There is something about the recent crypto crash that sets it apart from previous downturns.
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The two words currently on every crypto investor’s lips are undoubtedly “crypto winter.”
Cryptocurrencies have suffered a brutal decline this year, losing $2 trillion in value since the peak of a massive rally in 2021.
Bitcoin, the world’s largest digital coin, is down 70% from an all-time high in November of nearly $69,000.
That has led many experts to warn of a prolonged bear market known as “crypto winter.” The last such event occurred between 2017 and 2018.
But there is something about the recent crash that sets it apart from previous downturns in crypto — the last cycle has been marked by a series of events that, due to their interconnected nature and business strategies, have caused contagion across the industry.
From 2018 to 2022
In 2018, bitcoin and other tokens plummeted after a steep rise in 2017.
The market at the time was awash with so-called initial coin offerings, where people put money into crypto ventures that had popped up left, right, and center — but the vast majority of those ventures failed.
“The 2017 crash was largely due to the bursting of a hype bubble,” Clara Medalie, head of research at crypto data firm Kaiko, told CNBC.
But the current crash began earlier this year as a result of macroeconomic factors, including runaway inflation, which has prompted the US Federal Reserve and other central banks to raise interest rates. These factors were not present in the last cycle.
Bitcoin, and the broader cryptocurrency market, trades in close correlation with other risky assets, particularly stocks. Bitcoin posted its worst quarter in more than a decade in the second quarter of the year. During the same period, the tech-heavy Nasdaq fell more than 22%.
This sharp market reversal caught many in the industry, from hedge funds to lenders, off guard.
Another difference is that there were no major Wall Street players using “heavily leveraged positions” in 2017 and 2018, according to Carol Alexander, a professor of finance at Sussex University.
Certainly there are parallels between today’s meltdown and previous meltdowns – the most notable being seismic losses suffered by inexperienced traders lured by promises of high returns in crypto.
But a lot has changed since the last major bear market.
So how did we get here?
TerraUSD, or UST, was an algorithmic stablecoin, a type of cryptocurrency intended to be pegged one-to-one to the US dollar. It worked through a complex mechanism controlled by an algorithm. But UST lost its dollar peg, which also led to the collapse of its sister token Luna.
This sent shockwaves through the crypto industry, but also impacted companies exposed to UST, most notably hedge fund Three Arrows Capital, or 3AC (more on that later).
“The collapse of the Terra blockchain and UST stablecoin was largely unexpected after a period of immense growth,” Medalie said.
The nature of leverage
Crypto investors have gained tremendous leverage thanks to the advent of centralized credit systems and what is known as “decentralized finance,” or DeFi, an umbrella term for financial products developed on the blockchain.
But the nature of the leverage was different this cycle than the last. According to Martin Green, CEO of quant trading firm Cambrian Asset Management, in 2017 retail investors were mostly granted leverage via derivatives on cryptocurrency exchanges.
When crypto markets declined in 2018, positions opened by retail investors were automatically liquidated on exchanges as they were unable to meet margin calls, exacerbating selling.
“By contrast, the leverage that caused the forced sale in Q2 2022 was made available to crypto funds and lending institutions by retail crypto investors investing for returns,” Green said. “Starting in 2020, there has been a tremendous buildup of revenue-based DeFi and crypto ‘shadow banks’.”
“There was a lot of unsecured or undercollateralized lending because credit risk and counterparty risk were not assessed with vigilance. As market prices declined in the second quarter of this year, margin calls forced funds, lenders and others to sell.”
A margin call is a situation where an investor needs to put in more funds to avoid losing on a trade with borrowed money.
The inability to meet margin calls has led to another contagion.
High returns, high risk
At the heart of the recent turmoil in crypto assets is the exposure of numerous crypto firms to risky bets that have been vulnerable to “attacks,” including Terra, said Sussex University’s Alexander.
It’s worth taking a look at how some of this contagion has played out, with some high-profile examples.
Celsius, a company that offered users yields of more than 18% for depositing their cryptos with the company, suspended customer withdrawals last month. Celsius behaved like a bank. It would take the deposited crypto and loan it out to other players at a high rate of return. These other players would use it for trading. And the Celsius profit generated from the return would be used to repay investors who deposited crypto.
But when the downturn hit, that business model was put to the test. Celsius continues to face liquidity issues and has had to pause withdrawals to effectively halt the crypto version of a bank run.
“Players looking for high returns traded fiat for crypto, used the lending platforms as custodians, and then those platforms used the funds they raised to make high-risk investments — how else could they pay such high interest rates?” Alexander said.
Contagion via 3AC
One problem that has emerged recently is how much crypto companies rely on mutual loans.
Three Arrows Capital, or 3AC, is a Singapore-based crypto-focused hedge fund that has been one of the biggest victims of the market downturn. 3AC was exposed to Luna and suffered casualties following the collapse of UST (as noted above). The Financial Times reported last month that 3AC failed to meet a margin call from crypto lender BlockFi and its positions were liquidated.
Then the hedge fund defaulted on a more than $660 million loan from Voyager Digital.
As a result, 3AC plunged into liquidation and filed for bankruptcy under Chapter 15 of the US Bankruptcy Code.
Three Arrows Capital is known for its highly leveraged and bullish bets on crypto, which were wiped out during the market crash, demonstrating how such business models went under.
The contagion continued.
When Voyager Digital filed for bankruptcy, the company revealed that not only did it owe $75 million to crypto billionaire Sam Bankman-Fried’s Alameda Research — Alameda also owed Voyager $377 million.
To complicate matters further, Alameda owns a 9% stake in Voyager.
“Overall, June and Q2 overall was a very difficult one for the crypto markets where we saw the collapse of some of the largest companies in large part due to extremely poor risk management and contagion from the collapse of 3AC, the largest crypto hedge fund. ‘ said Kaiko’s medal.
“It is now apparent that almost every major centralized lender has failed to manage risk properly, exposing them to a contagion-style event with the collapse of a single entity. 3AC had borrowed from almost every lender that they were subsequently unable to repay, collapsing the broader market and causing a liquidity crisis amid high customer redemptions.”
Is the restructuring over?
It’s not clear when the market turmoil will finally subside. However, analysts expect more pain to come as crypto firms struggle to pay off their debts and process customer withdrawals.
The next dominoes to fall could be crypto exchanges and miners, according to James Butterfill, head of research at CoinShares.
“We believe this pain will spill over into the crowded stock market industry,” Butterfill said. “Given that this is such a crowded market and that exchanges rely to some extent on economies of scale, the current environment is likely to generate further losses.”
Even established players like Coinbase have been hit by declining markets. Over the past month, Coinbase laid off 18% of its employees to cut costs. The US crypto exchange has recently seen a collapse in trading volume along with falling digital currency prices.
Meanwhile, crypto miners who rely on specialized computing equipment to settle transactions on the blockchain could also run into trouble, Butterfill said.
“We’ve also seen examples of potential stress where miners allegedly failed to pay their utility bills, possibly alluding to cash flow issues,” he said in a research note last week.
“That’s probably why we’re seeing some miners selling their holdings.”
The role of miners comes at a high price – not only for the equipment itself, but also for the constant flow of electricity required to keep their machines running 24/7.