Why the ‘Crypto Winter’ of 2022 Is Different From Previous Bear Markets


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

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

Cryptocurrencies have suffered a precipitous drop this year, losing $2 trillion in value since peaking in a massive rally in 2021.

Bitcoin, the world’s largest digital coin, is down 70% from an all-time high of nearly $69,000 in November.

This has led many experts to warn of a prolonged 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 downturns – the last 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

In 2018, bitcoin and other tokens fell sharply after a strong rise in 2017.

The market was then flooded with so-called initial coin offerings, where people poured money into crypto businesses that had sprung up left, right and center – but the vast majority of those schemes ended. by fail.

“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 began earlier this year due to 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 in close correlation to other risky assets, especially stocks. Bitcoin released its worst quarter in more than a decade in the second quarter of the year. During the same period, the tech-heavy Nasdaq fell more than 22%.

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

As the markets began to sell off, it became clear that many large entities were unprepared for the rapid reversal.

Clara Medal

Research Director, Kaiko

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

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 big bear market.

So how did we get here?

Destabilized stablecoin

TerraUSD, or UST, was an algorithmic stablecoin, a type of cryptocurrency that was supposed to be pegged one-to-one with the American dollars. It worked through a complex mechanism governed 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 impacted companies exposed to UST, particularly hedge fund Three Arrows Capital or 3AC (more on them later).

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

The nature of leverage

Crypto investors have accumulated huge amounts of leverage through the emergence 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 effect was different in this cycle compared to the previous one. In 2017, leverage was widely provided to retail investors via derivatives on cryptocurrency exchanges, according to Martin Green, CEO of quantitative trading firm Cambrian Asset Management.

When crypto markets declined in 2018, positions opened by retail investors were automatically liquidated on exchanges as they could not meet margin calls, which exacerbated the sell-off.

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

“There were a lot of unsecured or under-secured loans because credit risks and counterparty risks were not carefully assessed. When market prices fell in the second quarter of this year, funds, lenders and others have become forced sellers due to margin calls.”

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A margin call is a situation where an investor must commit more funds to avoid losses on a trade made with borrowed money.

The inability to meet margin calls led to further contagion.

High returns, high risk

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

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

Celsius, a company that offered users returns of over 18% for depositing their crypto with the company, suspended withdrawals for customers last month. Celsius acted a bit like a bank. He would take the deposited crypto and lend it to other players at a high return. These other players would use it for trade. And the Celsius profit made from the yield 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 face liquidity issues and had to suspend withdrawals to effectively stop the crypto version of a bank run.

“Gamblers looking for high returns traded in fiat for crypto used lending platforms as custodians, then these platforms used the funds they raised to make very risky investments – how else could they pay such high interest rates?” Alexander said.

Contagion through 3AC

One problem that has become apparent lately is the amount of crypto companies 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 FinancialTimes reported last month that 3AC failed to respond to a margin call from crypto lender BlockFi and liquidated its positions.

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

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

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

The contagion continued further.

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 Voyager $377 million.

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

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

“It is now apparent that nearly all of the major centralized lenders failed to properly manage risk, which left them subject to a contagion-like event with the collapse of a single entity. 3AC had taken out loans from from almost all lenders that they were unable to repay following the broader market collapse, causing a liquidity crunch amid high customer redemptions.”

Is the deconfinement over?

It is unclear when the market turmoil will finally subside. However, analysts expect more pain to come as crypto firms struggle to service debts 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 congested stock industry,” Butterfill said. “Given this is such a crowded market and trading relies to some degree on economies of scale, the current environment is likely to highlight other victims.”

Even established players like Coinbase was impacted by the decline in the markets. Last month, Coinbase laid off 18% of its employees to cut costs. The US crypto exchange has seen trading volumes plummet lately, alongside falling digital currency prices.

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

“We also saw examples of potential stress where miners failed to pay their electricity bills, potentially hinting at cash flow issues,” he said in a research note last week.

“That’s probably why we’re seeing some miners selling their holdings.”

The role miners play comes at a steep price – not just for the equipment itself, but for the continuous flow of electricity needed to run their machines around the clock.


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