With almost $200 billion in value of crypto-currencies lost, the last weeks have been a crypto nightmare for some. We look at the reasons and legal implications of the crash as well as possible effects on web3 and metaverse projects.

Why have crypto-markets crashed so much in recent weeks?

Last week was one of the worst weeks ever for the crypto-markets when almost $200 billion in value of crypto-currencies was wiped as a result of a massive sell off. One after another, values of major crypto-currencies have tumbled to their lowest levels since 2020 with Bitcoin falling below $30 000, Ether below $2 500 The initial trigger for this was a collapse of the crypto-currency Luna and its correlated stablecoin TeraUSD (UST).

By way of a background, both Luna and UST are native tokens of the Terra network developed by Terra Labs in South Korea. UST, is an algorithmic stablecoin that aims to stabilize its value by being pegged to the US Dollar (meaning one UST is always supposed to be worth around the same as one US Dollar). The idea behind algorithmic stablecoins is that they do not maintain their peg by relying on a reserve of assets than instead use an algorithm to keep their price linked to the value of the reference asset. In this case, there are two crypto-assets that co-exist together, one stablecoin and one crypto-currency while the algorithm facilitates a change in supply and demand between the stablecoin (UST) and the cryptocurrency (Luna) that is supposed to absorb the price volatility of the stablecoin. The mechanism was supposed to work as follows: when the value of UCT goes down (below 1 US Dollar), the algorithm automatically initiates burning (destroying) of the certain amount of UCT by reducing its supply and thereby increasing its value in order to maintain its peg to 1 US Dollar and at the same time initiates minting (creation) of additional amount of Luna.

The crash started when traders started selling UCT in excessive amounts over the last weekend, and when the algorithm failed to initiate burning and minting process as described above, leading to prices of both Luna and UCT tumbling to almost zero.

What legal implications can the crash have for investors?

Recently, a huge number of investors (both private as well as institutional) have started investing in crypto-assets driven by their popularity and concerns around the rising inflation and as a result of this crash many of them have incurred huge losses. However, in the great number of countries around the world, crypto-industry is still largely unregulated and investments in crypto-assets are generally not protected by an investor compensation scheme like the investments in transferable securities. Against this background, many investors will most likely end up empty handed where they do not decide to wait for the market to recover. When it comes to investors in Luna and UST, we can expect a rising number in legal suits (from class actions to individual claims for damages) directed against the company that stands behind Luna and UCT, Seoul based company Terraform Labs.

On the policy front, the crash of UST and Luna has attracted attention of the regulators from around the globe in a major way. In the European Union, where the EU lawmakers are working on a harmonized regulatory framework on crypto-assets for almost two years now (the Markets in Crypto-Assets Regulation, better known as “MiCAR”), there are rising concerns around the use of stablecoins. MiCAR is supposed to introduce a designated regulatory framework on stablecoins, by requiring their issuers to comply with a number of regulatory requirements before starting to offer them to the public. To that end, the EU also aims to create a special supervisory framework for issuers of significant stablecoins (whose market capitalization and the number of daily transactions exceeds certain thresholds) as well. In the light of recent events, some quite radical proposals that have been discussed in the past in the course of the EU lawmaking process, like the ban on trading of all stablecoins whose market value exceeds certain amount (instead of the aforementioned special supervisory framework), can easily gain more support than before.

Recent events can also induce the regulators around the world to engage more in the development of special standards for crypto-advertisements that would require crypto-companies to emphasize risks associated with investments in crypto-assets in a clear way. That being said, we can expect to see more regulators following the approach of the UK Advertising Standards Authority (ASA) that has issued a clear guidance on the application of the UK Code of Non-broadcast Advertising and Direct & Promotional Marketing (“CAP Code“) to crypto-assets in March this year.

Crypto and the metaverse are closely linked. What impact will the crash have on the metaverse?

The first tangible initial impact that the crash from last week had on the metaverse was steep decline in value of some crypto-assets that support the development of commonly known metaverse projects, like Decentraland and Sandbox. Many investors and developers that support the development of various metaverse projects may have lost significant amounts of money as a result of this crash, and this may lead to decrease of their stakes in the metaverse ecosystem at least in the short term. Further, public confidence in stablecoins in general may decrease in the next period, especially algorithmic based stablecoins like UCT.

As always in such situations, the crash has also created new opportunities. It has provided a relatively low entry point for participants who previously sat on the fence of whether or not to enter the crypto market. This may have been facilitated by more seasoned players in the field that have already experienced crashes in the past and provided their own views (and solace) on Twitter and other social media platforms.

The ambivalence of the whole situation could be seen particularly in the NFT space, where the dip in the prices of even the most successful collections were touted as a rare opportunity to “buy in”. As a result, the trading volume for some collections has remained high and there were even a few NFT collections that increased in value during the aftermath of the crash (when calculated in the respective crypto currency, not fiat money).

All in all, while the impact for established players was surely significant in the short term and has led to disastrous consequences for some, other aspects of the crash may indeed turn out as a blessing in disguise in the long run as the ever-changing mix of risks and opportunities in web3 and the metaverse continues to hit the mainstream news.