% of governance token holders had cast in favor of the plan; it needs only 40% to pass, and the vote is set to end on Tuesday.
The next trick will be for investors and executives to convince the rest of the world that crypto—Bitcoin and stablecoins in particular—is still healthy a experiment. They certainly have good reason to do so: belief can actually drive up unbacked crypto markets. In a well-timed statement on Thursday, Bitcoin’s Lightning network startup Lightspark—founded by a veteran of Meta’s shuttered stablecoin project—announced that it had received funding from major Web3 players Andreessen Horowitz and Paradigm, among others. That same day, Bankman-Fried disclosed that he’d made a significant new investment in the faltering investment platform Robinhood; on Friday, the stock leaped 22%. More confidence- (and stock-) boosting announcements from crypto bigwigs may roll in this week.
What remains to be seen is if the real money still pouring into the industry from VCs and evangelists can float it through icy times, and—if it manages to find its way back into the sun—how many acolytes, and even regular market investors, will be sacrificed to the freezing waters first.
Rebecca Ackermann is a writer, designer, and artist based in San Francisco.
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