For a generation of solo technologists, the “all-for-one” spirit of cryptocurrency was their biggest attraction. Now panic is spreading throughout this universe – and this same spirit poses the greatest threat to its survival yet.
What began this year in the cryptocurrency markets as a “risk-off” sell-off fueled by a Federal Reserve suddenly bent on reining in excesses has exposed a web of interdependence that looks a bit like a derivatives tangle that has led to the collapse of the global financial system. in 2008.
With Bitcoin down nearly 70% from its all-time high, a group of altcoins have also fallen.
The collapse of the Terra ecosystem – a very encouraging experiment in decentralized finance – began with the loss of its algorithmic stablecoin peg to the US dollar, and ended with a bank trade that rendered $40 billion worth of tokens virtually worthless.
Crypto guarantees that once seemed valuable enough to back loans are now deeply discounted or illiquid, putting the fate of a once indomitable hedge fund and many prominent lenders in doubt.
The seeds that bred the collapse — greed, excessive use of influence, dogmatic belief in “over-numbering” — are nothing new.
They were present when almost every other asset bubble burst. Despite this, in cryptocurrencies, and especially at this very moment, they are descending into a new industry that remains largely unregulated simultaneously, with blurring of boundaries and weakening protection against failure due to the conviction that everyone involved can get rich together.
The cryptocurrency has gone through several major declines in its history — known as the cognoscenti as “crypto winter” and the rest of the funding as a bear market — but the expansion of the market and increased adoption from Main Street to Wall Street means that more is at stake now.
Kim Kardashian’s crypto sale soon after is one thing, but Fidelity’s plans to introduce Bitcoin in a 401(k) could affect an entire generation. Its growth has also made this year’s turmoil resonate much more:
After the cryptocurrency’s last two-year hibernation ended in 2020, the sector jumped to around $3 trillion in total assets last November, before dropping below $1 trillion.
Jason Urban, co-head of trading at Galaxy Digital Holdings Ltd. , in an interview: “It got a different flavor this time.” Galaxy, a $2 billion digital asset brokerage founded by billionaire Mike Novogratz, has benefited greatly from the cryptocurrency’s rise — but has also been one of the industry’s leading investors in Terra’s experiment. “Truthfully, being a victim of your own success.”
If Terra is the crypto winter Bear Stearns, many fear the Lehman Brothers moment is right around the corner. Just as the inability of lenders to meet margin calls was an early warning sign of the 2008 financial crisis, cryptocurrencies this month had their equivalent: Celsius Network, Babel Finance and Three Arrows Capital exposed major problems as digital asset prices plummeted, leading to a liquidity crunch. It ultimately stems from the interdependence of industry.
“In 2022, deflation looks more like a traditional leverage cut,” said Lex Sokolin, co-head of global financial technology at ConsenSys. “All the words people use, like ‘bank run’ or ‘insolvent’, are the same as you would apply to an efficient but overheated traditional financial sector. Consumer confidence and perception of bad actors certainly played a role in both cases, but what is happening now is The exit of funds from the widespread functional systems due to over-indebtedness and low risk.”
In bullish periods, leverage is a way for investors to make more profits with less money, but when the market crashes, these positions quickly fade away. Being a cryptocurrency, such bets usually involve more than one type of asset – increasing the potential for contagion throughout the market.
Cryptocurrency loans – especially those in decentralized finance applications that do away with intermediaries such as banks – often require borrowers to provide more collateral than the loan is worth, given the risk of accepting such assets.
But when market prices plummet, previously over-secured loans suddenly become at risk of liquidation — a process that often happens automatically in DeFi and has been exacerbated by the rise of traders and bots looking for ways to make a quick buck.
John Griffin, a professor of finance at the University of Texas at Austin, said the rally in cryptocurrency prices last year was likely driven by leveraged speculation, perhaps more than it was in the previous crypto winter. The low rate environment and very loose monetary policy helped pave the way.
“With rising interest rates as well as distrust of leveraged platforms, this de-leveraging cycle has the effect of undoing these rates much more quickly than they rose,” he said. Although traditional markets often rely on a slow and steady amount of leverage for growth, this effect appears to be amplified in cryptocurrencies due to how speculation is focused in this sector.
Regulators are circling the sector, watching for signs of instability that could threaten their children’s plans to rein in cryptocurrency.
