For a generation of alienated techies, crypto's all-for-one ethos was its biggest draw. Now panic is spreading across this universe — and that same ethos is posing what may be the biggest threat yet to its survival.
What started this year in crypto markets as a “risk-off” bout of selling fueled by a Federal Reserve suddenly determined to rein in excesses has exposed a web of interconnectedness that looks a little like the tangle of derivatives that brought down the global financial system in 2008. As Bitcoin slipped almost 70% from its record high, a panoply of altcoins also plummeted. The collapse of the Terra ecosystem — a much-hyped experiment in decentralized finance — 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. 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.
The seeds that spawned the meltdown — greed, overuse of leverage, a dogmatic belief in “number go up” — aren’t anything new. They’ve been present when virtually every other asset bubble popped. In crypto, though, and particularly at this exact moment, they are landing in a new and still largely unregulated industry all at once, with boundaries blurred and failsafes weakened by a conviction that everyone involved could get rich together.
Crypto has gone through several major drops in its history — known by its cognoscenti as “crypto winters” and to the rest of finance as a bear market — but the market’s expansion and increasing adoption from Main Street to Wall Street means more is at stake now. Kim Kardashian hawking a cryptocurrency that tanked shortly afterward is one thing, but Fidelity’s plans to offer Bitcoin in 401(k)s could impact an entire generation. Its growth has also made this year’s turbulence reverberate that much more: 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.
“It’s got a different flavor this time,” Jason Urban, co-head of trading at Galaxy Digital Holdings Ltd., said in an interview. 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. “Truthfully, it’s being a victim of your own success.”
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.
“In 2022, the downturn looks far more like a traditional financial de-leveraging,” said 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.”
In bullish periods, leverage is a way for investors to make bigger profits with less cash, but when the market tanks, those positions quickly unwind. And because it’s crypto, such bets usually involve more than one kind of asset — making contagion across the market even more likely to occur.
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 — a process that often happens automatically in DeFi and has been exacerbated by the rise of traders and bots hunting for ways to make a quick buck.
John Griffin, a finance professor at University of Texas at Austin, said the rise of crypto prices last year was likely fueled by leveraged speculation, perhaps more so than in the previous crypto winter. An environment of rock-bottom rates and ultra-accommodative monetary policy helped set the stage.
“With interest rates rising as well as lack of trust in leveraged platforms, this de-leveraging cycle has the effect of unwinding these prices much more rapidly than they rose,” he said. Though traditional markets often rely on a slow and steady amount of leverage to grow, that effect is seemingly amplified in crypto because of how speculation concentrates in the sector.
Regulators are circling the sector, watching for signs of instability that might threaten their infant plans to rein in crypto. Even rules that were announced in spring have had to change in the wake of Terra’s collapse, with some jurisdictions preparing rules to ease the systemic impact of failed stablecoin systems. Any further crypto failures could ultimately pave the way for tougher rules, making a market rebound any time soon less likely.
“There may be some bear rallies, but I don’t see a catalyst to reverse the cycle anytime soon,” Griffin said. “When the Nasdaq bubble burst, our research found that the smart investors got out first and sold as prices went down, whereas individuals bought all the way down and continually lost money. I hope history doesn’t repeat itself, but it often does.”
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 to both mom and pop investors and hedge fund titans alike, causing regulators to frequently intervene with statements warning consumers of the risk of trading such assets. As one infamous (now banned) advert on London’s transport network read in late 2020: “If you’re seeing Bitcoin on a bus, it’s time to buy.”