The deflating bubble in digital assets has exposed the weak system of credit and leverage in crypto that the credit crunch engulfed the traditional finance sector in 2008.
Since its inception, crypto enthusiasts have pledged the future of huge personal fortunes and foundations for a new and better financial system, dismissing critics who question its value and usefulness as spreading “FUD” – fear, uncertainty, and doubt.
But those sentiments now drive the crypto industry one by one, often interconnected projects in which customers face millions of dollars in losses and return to the industry’s heavy hitters for rescue packages.
“Fear is contagious. It’s true in any financial market. No one wants to be the last person without a chair when the music is off, so everyone is making money,” said Brett Harrison, president of crypto exchange FTX US.
The value of Bitcoin, the largest cryptocurrency, fell more than 70 percent from its peak in November, and the total value of cryptocurrencies fell from over $ 3 trillion to less than $ 900 billion.
As the market declines, the industry is booming. A token named Luna and her sister Terra, a stablecoin that tried to use computer algorithms to keep its value stable, collapsed in May; Crypto lender Celsius halted withdrawals earlier this month; And hedge fund Three Arrow Capital faced margin calls.
In recent days, another lender, Voyager, has made limited withdrawals while Exchange Coinflex has accumulated customer funds. Businesses and investments that seemed safe, liquid and profitable a few weeks ago have become risky and impossible to get out of. Investors fear that more dominoes are falling.
At the heart of the boom is the rise of decentralized finance, called DeFi, in a corner of the crypto world that claims to offer alternative financial systems without central decision-making authorities such as banks or exchanges. Instead, users can transfer, borrow, and lend assets using contracts defined in computer code. The changes are not by chief executives but by votes from special rule tokens, often from developer teams and early investors.
According to CryptoCompare data, the amount of circulating capital in DeFi projects by the end of 2021 had increased to about 0 230bn.
In the last crypto boom, in 2017, buyers only speculated on token prices. This time around, even small investors and some funds have sought higher yields from borrowing and lending crypto assets.
It appealed to both sophisticated crypto traders and public-facing lending platforms such as Celsius, which took customer deposits and paid interest rates of up to 17 percent.
Investors can raise their returns by taking multiple loans on the same collateral, which is called “recurring borrowing”. This freedom to reinvest capital with little restraint prompted investors to stack more products on various DeFi projects, earning multiple interest rates at once.
“As a subprime crisis, it’s a really favorite thing in terms of yields and it looks like a risk-free financial product for the general public and is packaged,” said Lenix Lyle, director of financial markets at Crypto Exchange OKX.
Financial gymnastics left large towers of borrowing and theoretical value on top of the same underlying assets. This continued when crypto prices were high. But then inflation, aggressive interest rates soared and the geopolitical shock of the Ukraine war washed away financial markets.
“It worked during a bull run where the value of all assets just went up. When prices started to go down, a lot of people wanted to get their assets out,” said Marcin Milosierney, head of market research at crypto hedge fund ARK36.
As token prices dropped, lenders called in their loans. According to research firm Glassnode, the process has removed more than 60 percent of the total value of the Ethereum blockchain, or more than $ 124 billion, since mid-May, according to research firm Glassnode.
The first domino fell in May, when Terra failed, shattering investor confidence. Another lender came Celsius, which froze customer accounts when it was caught in a serious liquidity mismatch in its books.
Last week, Three Arrow Capital, a major Singapore-based crypto hedge fund, hit skids after failing to meet margin calls. Voyager has confirmed that it may be exposed to Three Arrow defaults. BlackFi and Genesis also scrapped at least some of the Three Arrows locations, according to people familiar with the matter.
The heavy use of borrowing by crypto traders to increase the upside of their market bets has deepened the situation. In a declining market, traders face calls for more funds to support their position.
“There’s a snowball effect. Whenever the price of Bitcoin goes down, more people are forced to sell Bitcoin, increasing sales,” said Yves Choifetti, chief investment officer at asset management firm Tobam.
But some officials are surprised that if Crypto has already experienced its own “Lehman” moment, Celsius’s biggest name has fallen. They expect the mood to shift to market stability.
Without a central bank in crypto, they are pinning their optimism on intervention from industry-leading lights, especially Sam Bankman-Fried, the 30-year-old billionaire founder of Exchange FTX.
Over the past nine days through its companies, Bankman-Fried has extended millions of dollars in loans to BlockFi and crypto lender Voyager to keep both companies stable and increase trust in the system.
Bankman-Fried’s last resort to act as a lender involves an element of selfishness. His Almeida research trading firm is the largest shareholder in Voyager, with an 11 percent stake after buying shares last month. It will also become the “primary borrower” for any future Voyager loan.
The price of Bitcoin has remained stable at around 20,000 in the last week. But many wonder if the rest is temporary.
“The risk of infection in the crypto market remains high,” said Marianne LeBor, a senior strategist at Deutsche Bank. “A tougher Fed will expose crypto firms with additional credit risk by withdrawing liquidity and raising rates, which will reduce the value of the coin on which many of these schemes depend,” he added.
Bitcoin was invented at the height of the 2008 financial crisis as an alternative to the financial system, often praised by fans as the effect of inflation and the impact of political color monetary policy.
Many executives are now coming to the conclusion that the crypto industry may be subject to the same boom and bust as other markets.
Global central banks kept interest rates too low for a decade to boost economic growth, pushing those policies even harder into the epidemic. A lot of that cheap central bank money had fallen into crypto.
Venture capital firms have accumulated $ 38 billion in blockchain start-ups since 2020 alone, according to dealeroom data. Now, the tide is flowing as the Federal Reserve and other central banks move to address sharp inflation.
“In a high-rate environment, the emperor needs to wear some clothes to survive,” said Timur Hyatt, chief operating officer of PGIM, the $ 1.5 trillion asset manager.
This could push consumers to withdraw money or show more caution, with little legal protection or transparency in the financial health of companies behind crypto projects.
“Anyone who comes into space in the next two years … will have a natural aversion to sustainable motion machines and things that seem too good to be true,” said Sidney Powell, chief executive of Defy Protocol Maple.
“When people go through a big markdown on property values and trust breaches, I think it gives people immunity for the next several years, so in that sense it’s like Crypto’s 2008.”