Even the rules announced in the spring had to be changed in the wake of Terra’s collapse, with some jurisdictions preparing rules to mitigate the systemic impact of failed stablecoin regimes. Any further crypto failures could eventually pave the way for stricter rules, making a market rebound anytime soon less likely.
On Monday, Bitcoin slid along with much of the rest of the crypto market, dropping 3.5% to $20,650 as of 10:30 a.m. in New York. The world’s largest token is down about 35% this month alone.
“There may be some bear twitches, but I don’t see an incentive to reverse the cycle anytime soon,” said Griffin. “When the Nasdaq bubble burst, our research found that smart investors got out first and sold as prices fell, while individuals bought along the way and continually lost money. I hope history won’t repeat itself, but it does happen often.”
Now back to close to $1 trillion, the cryptocurrency market is only marginally above the $830 billion level it reached in early 2018 before last winter, driving the market up to around $100 billion in its depths, according to CoinMarketCap data. After that, digital assets were a playground for niche retail investors and a select number of crypto-focused funds.
This time around, the sector has built a broader appeal to parent investors, clients and hedge fund giants alike, causing regulators to intervene frequently with statements warning consumers about the risks of trading such assets. As an infamous (now banned) ad on Transport for London put it in late 2020: “If you see Bitcoin on a bus, it’s time to buy.”
Unlike the early believers in cryptocurrency, mass adoption means that most investors now view cryptocurrency as just another asset class and treat it the same way as the rest of their portfolios. This makes crypto prices more closely related to everything else, such as tech stocks.
Unfortunately, that doesn’t make most crypto bets any less complicated to understand.
Even though much of the financial world is taking a beating in 2022, the recent crash of the cryptocurrency market has been amplified by its experimental and speculative nature, eliminating small-town traders who parked their savings on untested ventures like Terra with little recourse.
And the sector’s hype machine is louder than ever, with tools like Twitter and Reddit fueled by new generations of crypto helpers. Exchanges have done their part, too, with FTX, Binance, and Crypto.com spending on high-profile marketing and sponsorship.
Sina Meyer, managing director of crypto fund manager 21Shares AG, said the extreme level of risk illustrates exactly why cryptocurrencies are not suitable for everyone. “Some people should definitely stay away,” she said during a panel discussion earlier this month at the Bloomberg Future of Finance conference in Zurich. Many retail investors are “get lost, they just follow what they read in the papers. This is wrong.”
Before the previous crypto winter, many startups used initial coin offerings, or ICOs, to raise capital by issuing their tokens to investors. They suffered when coin prices collapsed because they held most of their value in the same set of assets, plus Ether, and this was exacerbated when regulators started cracking down on ICOs such as offering unregistered securities to investors.
This time around, the financing landscape is very different. Many startups that emerged from the recent freeze, such as non-fungal token and gaming platform Dapper Labs, have sought venture capital funding as a more traditional way to raise funds. Giants like Andreessen Horowitz and Sequoia Capital combined have funneled nearly $43 billion into the sector since late 2020 when it last started a bull market, according to data from PitchBook.
This means that rather than relying on the cryptocurrency’s wealth, some of its biggest players already have massive hard-currency reserves in store to get them out of the blizzard as they work to develop new blockchains or build decentralized media platforms. On the other hand, the recent end of the bull market means that they are spending that money much faster than they were in the future.
This month, Coinbase Global Inc. and Crypto.com, Gemini Trust, and BlockFi Inc. Among the crypto companies that have announced batches of layoffs, citing the general macroeconomic downturn to scuttle their ever-expanding plans. Coinbase, which has employed about 1,200 people this year alone, is laying off roughly 18% of its workforce.
But thanks to the cryptocurrency’s recent boom, there is still more earmarked funding flowing around Silicon Valley’s coffers than in previous seasons. Andreessen alum Katie Haun first launched a $1.5 billion crypto fund in March, while Coinbase co-founder Matt Huang launched a $2.5 billion car in November. And while venture capital may now be more careful about where they put their money, it still has to be spent somewhere.
“None of these companies have matured for many years,” said Alston Zecha, partner at Eight Roads. “We have been spoiled over the past two years of seeing companies get these amazing improvements after six or nine months. As the tide recedes, there will be a lot of people found naked.”
(Except for the headline, this story has not been edited by the NDTV crew and is published from a syndicated feed.)