Cryptocurrencies are volatile, but so-called stablecoins were meant to be the exception. But after one major stablecoin, TerraUSD, crashed spectacularly, it caused ripple effects in cryptoland. WSJ’s Caitlin Ostroff explains why regulators are spooked, and what this could mean for the broader economy.

Crash of TerraUSD Shakes Crypto. ‘There Was a Run on the Bank. 

Cryptocurrency TerraUSD Falls to 11 Cents, Creator Announces Rescue Plan 

This transcript was prepared by a transcription service. This version may not be in its final form and may be updated.

Kate Linebaugh: Over the last few weeks in cryptoland, things haven't been good.

Speaker 2: For those in the crypto world, these are dark days.

Speaker 3: Volatility rippling through the crypto world.

Speaker 4: Okay, so I don't think there's any debate. We are in the middle of a crypto winter.

Speaker 5: Cryptocurrency has been in a sudden free fall.

Kate Linebaugh: One thing driving crypto lower has to do with stablecoins, a kind of crypto that was supposed to be immune to this chaos. Here's our colleague, Caitlin Ostroff.

Caitlin Ostroff: So when you think of most cryptocurrencies, you think of Bitcoin, Ether, Dogecoin. These are things that tend to be very, very volatile. They have these big moves and these big fluctuations. But you have a segment of the cryptocurrency market which is actually known for the opposite. So called stablecoins, get their moniker because they are, well, supposed to be stable.

Kate Linebaugh: Supposed to be. But over the last few weeks, one of these stablecoins was anything but stable. It's lost 90% of its value.

Caitlin Ostroff: You've also had this relatively large, it was the top 20 cryptocurrency that went from being worth billions of dollars to basically nothing over the span of four days.

Kate Linebaugh: It's called TerraUSD, and its fall is casting a shadow over the whole crypto economy. Welcome to The Journal; our show about money, business, and power. I'm Kate Linebaugh. It's Wednesday, May 18th. Coming up on the show, the collapse of a major stablecoin, and why it's sending shock waves beyond crypto. Stablecoins came to the market about eight years ago.

Caitlin Ostroff: Stablecoins are what they sound like they're supposed to be. They're supposed to be this non-volatile part of the cryptocurrency ecosystem. And that sounds insane, but they've become very popular. The way they're supposed to work is that even if Bitcoin is crashing from $40,000 to $30,000 in a day or two, these assets are supposed to always be pegged to usually $1. It's not really supposed to fluctuate.

Kate Linebaugh: There are several kinds of stablecoins. Most are tied to some other asset like a commodity or a currency, say a dollar. And if a coin is tied to a dollar, that would mean for every digital coin there's a greenback or a dollar equivalent to back it up.

Caitlin Ostroff: These are assets that are tied to $1, in some cases one Euro, but they're tied to government issued currencies and are supposed to maintain that stable value no matter what.

Kate Linebaugh: But this concept of tying crypto to a government issued currency rubbed some crypto purists the wrong way. For them, it went against the whole ethos of cryptocurrencies, which is a universe that is untied to traditional monetary systems, and people wanted an alternative, including a developer named Do Kwon.

Do Kwon: Hello, everyone. My name is Do Kwon, and I'm a co-founder at Terra.

Caitlin Ostroff: Do Kwon is a Stanford university graduate. He has a tech background. He's worked for Apple. He's worked for Microsoft. And a couple years ago, he delved into crypto.

Do Kwon: We're trying to create a decentralized economy that is difficult to censor and politicize.

Caitlin Ostroff: And part of the problem that he was trying to solve was that the biggest stablecoins, the biggest cryptocurrencies pegged to $1, are ones that are backed by cash and treasuries and all of these traditional assets that come from the regulated financial system.

Do Kwon: It is crucial that a decentralized economy and these decentralized apps depend on decentralized money. And that is essentially the core thesis behind what Terra is working on, in the sense that we have these stablecoins that are entirely decentralized and cannot be censored.

Caitlin Ostroff: And what he wanted to do was he wanted to make one that didn't rely on any of these centralized organizations and was truly decentralized in the way that cryptocurrency was always framed as, and always intended to be.

Do Kwon: The one thing that we should be asking for crypto projects is that how they plan to bring the value of their technology to millions and millions of users.

Kate Linebaugh: Kwon wanted a new kind of stablecoin. One that would keep the value of the dollar, but was detached from hard assets. He became a fan of a new concept; algorithmic stablecoins.

Caitlin Ostroff: These work a little bit differently in that they rely on this financial engineering. There's no hard asset backing them, in a lot of cases, to keep that peg. And so, that one isn't really backed by anything, but whatever system they've designed.

Kate Linebaugh: So a couple years ago, Kwon created TerraUSD, his own algorithmic stablecoin, and Terra soon became king of this new breed of crypto. Did people believe in it?

Caitlin Ostroff: Yeah. A lot of people believed in it. Individual investors who really believed in this project, who really believed that the number of people with really strong reputations in crypto investment who were supporting this was something that gave it credibility. It seems like a good deal. It seems like an easy way to make money.

