Why have cryptoassets crashed and what risks are we taking when we buy them? The "Luna" case and the correlation between crypto and classic cryptocurrencies, in the ASF Report on the stability of non-bank financial markets

Bucharest, 28 July 2022 – This year's first edition of the Financial Supervisory Authority's (ASF) Report on Non-Bank Financial Market Stability deals extensively with cryptocurrencies, especially in the context of the collapse in the value of these highly risky assets.

Although the Authority is not responsible for supervising the crypto markets, it is concerned about the evolution of these assets, as more and more consumers in Romania are accessing them. 

"The disconnection of financial markets from economic fundamentals can generate speculative bubbles and lead to increased systemic risk. One such example is the cryptocurrency market which was rocked by a wave of declines in the first quarter of 2022. The main cryptocurrencies have experienced a similar evolution to a speculative bubble, recording a rapid rise of more than 3 standard deviations, followed by a rapid decline from Q3 2021 to the present," ASF analysts point out at the beginning of the chapter on cryptoassets in the Report on Non-Bank Financial Market Stability.

The document, available on the ASF website, also comes with an extensive presentation of how cryptoassets work, as well as a classification of these assets, which may be useful for consumers considering investing.

For example, the report discusses the case of "Luna", the virtual currency that lost its entire value in just a few days, causing an earthquake in the market and a wave of reactions around the world.

"A major decline in Bitcoin coincided with a drop in the value of the Luna token as investors liquidated all cryptocurrencies. In most of the coin's history, the ratio is greater than one, meaning investors can always redeem TerraUSD tokens at face value. As of 10 May 2022, the ratio of Luna cryptocurrency to TerraUSD's market capitalization has fallen below 0.5. Therefore, there is no feasible way to redeem all TerraUSD coins at face value. The weak parity fundamentals triggered a speculative attack. The arbitrage mechanism broke down when Luna prices continued to fall. In conclusion, algorithmically stable currencies are prone to devaluation risk and speculative attacks when insufficiently collateralised," the report notes.

ASF specialists also note a direct relationship between the evolution of classic financial markets and that of crypto-assets, which shows, once again, that the usefulness of this type of asset in diversifying investment portfolios is not at the level at which it is often presented to potential investors.

"The increasing correlation of crypto-asset prices with major risky financial assets during market downturns calls into question their usefulness for portfolio diversification. An increase in the correlation between cryptoasset and equity returns was observed during and after the market uncertainty in March 2020, as well as during the market sell-off in December 2021 and May 2022. This may suggest that during periods of risk aversion in the broader financial markets, the cryptoasset market has become more closely linked to traditional risk assets, a trend that may be largely due to the increased involvement of institutional investors. In contrast, the correlation with gold has turned negative during a period of rising inflationary expectations and geopolitical tensions," the ASF's Report on Non-Bank Financial Market Stability shows.

A clear classification of crypto-assets, as well as details on how they operate and the risks assumed by investors, can be found in the latest Report on Non-Bank Financial Market Stability in Romania, which can be consulted HERE.

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About the Financial Supervisory Authority

The Financial Supervisory Authority is the national authority, established in 2013 by GEO 93/2012 approved by Law 113/2013, for the regulation and supervision of the insurance, private pension and capital markets. The FSA contributes to strengthening the integrated framework for the functioning of the three sectors, which total more than 10 million participants. More information can be found at www.asfromania.ro.