Why 2022’s ‘Crypto Winter’ Is Different From Past Bear Markets

There is something about the latest crypto crash that makes it different from previous downturns.

Arthur Widak | Nurfoto | Getty Images

The two words on every crypto investor’s lips right now are undoubtedly “crypto winter”.

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Cryptocurrencies have experienced a steep decline this year, losing $2 trillion in value since they peaked in a massive rally in 2021.

Bitcoin, the world’s largest digital currency, is down 70% from a record high of nearly $69,000 in November.

This has led many experts to warn of a protracted bear market known as “crypto winter”. The last such event occurred between 2017 and 2018.

But there is something about the latest crash that makes it different from previous crypto declines – the latest cycle was marked by a series of events that caused contagion across the industry due to their interconnected nature and their business strategies.

From 2018 to 2022

Bitcoin and other tokens fell sharply in 2018 after a sharp rise in 2017.

The market was then flooded with so-called initial coin offerings, with people pouring money into crypto companies that had sprung up left, right and center – but the vast majority of those schemes ended in failure.

“The 2017 crash was largely due to the bursting of a hype bubble,” Clara Medalie, research director at crypto data firm Kaiko, told CNBC.

But the current crash started earlier this year as a result of macroeconomic factors, including runaway inflation, which prompted the US Federal Reserve and other central banks to raise interest rates. These factors were not present in the last cycle.

Bitcoin and the cryptocurrency market in general trade closely with other risky assets, especially stocks. Bitcoin recorded its worst quarter in more than a decade in the second quarter of the year. Over the same period, the tech-heavy Nasdaq fell more than 22%.

This sharp market turnaround surprised many in the industry, from hedge funds to lenders.

As the markets started to sell out, it became clear that many large entities were unprepared for the rapid turnaround.

Clara Medal

Research Director, Kaiko

Another difference is that there were no major players on Wall Street using “high leverage” positions in 2017 and 2018, according to Carol Alexander, a professor of finance at the University of Sussex.

Of course, there are parallels between today’s crash and past crashes – the biggest being the seismic losses suffered by novice traders who were lured into crypto by promises of high returns.

But a lot has changed since the last major bear market.

So how did we get here?

Destabilized stablecoin

TerraUSD, or UST, was an algorithmic stablecoin, a type of cryptocurrency that had to be pegged one-to-one with the US dollar. It worked through a complex mechanism controlled by an algorithm. But UST lost its peg to the dollar, which also led to the collapse of its sister luna.

This sent shockwaves through the crypto industry, but also affected companies exposed to UST, most notably hedge fund Three Arrows Capital or 3AC (more on this later).

“The collapse of the Terra blockchain and UST stablecoin was largely unexpected after a period of massive growth,” said Medalie.

The nature of leverage

Crypto investors have built up massive amounts of leverage through the rise of centralized lending systems and so-called “decentralized finance” or DeFi, an umbrella term for financial products developed on the blockchain.

But the nature of the leverage was different in this cycle than in the previous one. According to Martin Green, CEO of quantitative trading firm Cambrian Asset Management, in 2017 leverage was provided to retail investors on a large scale through derivatives on cryptocurrency exchanges.

When crypto markets fell in 2018, positions opened by retail investors were automatically liquidated on exchanges as they failed to meet margin calls, exacerbating the sell-off.

“By contrast, the leverage that triggered the sell-off in Q2 2022 was provided to crypto funds and credit institutions by retail crypto depositors investing for returns,” Green said. “Starting in 2020, we saw a massive construction of yield-based DeFi and crypto shadow banks.

“There were many unsecured or unsecured loans because credit and counterparty risks were not carefully assessed. As market prices fell in the second quarter of this year, funds, lenders and others became forced sellers due to margin calls.

A margin call is a situation where an investor has to put in more money to avoid losses on a transaction involving borrowed money.

The inability to meet margin calls led to further contagion.

High return, high risk

At the heart of the recent turmoil in crypto assets has been the exposure of many crypto firms to high-risk bets that were vulnerable to “attacks,” including terra, said Alexander of the University of Sussex.

It’s worth examining how some of this contagion unfolded through high-profile examples.

Celsius, a company that offered users returns of more than 18% for depositing their crypto with the company, suspended withdrawals for customers last month. Celsius acted a bit like a couch. He would take the deposited crypto and lend it to other players at a high return. These other players would use it for trading. And the Celsius profit made from the proceeds would be used to pay back investors who deposited crypto.

But when the recession hit, this business model was put to the test. Celsius continues to experience liquidity problems and had to suspend withdrawals to effectively stop the crypto version of a bank run.

“Gamblers seeking high returns trading in fiat for crypto used lending platforms as custodians and then these platforms used the money raised to make risky investments – how else could they pay such high interest rates?” Alexander said.

Contamination via 3AC

One issue that has become apparent lately is the number of crypto firms that have lent to each other.

Three Arrows Capital, or 3AC, is a Singaporean crypto-focused hedge fund that has been one of the biggest victims of the market downturn. 3AC was exposed to Luna and suffered losses after the collapse of UST (as mentioned above). The Financial Times reported last month that 3AC failed to respond to a margin call from cryptocurrency lender BlockFi and liquidated its positions.

Subsequently, the hedge fund defaulted on a loan of more than $660 million from Voyager Digital.

As a result, 3AC went into liquidation and filed for bankruptcy under Chapter 15 of the US Bankruptcy Act.

Three Arrows Capital is known for its high leverage and bullish crypto betting that unraveled during the stock market crash, highlighting how these business models fell under the pump.

The contagion continued.

When Voyager Digital filed for bankruptcy, the company revealed that not only did it owe $75 million to crypto billionaire Sam Bankman-Fried’s Alameda Research, but that Alameda also owed $377 million to Voyager.

To complicate matters further, Alameda owns a 9% stake in Voyager.

“Overall, June and the second quarter as a whole were very difficult for crypto markets, where we saw the collapse of some of the largest companies, largely due to extremely poor risk management and contagion from the collapse of 3AC, the largest crypto hedge fund ‘ said Kaiko’s medal.

“It is now clear that almost all major centralized lenders failed to manage the risks well, leaving them subject to a contagious event with the collapse of a single entity. 3AC had taken out loans from nearly every lender that failed to repay them following the wider market crash, leading to a liquidity crunch amid high customer repayments.

Is the unlocking over?

It is unclear when the market turmoil will finally subside. However, analysts expect more pain to come as crypto firms struggle to pay off debt and process customer withdrawals.

The next dominoes to fall could be crypto exchanges and miners, according to James Butterfill, head of research at CoinShares.

“We believe this pain will ripple through the overstretched stock industry,” Butterfill said. “Given that this is such a busy market and trading relies to some extent on economies of scale, the current environment is likely to stress other victims.”

Even established players like Coinbase have been hit by the market downturn. Last month, Coinbase fired 18% of its employees to cut costs. The US crypto exchange has seen trading volumes plummet lately, alongside falling prices for digital currencies.

Meanwhile, crypto miners who rely on specialized computing equipment to handle transactions on the blockchain could also be in trouble, Butterfill said.

“We also saw examples of potential stress where miners failed to pay their electric bills, possibly indicating cash flow problems,” he said in a research note last week.

“That’s probably why some miners are selling their property.”

The role miners play comes at a high cost – not just to the equipment itself, but also to the continuous flow of electricity required to run their machines around the clock.

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