HIGHLIGHTS

• The value of cryptocurrencies has fallen by $2 trillion since the peak of a significant advance in 2021, resulting in a severe comedown this year.
• While there are similarities between the current market collapse and previous crashes, a lot has happened since cryptocurrency’s last significant bear market.
• Due to the advent of centralized lending schemes and so-called “decentralized finance,” the cryptocurrency market is already drowning in debt.
• The demise of the algorithmic stablecoin terraUSD and the ripple effects of Three Arrows Capital’s dissolution as a hedge fund demonstrated how linked the projects and businesses in this cycle were. 

Crypto winter is, without a doubt, the two words on every cryptocurrency investor’s lips at the moment. 

The value of cryptocurrencies has fallen by $2 trillion since the peak of a significant advance in 2021, resulting in a severe comedown this year.

The largest digital currency in the world, Bitcoin, is down 70% from its record high of about $68,000 reached in November.

Due to this, numerous analysts have issued warnings about a protracted bear market known as “crypto winter.” Such an incident last happened between 2017 and 2018.

But there’s something about the most recent crisis that sets it apart from other crypto downturns – the most recent cycle has been distinguished by a number of incidents that, due to their interconnectedness and business models, have spread throughout the industry.

From 2018 to 2022

After a rapid ascent in 2017, bitcoin and other tokens had a dramatic decline in 2018.

The market was flooded with “initial coin offerings” at that time, where investors poured cash into cryptocurrency enterprises that had sprouted up left, right, and center. However, the vast majority of those initiatives ultimately failed.

According to the research director of cryptocurrency analytics company Kaiko Clara Medalie,

“the 2017 crash was largely caused by the implosion of a hype bubble.”

However, macroeconomic issues, such as the escalating inflation that prompted the U.S. 

Federal Reserve and other central banks to raise interest rates, are to blame for the current meltdown, which started earlier this year. In the previous cycle, these elements weren’t present.

Bitcoin and the broader cryptocurrency market have been trading in a manner that is highly connected with other risky assets, particularly stocks. 

The year’s second quarter saw Bitcoin have its worst quarter in more than a decade. The tech-heavy Nasdaq had a decline of more than 22% over this time.

Many people in the market, from hedge funds to lenders, were taken off guard by that sudden market turn.

According to Carol Alexander, professor of finance at Sussex University, no major Wall Street players were using “highly leveraged positions” back in 2017 and 2018. This is another distinction.

There are similarities between the current and previous crises, with the most notable being the seismic losses endured by inexperienced traders seduced into crypto by promises of high returns.

But since the previous significant bear market, a lot has changed.

What brought us here, then?

 Destabilized Stablecoin

An algorithmic stablecoin, also known as UST or TerraUSD, was a form of cryptocurrency that was intended to be tied 1:1 to the US dollar. It operated via a sophisticated mechanism controlled by an algorithm. 

But when UST lost the dollar peg, its sister token Luna also collapsed.

This shocked the cryptocurrency market but also had repercussions for businesses exposed to UST, particularly hedge fund Three Arrows Capital, or 3AC (more on them later).

After seeing tremendous growth, the Terra blockchain and UST stablecoin collapsed, which was generally unanticipated, according to Medalie. 

Nature of Leverage

The rise of centralized lending schemes and “decentralized finance,” or DeFi, an umbrella term for financial products created on the blockchain, allowed cryptocurrency investors to accumulate enormous levels of leverage.

But compared to the previous cycle, the form of leverage has changed. Martin Green, CEO of quant trading company Cambrian Asset Management, claims that derivatives on bitcoin exchanges mostly supplied leverage to ordinary investors in 2017. 

Retail investors’ positions were immediately liquidated on exchanges as a result of their inability to pay margin calls when the cryptocurrency markets fell in 2018, which accelerated the selling.

In contrast, Green noted that retail crypto depositors who were investing for yield had given crypto funds and lending institutions the leverage that led to the forced selling in Q2 2022. From 2020 on, there was a significant expansion of yield-based DeFi and cryptocurrency “shadow banks.”

“A lot of lending was unsecured or undercollateralized because credit risks and counterparty risks were not carefully considered. 

