Crypto Feels Shockwaves From Its Own ‘Credit Crisis’

The deflating digital asset bubble has exposed a fragile system of credit and leverage in crypto similar to the credit crunch that enveloped the traditional financial sector in 2008.

Since its inception, crypto enthusiasts have promised a future of vast personal fortunes and the foundations of a new and better financial system, dismissing critics who questioned its value and usefulness as spreading “FUD” – fear, uncertainty and doubt.

But those emotions now stalk the crypto industry as one by one, often interconnected projects that lock up customer money face millions of dollars in losses and look to industry heavyweights for plans. safety.


“Fear is contagious. This is true in any financial market. . . No one wants to be the last person without a chair when the music stops, so everyone cashes out,” said Brett Harrison, president of crypto exchange FTX US.

The price of bitcoin, the largest cryptocurrency, has fallen more than 70% since its peak in November and the total value of crypto tokens has fallen from over $3 billion to less than $900 billion.

As the market shrinks, the industry creaks. A token called Luna and its sister Terra, a stablecoin that tried to use computer algorithms to keep its price stable, crashed in May; crypto lender Celsius halted withdrawals earlier this month; and hedge fund Three Arrows Capital faced margin calls.

In recent days, another lender, Voyager, has restricted withdrawals while the Coinflex exchange has frozen customer funds. Trades and investments that seemed safe, liquid and profitable a few weeks ago have become perilous and impossible to exit. Investors fear that more dominoes are about to fall.

At the heart of the boom is the growth of decentralized finance, known as DeFi, a corner of the crypto world that claims to offer an alternative financial system without central decision-making authorities such as banks or stock exchanges. Instead, users can transfer, lend, and borrow assets using contracts defined in computer code. Changes aren’t made by CEOs, but by the votes of those with special governance tokens, often teams of developers and early investors.

The amount of capital flowing into DeFi projects had soared to nearly $230 billion by the end of 2021, according to data from CryptoCompare.

During the last crypto boom, in 2017, buyers simply speculated on token prices. This time around, smaller investors and some funds also sought high returns by lending and borrowing crypto assets.

This appealed to both sophisticated crypto traders and public-facing lending platforms such as Celsius, which accepted customer deposits and paid interest rates of up to 17%.

Investors could increase their returns by taking out multiple loans against the same collateral, a process called “recursive borrowing.” This freedom to recycle capital with little restraint has led investors to accumulate more and more returns in different DeFi projects, earning multiple interest rates at once.

“As with the subprime crisis, it’s something really attractive in terms of yield and it looks and is presented as a risk-free financial product for ordinary people,” said Lennix Lai, director of financial markets at the OKX crypto exchange.

The financial gymnastics left huge borrowing and notional value towers hovering above the same underlying assets. This continued as crypto prices rose. But then inflation, aggressive interest rate hikes and geopolitical shock waves from the war in Ukraine swept through financial markets.

“Everything worked during the bull run where the prices of all assets only went up. When prices started falling, a lot of people wanted to withdraw their assets,” said Marcin Miłosierny, head of market research at crypto hedge fund ARK36.

As token values ​​plummeted, lenders called back their loans. The process led to the removal of more than 60%, or $124 billion, of the total value locked on the Ethereum blockchain since mid-May in a “great deleveraging,” according to research firm Glassnode.

The first domino fell in May, when Terra failed, shaking investor confidence. Next is lender Celsius, which froze its customers’ accounts when it was caught in a serious cash mismatch on its books.

Last week, Three Arrows Capital, a major Singapore-based crypto hedge fund, slipped after being unable to meet margin calls. Voyager has confirmed that he could be exposed to Three Arrows’ flaws. BlockFi and Genesis also liquidated at least some of Three Arrows’ positions, according to people familiar with the matter.

The situation has been exacerbated by the heavy reliance on borrowing by crypto traders to increase the upside of their market bets. In a falling market, traders face calls for more funds to support their positions.

“There is a snowball effect. Every time the price of bitcoin drops, more people are forced to sell bitcoin, overselling,” said Yves Choueifaty, chief investment officer at asset management firm Tobam.

But some executives wonder if the crypto has ever had its own “Lehman” moment, with Celsius being the biggest name to fall. They hope the mood shifts towards action aimed at stabilizing the market.

Without a central bank in crypto, they base their optimism on the intervention of industry leaders, including Sam Bankman-Fried, the 30-year-old billionaire founder of the FTX exchange.

Over the past nine days, through his businesses, Bankman-Fried has provided loans worth hundreds of millions of dollars to BlockFi and crypto lender Voyager to stabilize both businesses and build confidence in the system.

Bankman-Fried’s efforts to act as a lender of last resort include an element of self-interest. His trading company Alameda Research is Voyager’s largest shareholder, with an 11% stake after buying shares last month. It will also become the “preferred borrower” for any future Voyager loans.

Over the past week, the price of bitcoin has held steady at around $20,000. But many wonder if the respite is temporary.

“The risk of contagion in crypto markets remains high,” said Marion Laboure, senior strategist at Deutsche Bank. “A Fed tightening will expose more crypto firms to excessive credit risk by withdrawing liquidity and raising rates, which will reduce the value of the coins that many of these leveraged systems depend on,” said she added.

Bitcoin was invented at the height of the 2008 financial crisis as an alternative to the financial system, frequently hailed by fans as being immune to the impact of inflation and politically tinged monetary policy.

Many executives are now coming to the conclusion that the crypto industry may be subject to the same ups and downs as other markets.

Global central banks have kept interest rates extremely low for a decade to spur economic growth, and pushed those policies even harder during the pandemic. Much of this cheap central bank money had flowed into crypto.

Venture capitalists alone have invested $38 billion in blockchain startups since 2020, according to data from Dealroom. Now the tide is receding as the Federal Reserve and other central banks turn to tackling intense inflation.

“In a higher rate environment, the emperor has to wear clothes to survive,” said Taimur Hyat, chief operating officer of $1.5 billion asset manager PGIM.

This can push consumers, with little legal protection or transparency about the economic health of the companies behind crypto projects, to withdraw funds or exercise greater caution.

“Anyone entering space within the next two years. . . will have a natural aversion to perpetual motion machines and things that seem too good to be true,” said Sidney Powell, Managing Director of DeFi Protocol Maple.

“When people experience a big drop in asset values ​​and breaches of trust, I think that’s what immunizes people for the next few years, so in that sense it’s like the crypto of 2008.”

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Crypto Feels Shockwaves From Its Own ‘Credit Crisis’

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