Why the “crypto winter” of 2022 is different from previous bear markets

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

Cryptocurrencies have undergone a brutal downturn this year, losing $ 2 trillion in value since the height of a massive rally in 2021.

Bitcoin, the world’s largest digital currency, has fallen 70% from its record high of $ 69,000 in November.

As a result, many experts warn of a protracted bear market known as “crypto winter.” The last such incident took place between 2017 and 2018.

But there is something about the recent crash that makes it different from previous downturns in crypto – the last cycle has been marked by a series of events that have caused contagion across the industry due to their interconnected nature and business strategies.

Back in 2018, bitcoin and other tokens fell sharply after a steep rise in 2017.

The market was then flooded with so-called introductory coin offers, where people poured money into cryptocurrencies that had appeared on the left, right and in the middle – but the vast majority of these projects ended up failing.

“The 2017 crash was largely due to the explosion of a hype bubble,” Clara Medalie, research director at crypto data firm Kaiko, told CNBC.

But the current crash began earlier this year as a result of macroeconomic factors, including violent inflation that has led 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 more broadly have traded in a closely correlated way with other risk assets, especially equities. Bitcoin posted its worst quarter in more than a decade in the second quarter of this year. During the same period, technology-heavy Nasdaq fell more than 22%.

The sharp reversal of the market caught many in the industry, from hedge funds to lenders.

Another difference is that there were no major Wall Street players using “highly leveraged positions” back in 2017 and 2018, according to Carol Alexander, a professor of finance at Sussex University.

There are certainly parallels between today’s meltdown and previous crashes – the most important being seismic losses inflicted by beginners 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?

TerraUSD, or UST, was an algorithmically stable currency, a type of cryptocurrency that was to be linked one-to-one with US dollars. It worked via a complex mechanism controlled by an algorithm. But UST lost its dollar hold, which led to the collapse of its sister token luna as well.

This sent shockwaves through the crypto industry, but also had ripple effects on companies exposed to UST, especially the hedge fund Three Arrows Capital or 3AC (more on them later).

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

Crypto-investors built up enormous amounts of influence thanks to the emergence of centralized lending schemes and so-called “decentralized finance”, or DeFi, an umbrella term for financial products developed on the blockchain.

But the nature of the influence has been different in this cycle compared to the last. In 2017, influence was largely given to retail investors via derivatives on cryptocurrency exchanges, according to Martin Green, CEO of the quantum trading company Cambrian Asset Management.

When the crypto markets fell in 2018, the positions opened by retail investors were automatically liquidated on stock exchanges as they could not meet margin calls, which worsened sales.

“On the other hand, the influence that caused the forced sale in Q2 2022 had been given to crypto funds and lending institutions by retail depositors of crypto who invested for returns,” Green said. “2020 and beyond saw a huge build-up of return-based Defi and crypto” shadow banks. “

“There was a lot of unsecured or under-mortgaged lending as credit risk and counterparty risk were not assessed with caution. When market prices fell in the second quarter of this year, funds, lenders and other foreclosures became due to margin requirements.”

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

Inability to meet margin calls has led to further infection.

At the heart of the recent cryptocurrency turmoil is the exposure of a number of crypto companies to risky games that were vulnerable to “attacks”, including terra, said Alexander at Sussex University.

It is worth looking at how some of this infection has unfolded via some high-profile examples.

Celsius, a company that offered users a return of more than 18% for depositing crypto at the company, stopped withdrawals for customers last month. Celsius behaved like a bank. It would take the deposited crypto and lend it to other players with high returns. The other players would use it for trading. And Celsius’ profits from the returns would be used to repay investors who deposited crypto.

But when the downturn hit, this business model was put to the test. Celsius continues to face liquidity problems and has had to pause withdrawals to effectively stop the crypto version of a bank run.

“Players who sought high returns switched fiat to crypto used the lending platforms as depositors, and then these platforms used the funds they raised to make very risky investments – how else could they pay such high interest rates?” in Alexander.

One problem that has become apparent lately is how much crypto companies rely on loans for each other.

Three Arrows Capital, or 3AC, is a cryptocurrency-focused hedge fund in Singapore 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 cryptocurrency lender BlockFi and had its positions wound up.

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

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

Three Arrows Capital is known for its highly leveraged and bullish bets on crypto that were undone during the market crash, and highlights how such business models came under the pump.

The infection continued.

When Voyager Digital filed for bankruptcy, the company revealed that it not only owed cryptomillionaire Sam Bankman-Frieds Alameda Research $ 75 million – Alameda also owed Voyager $ 377 million.

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

“Overall, June and Q2 as a whole were very difficult for the crypto markets, where we saw the meltdown of some of the largest companies largely due to extremely poor risk management and contagion from the collapse of 3AC, the largest crypto hedge fund,” said Kaikos Medalie.

“It is now clear that almost all major centralized lenders were unable to manage the risk properly, exposing them to an infection-style incident with the collapse of a single entity. 3AC had taken out loans from almost all lenders that they were not. able to pay back after the broader market collapse, which causes a liquidity crisis among high redemptions from customers. “

It is not clear when the market turbulence will finally subside. However, analysts expect that there will be some more pain in the future as crypto companies struggle to pay down debt and process client withdrawals.

The next dominoes to fall may be crypto exchanges and miners, according to James Butterfill, head of research at CoinShares.

“We feel that this pain will spread to the crowded stock market industry,” Butterfill said. “Given that it is such a crowded market, and that stock exchanges are to some extent dependent on economies of scale, the current environment is likely to highlight further losses.”

Even established players like Coinbase have been affected by falling markets. Last month, Coinbase laid off 18% of its employees to cut costs. The US cryptocurrency exchange has seen trading volumes collapse recently in line with falling digital currency prices.

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

“We have also seen examples of potential stress where miners have reportedly not paid their electricity bills, which potentially refers to cash flow problems,” he said in a research note last week.

“This is probably why we’re seeing some miners sell their holdings.”

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