“Crypto Winter” On A Summer Day
A few weeks ago, I posted my quarterly review, where I discussed the implosion of the Terra-Lune ecosystem. Yet, to keep that post's length in check, I decided to skip the broader consequences of this crypto industry debacle and dedicate a separate post to them.
Besides sending the crypto market into a free fall, the Terra-Lune collapse in mid-May launched a massive deleveraging process. Throughout June and early July, we saw failures of highly leveraged crypto hedge funds and various companies that offered exotic high-yield products.
I borrowed this chart from ARK Invest's June Bitcoin report to summarise the timeline of the events (you can also check the July one here).
The failure of these companies tanked the crypto prices as everyone rushed to sell their coins to raise liquidity and meet their obligations (marginal calls or deposit withdrawals).
To better understand what happened and why, we need to explore how the industry has been operating over the recent years.
Inherently high cryptocurrencies' volatility makes trading and investment strategies like yield farming very attractive, thus allowing borrowers to pay higher rates on their loans. In turn, lenders can offer high-interest rates, well above those in the traditional finance world, to yield-starved depositors. As it turned out, these interest rates were very unsustainable.
The attractive returns environment caused the crypto borrowing and lending business to balloon over recent years from the massive inflows of funds from hungry investors. Such inflows of deposits gave crypto lenders more capital to lend than the responsible borrowers needed at the time. As the deposits promised to pay high-interest rates, the lenders were under pressure to deploy their capital as soon as possible or lose money. Many of them eventually lost their money.
Crypto lenders chose to sacrifice prudent risk management and high borrowing standards to get deposited capital out the door as quickly as possible.
The market was happy to absorb this capital. Since the last major crypto sell-off in 2018, a vast number of new cryptocurrencies, DeFi protocols and crypto-related projects have popped up. Many traditional investors became interested in the space and set up crypto funds that invest in crypto coins and projects.
With this massive wave of capital (looking for a new home) came irresponsive and speculative practices. Traders always look for ways to generate huge returns with little capital upfront. Here is where the word — leverage — comes in, which is the key to this story.
Investors use leverage to increase their buying power while posting only a small amount of capital up-front. This investment strategy relies on borrowing money via various financial instruments such as options, futures, or margin accounts. The latter tool is the most relevant for our discussion.
Leverage is a dangerous beast, however. Investors can make huge profits when the times are prosperous, and prices go up. Yet, when the market direction reverses, the losses tend to be immense if investors misuse the leverage strategies.
Financial institutions require collateral to mitigate risk when borrowers cannot repay a loan due to losses on their investment. In the case of a mortgage, the house acts as collateral. Stocks or bonds are the collateral in a margin account when one borrows money for purchasing securities. A firm sells the collateral to cover the loan loss.
People usually use bitcoin and Ethereum as collateral in the crypto industry because they are the two largest and most liquid cryptocurrencies. And yet, as we all know, cryptocurrencies are highly volatile.
When the value of the collateral falls below a certain threshold, a borrower receives a margin call from their lender asking to post additional assets to bring the collateral amount to the original value. If the borrower fails to do so, the lender liquidates the loan by selling the collateral. In the traditional financial industry, the social aspect plays a role. A broker can give extra time to its largest client to meet the margin call. Crypto lenders, meanwhile, use DeFi protocols that trigger the liquidation process — a sale of the collateral asset by the lender — automatically when the value of the collateral plunges with the falling prices. This further exacerbates the market sell-off of the assets — painful but fair.
Things get more troubling when lenders and brokers use the collateral for their own purposes, such as further lending or investments. This practice is rehypothecation. Vijay Boyapati talked about this practice in his book "The Bullish Case For Bitcoin" (the book is based on Vijay's article with the same title [LINK D]) and emphasised the risks in the second episode of "Hard Money".
Rehypothecation risk is when bitcoin is lent out irresponsibly.
The rehypothecation practice allows lenders to increase profits but puts the collateral at risk. It also benefits the borrower, for instance, by lowering interest payments on the loan.
When financial institutions are not prudent in their practices, rehypothecation introduces a systemic risk to a financial system. Vijay wrote in his book:
When collateral is lent out repeatedly and passes through many financial institutions, a failed investment at one institution can cause a series of cascading liquidations among many institutions, driving the price of the collateral asset down precipitously and triggering a liquidity crisis.
It's also worth pointing out that bitcoin is subject to a greater rehypothecation risk than any other financial asset. Unlike bonds, widely used collateral in the traditional banking system, there are no cash flows that can protect bitcoin's price decline during a liquidity crisis.
Imprudent investment behaviour that we've seen rarely leads to anything but total collapse. Institutions fail in quick succession, triggering a fire sale of assets. Asset prices (in this case, bitcoin) plummet, causing further bankruptcies.
And yet, such bad practices usually get exposed when the status quo changes. This time around, there were multiple triggers: the blowup of the Terra-Luna blockchain, the increase in interest rates (both of which I covered before) and the de-pegging of coins on the Ethereum blockchain.
Madeline Hume from Morningstar wrote an excellent article explaining the causes of the crypto sell-off in June. I've summarised the main takeaways.
