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Thursday, August, 11, 2022

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Why is the current “crypto winter” unique for the entire industry?

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Cryptocurrencies have experienced a massive drop this year, losing $2 trillion in capitalization since the peak of a massive rally in 2021, but despite a number of parallels between today’s crisis and past crashes, a lot has changed since the last major bear market, writes CNBC.

Bitcoin, the world’s largest digital coin, is down 70% from its November all-time high of nearly $69,000, leading many pundits to warn of an extended bear market, or “crypto winter,” which will last took place between 2017 and 2018.

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The large-scale collapse gave rise to a number of factors: flooding the cryptocurrency market with debt due to the emergence of centralized lending schemes and so-called “decentralized finance”, the collapse of the algorithmic stablecoin TerraUSD, which caused a “domino effect” in the sector, which entailed, in particular, the liquidation of the hedge fund Three Arrows Capital. Perhaps the similarity between the current crash and the past can be seen in the losses suffered by novice and inexperienced traders who were lured into cryptocurrencies with promises of high returns.

But there was something different about the latest crash of cryptocurrencies from previous crashes: it is a series of events that caused the entire industry to decline due to the interconnected nature of projects and companies.

If in 2018 bitcoin and other tokens fell sharply after a steep rise a year earlier, then that crash was largely due to the bursting of the “hype bubble”. The market was flooded with so-called initial offerings where people invested in crypto-currency ventures that popped up again and again, but the vast majority of these projects ended up failing.

The crash this year was driven more by macroeconomic factors, including runaway inflation that forced the US Federal Reserve and other central banks around the world to raise interest rates. Bitcoin and the cryptocurrency market more broadly trade in close association with other risky assets, in particular equities. It was the worst quarter for BTC in over a decade, and the Nasdaq fell over 22% at the same time. This sharp turn in the market took many in the industry, from hedge funds to lenders, by surprise. When the sell-offs began, it became clear that many large companies were not ready for a quick turnaround. Such an effect was simply absent during the crash of cryptocurrencies in 2018.

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Another difference is that in 2017-2018 there were no major players on Wall Street using “highly leveraged positions” to invest in cryptocurrencies.

Now let’s look at the differences in more detail.

The TerraUSD stablecoin, or UST, was an algorithmic stablecoin pegged one-to-one to the US dollar. It worked through a complex mechanism controlled by an algorithm. But then UST lost its dollar peg, which also led to the collapse of its sister token, Luna. Like a domino chain, this event caused a shock in the crypto industry, having a direct negative impact on companies associated with UST, in particular, the hedge fund Three Arrows Capital or 3AC.

Crypto investors have amassed massive amounts of credit thanks to the emergence of centralized lending schemes and so-called “decentralized finance” or DeFi, but the nature of the lending support is different this time around. If in 2017 lending was mainly provided to retail investors through derivatives on cryptocurrency exchanges, and with the decline of the crypto market in 2018, positions opened by retail investors were automatically liquidated on exchanges because they could not meet margin requirements, which aggravated the sell-off, then in 2022 Lending was provided to crypto-currency funds and lending institutions by retail crypto-currency depositors who invested with the sole purpose of generating income.

From 2020 onwards, there has been a huge rise in profitable DeFi and crypto-currency “shadow banks” as there has been a lot of unsecured or undersecured lending in the market as credit and counterparty risks have not been properly assessed. When market prices declined in the second quarter of this year, funds and lenders became forced sellers due to margin calls. The latter is a situation where the investor must allocate more funds to avoid losses on a leveraged trade. And the inability to meet margin calls led to further spread of insolvency.

Numerous crypto firms have made too risky bets, hoping to get a big profit. The most striking example is Celsius, which offered users a yield of more than 18% for holding cryptocurrencies on deposits, which suspended the withdrawal of customer funds last month. Celsius positioned itself as a crypto bank: it accepted deposited cryptocurrencies and provided them on credit to other players at a high percentage. They used it for trade. And the profits made by Celsius were used to return funds to investors who invested in cryptocurrencies. Since the start of the economic downturn, this business model has stopped working, and therefore Celsius experienced liquidity problems and was forced to suspend withdrawals in order to effectively stop the cryptocurrency bankruptcy.

In fact, the main problem is how heavily crypto companies relied on loans to each other. In the case of the collapse of 3AC, it is clear that almost every major centralized lender failed to properly manage risk, leaving everyone hurt by the failure of one company. 3AC took out loans from almost all lenders that they were unable to repay after the market crash, which caused a liquidity crisis amid a large number of customer withdrawals.

The problem is being extended by the inclusion of the exchange industry, for example, even for an established player like Coinbase (NASDAQ: COIN), which was forced to lay off 18% of its employees to cut costs. Recently, this American crypto exchange has seen a collapse in trading volumes along with a fall in prices for digital currencies.

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Another aspect of the problem is the damage to cryptocurrency miners who rely on specialized computing equipment to conduct transactions on the blockchain. There has been an increase in cases of miners not paying their electricity bills, potentially indicating cash flow problems. It is likely that soon some miners will sell their shares. The damage they incur is generated by a sharp increase in costs – not only for the equipment itself, but also for the continuous flow of electricity needed to run computers around the clock, which is not covered by income.

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