Panic is spreading across the crypto universe. What started this year in crypto markets as a “risk-off” bout of selling fuelled by a Federal Reserve has exposed a web of interconnectedness that looks a little like the tangle of derivatives that brought down the global financial system in 2008, a Bloomberg report says.
As Bitcoin slipped almost 70 per cent from its record high, a panoply of altcoins also plummeted. The collapse of the Terra ecosystem began with its algorithmic stablecoin losing its peg to the US dollar, and ended with a bank run that made $40 billion of tokens virtually worthless.
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Crypto collateral that seemed valuable enough to support loans one day became deeply discounted or illiquid, putting the fates of a previously invincible hedge fund and several high-profile lenders in doubt.
Higher stakes
Crypto has gone through several major drops in its history — known as “crypto winters” — but the market’s expansion and increasing adoption to Wall Street means more is at stake now.
After crypto’s last two-year hibernation ended in 2020, the sector spiked to around $3 trillion in total assets last November, before plunging to less than $1 trillion.
Galaxy, the $2 billion digital-asset brokerage founded by billionaire Mike Novogratz, benefited immensely from crypto’s rise — but was also one of the industry’s most prominent investors in the Terra experiment.
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If Terra was this crypto winter’s Bear Stearns, many fear that the Lehman Brothers moment is just around the corner. Just as the inability of lenders to meet margin calls was an early warning sign in the 2008 financial crisis, crypto this month has had its equivalent: Celsius Network, Babel Finance and Three Arrows Capital all revealed major troubles as digital-asset prices plunged, triggering a liquidity crunch that ultimately stems from the industry’s interdependence.
A more traditional financial look
“In 2022, the downturn looks far more like a traditional financial de-leveraging,” Bloomberg quotes Lex Sokolin, global fintech co-head at ConsenSys. “All the words that people use, like ‘a run on the bank’ or ‘insolvent,’ are the same that you would apply to a functioning but overheated traditional financial sector. Consumer confidence and perception of bad actors definitely played a role in both cases, but what is happening now is about money moving out of deployed, functional systems due to over-leverage and poor risk-taking.”
Crypto loans — particularly those in decentralized-finance apps that dispense with intermediaries like banks — often require borrowers to put up more collateral than the loan is worth, given the risk of accepting such assets. But when market prices sour, loans that were once over-collateralized become suddenly at risk of liquidation.
On Monday, Bitcoin slumped along with much of the rest of the crypto market, declining about 3.5 per cent to $20,650 as of 10:30 am in New York. The world’s largest token is down about 35 per cent this month alone.
Now back around $1 trillion, the crypto market is only marginally above the approximately $830 billion mark it reached in early 2018 before the last winter set in, spurring a downdraft that sent the market to as low as about $100 billion at its depths, according to CoinMarketCap data.
Then, digital assets were the playground of dedicated retail investors and a select number of crypto-focused funds. This time around, the sector has built a broader appeal, causing regulators to frequently intervene with statements warning consumers of the risk of trading such assets.
Hard currency reserves
Though most of the financial world is taking a beating in 2022, the recent crypto market crash was amplified by its experimental and speculative nature, wiping out small-town traders who stuck their life savings in untested projects like Terra with little recourse.
Many start-ups born out of the last freeze have sought out venture capital funding as a more traditional route to raising cash. Behemoths like Andreessen Horowitz and Sequoia Capital collectively plugged almost $43 billion into the sector since late 2020 when the last bull market began, according to data from PitchBook.
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This means that instead of relying on crypto wealth, some of its biggest players actually have vast reserves of hard currency stored to get them through the blizzard as they work on growing new blockchains or building decentralized media platforms. On the other hand, the recent end to the bull market means they’ve been spending that cash much faster than it’s been coming in.