Luna crash sends a chill through decentralised finance market

Traders are shifting away from investments linked to decentralised finance, in the latest sign of how the $40bn collapse of cryptocurrency luna has sent shockwaves through a key portion of the digital asset market.

Ether, the world’s second-biggest crypto token and a proxy for sentiment on the $100bn DeFi market, has shed more than a third of its value over the past month. Its fall is significantly more severe than the 23 per cent decline for bitcoin, the oldest and most valuable digital token by market value.

Many crypto advocates consider DeFi to be one the most promising innovations in the digital asset industry, with projects aiming to operate without centralised intermediaries such as banks through the use of automated systems that dole out control to the biggest stakeholders. However, the failure last month of luna, and its linked stablecoin terraUSD, highlighted the risks of investing in DeFi projects and the potential for catastrophic flaws in the design of programmes that underpins their operations.

“Confidence in the crypto ecosystem and decentralised finance remains at historically low levels” after the breakdown of terra and luna, said Sipho Arntzen, an analyst at Swiss private bank Julius Baer, adding that, “we expect no swift recovery for now”.

Stablecoins act as lubricants of transactions in DeFi markets, and the wipeout of terra was seen as a particularly strong blow to confidence in the sector. Terra was designed to match the value of the US dollar through a financial relationship with sister token luna, in contrast to other major stablecoins that claim to be backed by portfolios of reserves.

Ether’s fall is a sign of how the crash in terra and luna has sent a chill through the wider DeFi sector, analysts said. The token price is tied to investors’ expectations for the future of DeFi since many of the computerised financial apps in the decentralised market are built on the Ethereum blockchain where ether resides.

Investors drained $56mn from Ethereum investment products in May, taking this year’s total net outflows to $250mn, according to data from digital asset manager Coinshares. Bitcoin products, in contrast, have drawn $369mn of net inflows in 2022.

“As [Ethereum] primarily aims to provide the infrastructure for the emerging world of decentralised apps, we believe that these drawdowns are symptomatic of a loss in confidence in the broader DeFi ecosystem,” Arntzen said.

Some investors argue the hit to ether also reflects a reassessment of the future demand for multiple facets of the crypto industry, such as digital collectibles known as non-fungible tokens and borrowing and lending protocols, which also often use the Ethereum network.

“Ethereum, like Netflix or any stock, reflects expectation of future demand,” said Ilan Solot, partner at Tagus Capital. He said investors were doubting the level of future demand on the Ethereum network as the economic outlook darkens.

“If the Federal Reserve is tightening [monetary policy], the world is in recession, and people need to pay $4.5 per gallon of gas, they’ll have less to invest in DeFi or spend on blockchain games,” he added.

Investors have also soured on risky assets more broadly, said Daniel Ives, analyst at Wedbush. He said DeFi was “caught in a general risk-off tornado”.

Derivatives markets suggest that investors remain nervous about the near-term prospects of ether, despite optimism about bitcoin’s path. While options markets signal a positive tone for bitcoin over the next month, investors see difficult trading conditions for ether on the same time horizon, said Adam Farthing, chief risk officer for Japan at market maker B2C2.

“The market has become much more cautious of ether due to its recent performance and in a way it hasn’t for bitcoin,” he said. Bitcoin still enjoys a reputation among some investors as a hedge against inflation, despite losing more than half its value from its November high.

Another challenge facing Ethereum is the network’s long-awaited shift to a different kind of blockchain system called proof of stake. This shift is expected to relieve frustrations surrounding Ethereum’s longstanding transaction fees and clunky processing speeds.

Ingo Fiedler, co-founder of Blockchain Research Lab, said Ethereum’s blockchain shift “could go wrong as any code change is risky for any software”. He added that there may be unknown risks that will come to light only once Ethereum’s new system is tested in the real world.

“We saw this flight to safety from terra to [rival stablecoin USD Coin] and into assets people perceive to be more established, and so I think that anything that’s new, or overly technical, will probably have people a little standoffish,” said Teana Baker-Taylor, vice-president of policy and regulatory strategy at crypto firm Circle.