The two words on every crypto investor’s lips right now are undoubtedly “crypto winter.’ Back in 2018, bitcoin and other tokens slumped sharply after a steep climb in 2017. The market then was awash with so-called initial coin offerings. Cases where people poured money into crypto ventures that had popped up left, right and center. Sadly, the vast majority of those projects ended up failing.
“The 2017 crash was largely due to the burst of a hype bubble.” Clara Medalie, research director at crypto data firm Kaiko
But the current crash began earlier this year as a result of macroeconomic factors. One of these factors include rampant inflation that has caused the U.S. Federal Reserve and other central banks to hike interest rates. These factors weren’t present in the last cycle.
Bitcoin and the cryptocurrency market has been trading in a closely correlated fashion to other risk assets, in particular stocks. Bitcoin posted its worst quarter in more than a decade in the second quarter of the year. In the same period, the tech-heavy Nasdaq fell more than 22%.
For sure, there are parallels between today’s meltdown and crashes past. The most significant being seismic losses novice traders had to suffer after being lured into crypto by promises of lofty returns. But a lot has changed since the last major bear market. So how did we get here?
The Nature Of Leverage In Crypto
Crypto investors built up huge amounts of leverage thanks to the emergence of centralized lending schemes and so-called decentralized finance. DeFi is an umbrella term for financial products developed on the blockchain.
But the nature of leverage has been different in this cycle versus the last. In 2017, leverage was largely provided to retail investors via derivatives on cryptocurrency exchanges, according to Martin Green.
When the crypto markets declined in 2018, those positions opened by retail investors were automatically liquidated on exchanges. This is because they couldn’t meet margin calls, which exacerbated the selling.
A margin call describes where an investor commits more funds to avoid losses on a trade made with borrowed cash. The inability to meet margin calls has led to further contagion.
High Crypto Yields Means High Risk
Celsius, a company that offered users yields of more than 18% for depositing their crypto with the firm, paused withdrawals for customers last month. Celsius acted sort of like a bank. It would take the deposited crypto and lend it out to other players at a high yield. Those other players would use it for trading. And the profit Celsius made from the yield would be used to pay back investors who deposited crypto.
“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 problem that has become apparent lately is how much crypto companies relied on loans to one another.
Three Arrows Capital (3AC), is a Singapore crypto-focused hedge-fund. They happen to be one of the biggest victims of the market downturn. 3AC had exposure to Luna and suffered losses after the collapse of UST. The Financial Times reported last month that 3AC failed to meet a margin call from crypto lender BlockFi and had its positions 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 U.S. Bankruptcy Code.