Kate Linebaugh: Kwon came up with a system that would keep his stable coin, Terra, valued at $1. To do this. He created a sister currency called Luna. The two coins would work together to keep Terra's values stable at $1. Here's Kwon explaining his model to Yahoo! News.

Do Kwon: So, how Terra works is instead of keeping a dollar in the bank account for every stable point that's issued, you have a reserve currency called Luna that helps to stabilize Terra's bank. So the idea is that at any given time, in order to min one unit of TerraUSD, you need to burn a dollar's worth of Luna. And then vice versa if you're trying to redeem out of TerraUSD, you burn it and then get a dollar's worth of Luna in return.

Kate Linebaugh: Terra and Luna, the earth and the moon, would work in tandem and even each other out. If one went down, the other's value would increase, and crypto traders could rebalance the value of Terra and Luna earned money in the process. For a while, Kwon's system seemed to be working. Terra became the most popular algorithmic stablecoin out there, and the third biggest stablecoin in circulation, worth $18 billion.

Caitlin Ostroff: For TerraUSD's part, it was stable. And you had a lot of these big crypto investment firms that gave millions of dollars to Do Kwon for this project. And so, a lot of people looked at it as, "All of these really smart people in the crypto space are putting their money there. They think that this project is going to be stable and valuable. Why shouldn't I?"

Kate Linebaugh: Even while investors were piling in, there were also skeptics. One predicted that if people lost faith in the system, it would come crashing down. How would Do Kwon defend himself against people saying this?

Caitlin Ostroff: He would call people idiots. He would say that, "You don't understand what you're talking about. It's stable."

Kate Linebaugh: When a British economist questioned his two-token system on Twitter, Kwon mocked her as poor. When another person asked Kwon where some of Tara's financing would come from, Kwon replied in a tweet, "Your mom."

Caitlin Ostroff: He would get into spats with people on Twitter where he would just completely dismiss concerns that people had about these stablecoins. He gained a lot of followers from that. They called themselves Lunatics. He was such a full-throated defender of it that he named his daughter Luna. This is a founder who's willing to take on people who are the naysayers.

Kate Linebaugh: Kwon confident about Terra's staying power. So confident that he recently predicted the demise of most of his crypto competitors.

Do Kwon: 95% are going to die.

Do Kwon: 95% are going to die. But yeah, there's also entertainment to watching companies die too.

Speaker 8: There's entertainment. Oh, man. That's so evil. At least you get to learn from it, right?

Kate Linebaugh: Kwon did do something to address concerns about Terra. He created a reserve fund of crypto worth billions of dollars as a backstop to maintain the $1 peg. But one problem with Kwon's system is it relied on human traders, and a not uncommon human behavior is panic.

Caitlin Ostroff: That system only works so long as people, well, want to buy Luna, so long as they trust that they should buy the other in order to maintain the stablecoin peg. And the issue with that is that when trust breaks, it can break very quickly. And if your system is reliant on trust in both coins, as soon as one breaks, the other does too, and so the entire thing collapses.

Kate Linebaugh: And last week, cracks started to show in Kwon's stablecoin.

Caitlin Ostroff: All of a sudden, people got very nervous about holding TerraUSD, and Luna fell completely through the floor with it. And so all of a sudden, everyone just wants to sell both of them as quickly as they can, and is selling to get selling and you literally have no buyers.

Kate Linebaugh: And there's a term for that in crypto.

Caitlin Ostroff: It's called a death spiral. And if that sounds bad, it's because it is bad, and it's what we witnessed last week.

Kate Linebaugh: Coming up, the death spiral. Terra's death spiral wasn't the first for an algorithmic stablecoin, but it was the biggest, and it all happened so fast.

Speaker 9: Something has gone wrong here.

Speaker 10: Terra's UST is down 46% to 49 cents.

Speaker 12: TerraUSD fell to a low of 23 cents.

Kate Linebaugh: This morning, Terra dropped further, as low as 10 cents. Caitlin says this plunge in the currency started with some huge withdrawals.

Caitlin Ostroff: So, part of the incentive of holding the stablecoin TerraUSD was because if you put it in this crypto bank, you got this 20% annual interest rate just for keeping your money there. So, the weekend of May 7th, May 8th, you started seeing a bunch of withdrawals from that crypto bank. And all of a sudden, hundreds of millions come out of that the first weekend of May. And once all of that money started leaving, people started to get nervous, and they went, "Why is everyone all of a sudden selling?" And for anyone sitting on the sidelines, you were like, "Oh God, something's wrong," and you started to see the peg start to come off a little bit. 99.50 cents, 99 cents. And even that deviation, for some people, that was all the catalyst they needed to start selling more. And so all of a sudden, you had this cascade of sell orders start to come in over Monday, Tuesday, Wednesday of that week, and it all completely intensified and it brought Luna down with it.

