TerraUSD and Luna Send Ripples Through Crypto Markets

The Creation and Collapse of Terra and Luna. Terra launched in 2020, amassing a market capitalization of nearly US$20 billion before its collapse.[16] Exchanges between Terra and Luna are central to Terra maintaining its US$1 price, yet that system broke down earlier this month.  Beginning around May 7, Terra broke from its peg and began losing value.[17]  As Terra fell below US$1, investors rapidly sold Luna, causing the linked cryptocurrencies to nosedive.[18] Terra dropped to a low of US$0.08, briefly rallied to US$0.31, and is now valued at just US$0.0687.[19]  Terra’s market value has fallen from its nearly US$20 billion high[20] to about US$773 million.[21] Luna has also plummeted, currently trading at US$0.0001591, down from a high of nearly US$100 in April.[22]  Its market value has fallen to about US$1 billion, down from about US$41 billion earlier this year.[23]  One analytics firm estimates that holders of Terra and Luna lost about US$42 billion from May 9 to May 16.[24]

The broader crypto market felt the aftershocks of Terra’s collapse.  All told, crypto investors lost “more than US$240 billion of wealth in a single day” as a result of Terra’s decline,[25] and current losses stand around US$300 billion “across the crypto economy.”[26]  This market uncertainty hit Bitcoin particularly hard, driving its price below US$26,000 for the first time since December of 2020.[27]  Other stablecoins also felt the effects of Terra’s swift decline.  For example, the industry’s largest stablecoin, asset-backed Tether, saw its market capitalization decline from an all-time high of US$83 billion on May 11 to US$75.6 billion on May 17 as it briefly lost its dollar peg.[28]

The Attempt to Revive Terra and Luna. Terra’s creator, South Korean entrepreneur Do Kwon, announced a plan on May 16 to attempt to revive Terra.[29] He plans to do “what is called a ‘fork’ in software terms—basically taking the existing code and starting over with an updated version.”[30] The updated version would eliminate the algorithmic stablecoin and “distribute 1 billion tokens of a new version of Luna to existing Luna and Terra[] holders and developers.”[31]

Kwon unsuccessfully tried to save Terra last week during its slide, as well. Although an algorithmic stablecoin, Terra did have some reserves meant to protect it from this type of collapse. Specifically, the Luna Foundation Guard (“LFG”), a non-profit Kwon co-founded to support Terra, holds substantial Bitcoin reserves, which as of May 7, totaled about US$3.5 billion.[32] But even though Terra was purportedly backed by these reserves, Terra’s value still plunged.[33]

Volatility in the Stablecoin Market Expands Beyond Terra

Terra’s collapse is just the most recent example of extreme volatility in the stablecoin market. Last fall, GYEN, an asset-backed stablecoin pegged to the Japanese yen, caused turmoil when it became untethered from the yen and spiked in value.[34] GYEN was listed for trading on Coinbase on November 10, 2021.[35] One week later, GYEN broke free from its peg, increasing to about 7.5 times the value of the yen before falling back to the peg.[36] Coinbase eventually disabled trading for “technical reasons” after a flurry of trading activity.[37]

Last week, private investors sued GMO Trust (the issuer of GYEN) and Coinbase on behalf of themselves and a purported class.[38] The proposed class action complaint accuses GMO Trust and Coinbase of misleading investors about GYEN. Specifically, the complaint alleges the defendants knew, “based on a prior destabilizing event, that GYEN’s peg to the yen was prone to break and that such an event would be likely, if not certain, when GYEN opened for trading on Coinbase.”[39] Plaintiffs further claim that Coinbase “compounded the harm by restricting many customers’ ability to sell the asset,” causing the loss of “untold millions in a matter of hours.”[40]

The proposed class action complaint advances numerous potential liability theories against GMO Trust and Coinbase, including consumer class action claims under California law and alleged violations of the Securities Act of 1933. Plaintiffs claim that Coinbase, as a trading platform, had itself marketed the cryptocurrencies available for trading. GYEN, however, has not previously been viewed as a security by the Securities and Exchange Commission or any court, and therefore, we think it unlikely that the securities claims will survive a motion to dismiss.

Looking Ahead

Litigation. The suit against GMO Trust and Coinbase is just the tip of the iceberg. According to Morrison Cohen’s Cryptocurrency Litigation and Regulation Tracker, “[c]rypto has generated more than 200 class action lawsuits and other private litigation as of this month, up more than 50% since the start of 2020.”[41]  The Cryptocurrency Litigation and Regulation Tracker further shows that class actions and private suits make up half of all crypto litigation.[42]  Given these metrics, it seems likely that the Terra and Luna collapse will invite its own deluge of legal claims.  But clarity as to what recourse investors may have, if any, will likely have to wait for a greater understanding of the events that precipitated the collapse.[43]  And whether courts will accept plaintiffs’ theories of liability or efforts to litigate these cases as class actions remain open questions that will likely depend on the individualized facts of each case.  Despite much uncertainty, one thing seems clear: the flood of crypto litigation will continue.

Federal Regulation and Legislation. The U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing on May 10 during which Treasury Secretary Janet Yellen called for increased regulation of stablecoins in the United States.[44] In doing so, she acknowledged Terra’s decline, saying it “simply illustrates that this is a rapidly growing product and there are risks to financial stability. We need a framework that’s appropriate.”[45]

At the May 10 hearing, Banking Committee Chairman Sherrod Brown (D-Oh.) said the stablecoin’s failure “underscores the seriousness of its threat to the financial system, because it’s unregulated. . . . [T]here’s just too many examples in the cryptocurrency world of that potential.”[46]  Senator Pat Toomey (R-Pa.), the Ranking Member, seemingly agreed with the problem and expressed interest in moving quickly on legislation establishing a regulatory framework for stablecoins.[47] Yet it remains to be seen whether Senators can agree on what to regulate and how.  Senator Toomey disputed the notion that Terra’s collapse would require broader stablecoin regulation and instead expressed support for regulations targeting those stablecoins that are likely to pose a greater systemic risk.[48]

Meanwhile, in the House of Representatives, a bipartisan group has re-introduced the Digital Commodity Exchange Act.[49] The bill, which is an updated version of a similar bill introduced in 2020, seeks to extend the authority of the Commodity Futures Trading Commission to regulate cryptocurrencies, including stablecoins, and their issuers.[50]  Notably, the bill seeks to ensure that stablecoin issuers have enough assets on hand to redeem stablecoins for fiat currency.[51]

In the event that Congress can’t agree on a regulatory framework for stablecoins, Democrats have proposed that the Executive Branch, through the Securities and Exchange Commission, the Federal Reserve, and the Federal Deposit Insurance Corporation, take the regulatory measures that they believe would be necessary to protect consumers.