LUNA, the native token of the Terra blockchain, has plunged more than 25% sing mid-january following controversy in other DeFi protocols.
LUNA suffering from DeFi contagion
Traditional financial markets are well familiar with the concept of contagion. That became blatantly obvious during the Great Financial Crisis when subprime mortgages led to a credit crunch, which eventually brought down the entire financial system and with it, the real economy.
The crypto economy has thus not been very familiar with that kind of contagion. All crypto assets are correlated with Bitcoin to a high degree, but one asset’s losses causing another one to go down with it has been the exception rather than the norm.
However, the drama unfolding around the Wonderland protocol and its TIME token caused such contagion, leading to a significant loss in the value of LUNA, the token of the Terra blockchain. Wonderland is a DeFi protocol at the heart of Magic Internet Money (MIM), an algorithmic stablecoin that is not backed by reserve assets but an intricate system of loans. Recently, information surfaced that the CFO of Wonderland was a well-known scammer with a history of multi-million dollar heists in the crypto space.
That led Wonderland to expel its CFO, causing the price of its TIME token to crater and lose 90% of its value in a short time. However, with TIME acting as the treasury that manages the MIM stablecoin (albeit does not act as its collateral), that subsequently caused markets to lose confidence in MIM.
But there is another layer of complexity to this.
MIM is tied to UST, itself an algorithmic stablecoin that is backed (by LUNA). With insecurity spreading from MIM to UST – and UST being very closely tied to LUNA – investors cut their losses, dumping the LUNA token and leading to the 25% price drop.
Although both stablecoins have since recovered and restored their pegs, which they briefly lost at the peak of the market panic, LUNA continues to suffer in already tricky market conditions.
Contagion could become the norm in crypto
If all of that sounded awfully complex, that’s because it is.
As the crypto economy becomes ever more complex, with protocols resembling real-world financial use cases, real-world financial problems like financial contagion are an inevitable byproduct. Wonderland pledged to become the crypto equivalent of a publicly owned hedge fund, with MIM being the fund’s own currency. Naturally, as other protocols begin to take this currency onto their balance sheets, market panic leads to decreasing valuations across the board.
Crypto enthusiasts should therefore be careful what they wish for when trying to build a better financial system. As it turns out, financial systems eventually only mirror the complexities of the real world, and it takes much less than a butterfly effect for one bad apple to spoil the bunch.
LUNA should eventually recover, as analysts predict it to be at the forefront of layer-one blockchains that compete for “best of the rest” status behind Ethereum. But protocols may just want to do a bit more due diligence with whom they are cooperating.