Kate Linebaugh: It sounds like a typical bank run.

Caitlin Ostroff: It basically is. It is crypto's bank run.

Kate Linebaugh: Do we know why somebody withdrew so much money?

Caitlin Ostroff: The million dollar question. It's the one that every single crypto person I speak to is trying to figure out right now. There's a ton of rumors about who did the selling, who pulled their money, what their motivations were, and honestly, we just don't know that for the moment. What we do know is that people had voiced concerns that that bank fund could be enough to cause everyone else to pull their money out, and that's exactly what happened.

Kate Linebaugh: And did you talk with any investors about how they handled this moment?

Caitlin Ostroff: Yeah. I mean, talked with a couple and some of them wanted to sell and they just weren't able to, because you had this massive queue of people who wanted to sell and that got backlogged and the price kept falling. And at some point, some of them thought, "Is it even worth selling at this point? It's already worth nothing," and maybe just hold onto it and see if it comes back at all. But for some people, this is money that they had saved up to pay a mortgage or to go take classes at uni. And for some people, we've heard this is life savings that they had invested and you've had billions of dollars, especially among individual investors, just completely erased in a matter of days.

Kate Linebaugh: On Twitter last week, Kwon said he was phoning people who have been hurt by Terra's collapse. He said he was, quote, "heartbroken about the pain his invention has brought." Terra's collapse ricocheted across the crypto world, which was already taking a beating.

Caitlin Ostroff: And what that meant was that you had a massive wash of selling pressure hit Bitcoin and Ether and all of these other cryptocurrencies, and it had this cascading effect where you had Bitcoin knocked down below $26,000. It created this hangover over the rest of the crypto system from the sell off of this one stablecoin.

Kate Linebaugh: But Kwon is still standing by Terra. On Monday, he published what he called a new revival plan that would start from scratch. That plan doesn't involve an algorithmic stablecoin. Caitlin says Terra's collapse has shown that this corner of the crypto market, once touted as being stable, turned out to be more wobbly than investors believed, and it could impact the real world financial system.

Caitlin Ostroff: Stablecoins are a breed of cryptocurrencies that regulators have been really concerned by in the last year, in part because their mandate is to have these government issued currencies that are stable. And in one way, this is a competitor, but also because some of these stable coins have grown in adoption and they're tied to real world assets. So, that's concerning because if you have a blow up of one of those, potentially there are ripple effects to the broader financial system.

Kate Linebaugh: For regulators, the whole episode has underscored the need for more oversight over the crypto economy as a whole. Last week in Senate testimony, Treasury Secretary Janet Yellen pointed to the recent Terra meltdown as proof of the risks of stablecoins. Here's Yellen.

Janet Yellen: I think that simply illustrates that this is a rapidly growing product, and that there are risks to financial stability and we need a framework.

Caitlin Ostroff: More and more, we've seen the cryptocurrency ecosystem become intertwined. In this case, it wasn't just the one stablecoin that got hit, it was Bitcoin and Ether, and all of the selling that begetted selling. And so, what we saw in this case was that it can have knock-on effects. And I think that's the other thing that has spooked regulators is in this case, all of the knock-on effects were really just kept within the cryptocurrency ecosystem, and I think the fear is that next time that that may not be true.

Kate Linebaugh: And does it challenge the idea that stablecoins were safe?

Caitlin Ostroff: I think it does. And I think a lot of people also thought that, at the end of the day, even though there's no central bank in crypto, that someone would step in, someone would give emergency funding, someone would help put the floor back in it. And the fact that didn't happen in this case, I think has made a lot of people really nervous, where they just assumed that someone would come in and save the day, and no one has.

Kate Linebaugh: That's all for today, Wednesday, May 18th. The Journal is a co-production of Gimlet and The Wall Street Journal. Additional reporting in this episode by Paul Vigna and Alexander Osipovich. Thanks for listening. See you tomorrow.

Kate Linebaugh is the co-host of The Journal. She has worked at The Wall Street Journal for 15 years, most recently as the deputy U.S. news coverage chief. Kate started at the Journal in Hong Kong, stopping in Detroit and coming to New York in 2011. As a reporter, she covered everything from post-9/11 Afghanistan to the 2004 Asian tsunami, from Toyota's sudden acceleration recall to General Electric. She holds a bachelor degree from the University of Michigan in Ann Arbor and went back to campus in 2007 for a Knight-Wallace fellowship.

Ryan Knutson is the co-host of The Journal. Previously, he spent more than four years in the newsroom covering the wireless industry, and was responsible for a string of scoops including Verizon's $130 billion buyout of Vodafone's stake in their joint venture, Sprint and T-Mobile's never ending courtship and a hack of the 911 emergency system that spread virally on Twitter. He was also a regular author of A-heds, including one about millennials discovering TV antennas. Previously, he reported for ProPublica, PBS Frontline and OPB, the NPR affiliate station in Portland, Ore. He grew up in Beaverton, Ore. and graduated from the University of Oregon.