First thing first, the Ethereum blockchain is in the process of upgrading from proof-of-work to proof-of-stake. The upgrading process involves some ether (native Ethereum blockchain coin) holders locking or staking their coins in the test environment and receiving an IOU token — staked ether. Owners of staked ether retain claims on their coins but can't access it until the update happens.
Since staked ether is the same as ether but less liquid, both coins have been trading in tandem until late May, when staked ether lost its "peg" to its counterpart as investors started to lose confidence following the Terra-Luna blowup. Then on the 8th of June, large investors offloaded a massive amount of staked ether coins bringing the price further down. On the 18th of June, the discount to ether reached 8%. Although this decoupling differs from the Terra USD stable coin collapse, these events, coupled with the Fed interest rate hike, started a contagion event in the crypto sector.
Celsius, a crypto lender, had over $400 million in staked ether. The company invested users' ether deposits into the staked ether as one of the ways to generate returns to meet its promised interest rate of up to 17% on the deposits. Celsius has a track record of inadequately managed risk. In 2021, it lost around $100 million on investments in some DeFi platforms with improper security features. The company also had exposure to the Terra-Luna blockchain, the collapse of which cost $500 million in customers' reclaims.
Eventually, customers became dissatisfied with Celsius' poor risk management and started pulling out funds in the form of liquid ether. Late 12th of June, Celsius decided to halt redemptions instead of liquidating positions in staked ether, which was suffering under pressure, and returning funds to the depositors.
Shortly after, the news started to come through that Three Arrow Capital (3AC), one of the largest crypto hedge funds, started rapidly offloading staked ether to meet margin calls. On the 16th of June, 3AC confirmed it could not meet marginal calls. The hedge fund also lost around $200 million in the Terra-Luna blowup.
On the 29th of June, Bloomberg reported that 3AC fell into liquidation. According to the bankruptcy filing documents, 3AC owes $3.5 billion to 27 companies, such as Voyager Digital, Genesis and Blockchain.com. Genesis had the most considerable exposure to 3AC, lending $2.36 billion under-collateralised. When the troubles began, 3AC tried to borrow more from Genesis to meet margin calls from another lender.
Voyager Digital - a Canadian listed lender - lost $650 million in loans to 3AC. The lender had to freeze customers' deposits. On the 14th of July, Celcius filed for bankruptcy, revealing a $1.19 billion hole on its balance sheet (the company owes way more than it can pay).
I think this is an excellent place to sum everything up. We saw several crypto companies collapsing and $2 trillion exiting the market in the recent crypto turbulence [LINK N]. The crucial point is -- the money did not abandon the functional and deployed system due to loss of confidence and conviction but because of over-leveraging and poor risk management.
Many have compared this summer's events to the start of the 2008 financial crisis. The collapse of Terra-Lunna is the equivalence of Bear Stearns, while the liquidity troubles of Celsius Network and Three Arrows Capital due to plunging prices and banks' failure to meet marginal calls back in 2008.
However, the deleveraging spiral was more fierce in the crypto market not just due to its speculative and experimental nature, as some experts said, but because there was no one to stop the contagion.
Unlike in the fiat monetary system, where central banks tend to step in and bail out failing institutions, this burden falls on the shoulders of other companies in the crypto space. For instance, the FTX exchange injected $250 million into BlockFi and $200 million to Voyager. The loan is intended to strengthen BlockFi's balance sheet.
This mass deleveraging is healthy for the Bitcoin ecosystem because it allowed to correct the errors that the market accumulated in the recent cycle in a free-market fashion. The industry got rid of imprudent and fraudulent companies, which gambled with investors' money and misused them for fake projects, with the help of free-market forces. The market has cleansed itself from inefficient companies. The trustworthy companies that weathered the storm have strengthened will likely be held in more favourable regard by investors and will have access to funds to continue working for the good of the space.
Valkyrie CEO Lean Wad told in the interview with Blockworks:
There's always a cleansing that happens of companies that were not well-suited from a foundational level that were not strong and that were fads, not trends.
Investors, who took an excessive risk to earn an easy dollar, have learned the hard but necessary lesson of not entrusting companies that offer investment products that sound too good to be true. Marty Bent wrote on the 22nd of June:
If you take undue risks and those risks come back to bite you ..., there is no lender of last resort.
Excessive speculation and overconfidence that fuelled the industry's growth have finally brought the market down. In a Bloomberg interview, Su Zhu, one of the founders of 3AC, said that overconfidence born from the multi-year bull market played a role in bringing the company to its knees. Cryptocurrencies are the new asset class. Thus, one must be humble and careful when making investment decisions (it is always best to consult your financial adviser) and constantly educate oneself (here is a good list of resources about bitcoin).
What can we expect going forward? I think valuable lessons have been learnt from the events of this summer, and bitcoin will only benefit and come out strong.
We can also expect new regulations from governments and the industry that will bring further clarity and protection to investors. Here is an excellent summary of government regulations currently in the pipelines on both sides of the Atlantic.
If you’ve been enjoying my writing, I want to encourage you to subscribe to the notification list so that you never miss when I post a new blog! It may even prompt me to write more often :) And now to the new post!