There’s something about the latest crypto crash that sets it apart from previous downturns.
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The two words on every crypto investor’s lips right now are definitely “crypto winter”.
Cryptocurrencies have suffered a devastating blow this year, losing $2 trillion in value since the height of a major rally in 2021.
Bitcoinworld’s largest digital currency, down 70% from November’s all-time high of nearly $69,000.
That led many experts to warn of a protracted bear market known as “crypto winter”. The most recent event occurred between 2017 and 2018.
But there’s something about the latest crash that sets it apart from previous downturns in crypto — the latest cycle was marked by a series of events that caused contagion across the industry because of its nature. and their business strategies are interconnected.
From 2018 to 2022
Back in 2018, bitcoin and other tokens plummeted after a steep climb in 2017.
The market was then flooded with so-called initial coin offerings, where people poured money into crypto projects that popped up from left, right, and center — but the majority of those projects failed. .
“The 2017 crash was largely due to the bursting of the hype bubble,” Clara Medalie, research director at crypto data firm Kaiko, told CNBC.
But the current fall began earlier this year as macroeconomic factors including rampant inflation prompted the US Federal Reserve and other central banks to raise interest rates. These elements did not appear in the previous cycle.
Bitcoin and the broader crypto market have been trading in a way that is strongly correlated with other risky assets, especially stocks. Bitcoin posted it worst quarter in over a decade in second quarter of the year. During the same period, the tech-heavy Nasdaq fell more than 22%.
That dramatic market reversal caught many in the industry from hedge funds to lenders off guard.
When the market started to sell off, it was clear that many large players were not prepared for a quick reversal
Clara Medalie
Research Director, Kaiko
According to Carol Alexander, a professor of finance at the University of Sussex, there were no major Wall Street players using “highly leveraged positions” in 2017 and 2018.
Undoubtedly, there are similarities between today’s crisis and past crises – most notably the seismic losses that beginner traders are attracted to crypto by the words promise of huge profits.
But a lot has changed since the last major bear market.
How did we get here?
Stablecoins destabilize
TerraUSD, or UST, is an algorithmic stablecoin, a cryptocurrency that is said to be pegged one-to-one with U.S. dollar. It worked through a complex mechanism governed by an algorithm. But the UST lost its dollar rate, resulting in the demise of its sister token luna too.
This has sent shockwaves through the crypto industry but has also had a direct impact on companies exposed to UST, namely hedge fund Three Arrows Capital or 3AC (more info coming soon). about them later).
“The collapse of the Terra blockchain and stablecoin UST was unexpected after a period of tremendous growth,” said Medalie.
The essence of leverage
Cryptocurrency investors have built enormous amounts of leverage thanks to the emergence of centralized lending schemes and so-called “decentralized finance”, or DeFi, a umbrella term for financial products developed on blockchain.
But the nature of leverage in this cycle is different from the previous one. In 2017, leverage was mainly offered to retail investors via derivatives on crypto exchanges, according to Martin Green, CEO of quantum trading firm Cambrian Asset Management.
As the crypto market crashed in 2018, positions opened by retail investors were automatically liquidated on exchanges because they were unable to meet margin calls, which further aggravated the situation. aggravate selling.
“Conversely, the leverage that caused the forcible sale in Q2 2022 was made available to crypto funds and lending institutions by retail crypto depositors who are investing for a profit.” , Green said. “2020 onward has seen a huge build-up from shadow banks based on DeFi and crypto yields.”
“There are a lot of loans that are unsecured or not decentralized because credit risk and counterparty risk are not assessed prudently. As market prices fell in the second quarter of this year, the funds did not. , lenders and others forced to sell because of margin orders.”
A margin call is a situation in which an investor must commit more funds to avoid a loss in a trade made with borrowed cash.
The inability to respond to margin calls led to further contagion.
High yield, high risk
At the heart of the recent turmoil in crypto assets is the exposure of many crypto firms to risky bets that are vulnerable to “hacks”, including terra, University of Sussex’s Alexander said. .
It’s worth looking at how some of this contagion has played out through some striking examples.
Celsius, a company that has offered users a yield of more than 18% on depositing their crypto with the company, Withdrawal paused for customers last month. Celsius works like a bank. It will take the deposited cryptocurrency and lend it to other players at a high interest rate. Other players will use it to trade. And the profit C obtained from the yield will be used to return to the investors who deposited the cryptocurrency.
But when the recession hit, this business model was put to the test. Celsius continued to face liquidity problems and had to halt withdrawals to effectively stop the crypto version of banking operations.
“High-yield players who exchanged fiat for crypto used lending platforms as custodians and then those platforms used the funds they raised to execute,” said Alexander. doing high-risk investments – how else can they pay such high interest rates?”.
Infection via 3AC
One issue that has become apparent recently is the extent to which crypto companies rely on loans to each other.
Three Arrows Capital, or 3AC, is a Singaporean crypto-focused hedge fund that has been one of the biggest victims of the market downturn. 3AC was exposed to the luna and suffered damage after the collapse of the UST (as mentioned above). The Financial Times reported last month that 3AC failed to respond to a margin call from crypto lender BlockFi and its positions were liquidated.
Then the hedge fund default over $660 million loan from Voyager Digital.
The result is, 3AC rushes to liquidation and filed for bankruptcy under Chapter 15 of the United States Bankruptcy Code.
Three Arrows Capital is known for its high leverage and bullish bets on cryptocurrencies that were undone during the market crash, highlighting how such business models work under the correction.
The spread continued.
When Voyager Digital filed for bankruptcyThe company revealed that it not only owes crypto billionaire Sam Bankman-Fried Alameda Research $75 million — Alameda also owes Voyager $377 million.
To complicate matters further, Alameda owns a 9% stake in Voyager.
“Overall, June and Q2 were generally very difficult for the crypto market, where we saw the collapse of some of the largest companies largely due to extremely poor risk management and affected by the collapse of 3AC, the largest crypto hedge fund,” said Kaiko’s Medalie.
“It’s clear that nearly every major centralized lending institution fails to properly manage risk, which leaves them experiencing a contagion-type event with the demise of a single institution. 3AC took it loans from most lenders that they were unable to repay after the broader market crash, causing a liquidity crunch amid high customer acquisition.”
Is the swing over yet?
It is unclear when the market turbulence will subside. However, analysts expect some pain ahead as crypto companies struggle to pay their debts and process customer withdrawals.
According to James Butterfill, head of research at CoinShares, the next dominoes could be cryptocurrency exchanges and miners.
“We feel that this pain will spill over into the crowded exchange industry,” Butterfill said. “Given such a crowded market, and bartering based to some extent on economies of scale, the current environment is likely to highlight further casualties.”
Even established players like Coinbase affected by market decline. Last month, Coinbase lay off 18% of employees to cut costs. U.S. crypto exchanges have recently seen trading volumes crash along with cryptocurrency prices falling.
Meanwhile, cryptocurrency miners that rely on specialized computing equipment to settle transactions on the blockchain could also be in trouble, Butterfill said.
“We have also seen examples of potential stress in which miners are accused of not paying their electricity bills, potentially alluding to the cash flow problems”.
“This could be why we see some miners selling their shares.”
The role of miners comes at a heavy price – not only for the equipment itself, but also for the constant current needed to keep their machines running around the clock.