Due to margin calls, funds, lenders, and other parties were obliged to sell as market prices fell in Q2 of this year.

A margin call occurs when a borrowed money trader must provide additional money to prevent losses.

Further contagion has been caused by the inability to meet margin calls. 

High Risk, High Yields

The vulnerability of multiple crypto enterprises to dangerous bets that were open to “attack,” including terra, is at the root of the recent instability in crypto assets, according to Alexander of Sussex University.

It’s important to consider how some of these infections have manifested through certain well-known examples.

Customers’ withdrawals from Celsius, a company that offered more than 18% yields for storing their cryptocurrency with the company, were halted last month. In a way, Celsius functioned like a bank. 

It would use the deposited cryptocurrency and lend it to other players at a high yield. 

They would be used for trading by those other players. Additionally, investors who put cryptocurrency would be repaid with the profit Celsius gained from the yield.

However, this business model was tested when the recession started. In order to successfully stop the cryptocurrency equivalent of a bank run, Celsius has been forced to pause withdrawals due to ongoing liquidity problems.

“Players seeking high yields exchanged fiat for crypto used the lending platforms as custodians, and then those platforms used the funds they raised to make highly risky investments – how else could they pay such high interest rates?,” said Alexander.

Contagion via 3AC

One issue that has recently come to light is how heavily crypto firms relied on loans from one another.

One of the biggest casualties of the market slump has been Three Arrows Capital, or 3AC, a Singapore-based hedge fund with a specialty in cryptocurrencies. 3AC experienced losses during the UST collapse because of its exposure to luna (as mentioned above).

Last month, according to a report in The Financial Times, 3AC had its positions liquidated after failing to meet a margin requirement from cryptocurrency lender BlockFi.

The hedge fund then failed to repay a loan from Voyager Digital totaling more than $660 million.

As a result, 3AC filed for bankruptcy under Chapter 15 of the U.S. Bankruptcy Code and went into liquidation.

When the market crashed, Three Arrows Capital’s heavily leveraged and bullish wagers on cryptocurrencies came crashing down, illuminating how such business models were put under pressure.

The outbreak Spread Further.

Voyager Digital claimed in its bankruptcy filing that Alameda Research, owned by crypto millionaire Sam Bankman-Fried, owes not just $75 million to Voyager Digital but also $377 million.

The fact that Alameda holds a 9% share in Voyager just makes things more difficult.

“Overall, June and Q2 as a whole were very difficult for crypto markets, where we saw the meltdown 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,” Kaiko’s Medalie said.

“It is now apparent that nearly every large centralized lender failed to properly manage risk, which subjected them to a contagion-style event with the collapse of a single entity. 

3AC had taken out loans from nearly every lender that they were unable to repay following the wider market collapse, causing a liquidity crisis amid high redemptions from clients.” 

Has the Shakeout Ended?

When the market volatility finally calms down is uncertain. Analysts anticipate further suffering, though, as crypto businesses struggle to settle their debts and handle client withdrawals.

Crypto exchanges and miners might be the next domino to fall, according to James Butterfill, head of research at CoinShares.

“We feel that this pain will spill over to the crowded exchange industry,” said Butterfill. 

“Given it is such a crowded market, and that exchanges rely to some extent on economies of scale the current environment is likely to highlight further casualties.”

Even seasoned competitors like Coinbase have felt the effects of contracting marketplaces. 

Coinbase fired 18% of its staff members last month to save costs. Trading volumes on the U.S. cryptocurrency exchange have recently decreased along with declining values for digital currencies.

According to Butterfill, cryptocurrency miners who depend on specialized computer hardware to resolve transactions on the blockchain may also be in jeopardy.

“We have also seen examples of potential stress where miners have allegedly not paid their electricity bills, potentially alluding to cash flow issues,” he said in a research note last week.

“This is likely why we are seeing some miners sell their holdings.”

The work miners do is costly, not only in terms of the equipment itself but also the constant electrical supply required to keep their equipment working round-the-clock.

Disclaimer:
All information has been prepared by TraderFactor or partners. The information does not contain a record of TraderFactor or partner’s prices or an offer of or solicitation for a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. Any material provided does not have regard to the specific investment objective and financial situation of any person who may read it. Past performance is not a reliable indicator of future performance.