The Current Crypto Winter & The Bull Ahead

Since November 2021 — despite a few surges — the crypto economy is largely experiencing a major downturn. But when is it going to end. Read on to find out.

The two words on every cryptocurrency investor’s lips right now are undoubtedly crypto winter! Cryptocurrencies have suffered a brutal meltdown this year, losing $2 trillion since the height of a massive rally in 2021. Bitcoin, the world’s biggest digital coin, is off 70% from a November all-time high of nearly $69,000 (nice). That resulted in many experts warning of a prolonged bear market known as “crypto winter” — the last such event occurred between 2017 and 2018. But there’s something about the latest crash that makes it different from previous downturns in crypto.

From 2018 To 2022

The latest cycle has been marked by a series of events that have caused contagion across the industry because of their interconnected nature and business strategies. Back in 2018, bitcoin and other tokens slumped sharply after a steep climb in 2017. The market then was awash with so-called initial coin offerings, where people poured money into crypto ventures that had popped up left, right and centre — but the vast majority of those projects ended up failing. Clara Medalie — research director at crypto data firm Kaiko — at a recent interview with CNBC, pointed out,

“The 2017 crash was largely due to the burst of a hype bubble!”

But the current crash began earlier this year as a result of macroeconomic factors including rampant inflation that has caused the U.S. Federal Reserve and other central banks to hike interest rates. These factors weren’t present in the last cycle. Bitcoin and the cryptocurrency market more broadly has been trading in a closely correlated fashion to other risk assets, in particular stocks. Bitcoin posted its worst quarter in more than a decade in the second quarter of the year. In the same period, the tech-heavy Nasdaq fell more than 22% — raising a concern amid savvy investors.

Stablecoin Destabilized

That sharp reversal of the market caught many in the industry from hedge funds to lenders off guard. Another key difference is there weren’t big Wall Street players using highly leveraged positions back in 2017 and 2018, according to Carol Alexander, professor of finance at Sussex University. For sure, there are parallels between this meltdown and crashes past — the most significant being seismic losses suffered by novice traders who got lured into crypto by promises of lofty returns. But a lot has changed since the last major bear market. So how did we even get here?

Terra USD, or UST, was an algorithmic stablecoin, a type of cryptocurrency that was supposed to be pegged one-to-one with the U.S. dollar. It worked via a complex mechanism governed by an algorithm. But UST lost its dollar peg which led to the collapse of its sister token Luna too. This sent shockwaves through the crypto industry but also had knock-on effects to companies exposed to UST, in particular hedge fund Three Arrows Capital or 3AC. The collapse of the Terra blockchain and the Terra USD stablecoin was widely unexpected following a period of immense growth.

The Nature Of Leverage

Crypto investors built up vast amounts of leverage with the emergence of centralized lending schemes and DeFi, an umbrella term for financial products developed on the blockchain. In 2017, leverage was largely provided to retail investors via derivatives on cryptocurrency exchanges, according to Martin Green, the CEO of quant trading firm Cambrian Asset Management. When the crypto markets declined in 2018, those positions opened by retail investors were automatically liquidated on exchanges as they couldn’t meet the margin calls, which exacerbated the selling.

In contrast, the leverage that caused the forced selling in Q2 2022 had been provided to crypto funds and lending institutions by retail depositors of crypto who were investing for yield. 2020 onwards saw a huge build out of yield-based DeFi and shadow banks. There was a lot of unsecured lending as credit risks and counterparty risks were not assessed with vigilance. When the market prices declined in Q2 this year, funds and lenders became forced sellers because of margins calls. The margin call is a situation where an investor has to commit more funds to avoid losses.

Contagion Via 3AC

One problem that has become apparent lately is how much crypto companies relied on loans to one another. Three Arrows Capital, or 3AC, is a Singapore crypto-focused hedge fund that has been one of the biggest victims of the market downturn. 3AC had exposure to luna and suffered losses after the collapse of UST (as mentioned above). The Financial Times reported last month that 3AC failed to meet a margin call from crypto lender BlockFi and had its positions liquidated. Then the hedge fund defaulted on a more than $660 million loan from the Voyager Digital.

3AC plunged into liquidation and filed for bankruptcy under Chapter 15 of the United States Bankruptcy Code. Three Arrows Capital is known for its highly-leveraged and bullish bets on crypto which came undone during the market crash, highlighting how such business models came under the pump. When Voyager Digital filed for bankruptcy, the firm disclosed that, not only did it owe crypto billionaire Sam Bankman-Fried’s Alameda Research $75 million — Alameda also owed Voyager $377 million. To further complicate matters, Alameda owns a 9% stake in the Voyager.

Is The Shakeout Finally Over?

It’s not clear when the market turbulence will finally settle. However, analysts expect there to be some more pain ahead as crypto firms struggle to pay down their debts and process client withdrawals. The next dominoes to fall could be crypto exchanges, according to James Butterfill, head of research at CoinShares. Even established players like Coinbase have been impacted by declining markets. Last month, Coinbase laid off 18% of its employees to cut down on costs. The US crypto exchange has seen trading volumes collapse in tandem with falling currency prices.

Non-Financial Advice: The data, resources, and statistics in this article have been consolidated from multiple sources and neither the author nor the site is responsible for any financial profit/loss incurred from the data and opinions present in this article. Readers understand that all risks associated with cryptocurrency are taken on by themselves.