Crypto Feels Shockwaves From Its Own ‘Credit Crisis’

The deflating digital asset bubble has exposed a fragile system of credit and leverage in crypto, similar to the credit crunch that enveloped the traditional financial sector in 2008.

Since its inception, crypto enthusiasts have promised a future of vast personal fortunes and the foundation for a new and better financial system, dismissing critics who questioned its value and usefulness as spreading “FUD” – fear, uncertainty and doubt.

But those emotions are now creeping up on the crypto industry one by one, often interconnected projects that lock up customers’ money and lose millions of dollars and turn to the industry’s heavy hitters for rescue packages.

“Fear is contagious. That is the case in every financial market. † † No one wants to be the last without a seat when the music stops, so everyone is withdrawing money,” said Brett Harrison, president of crypto exchange FTX US.

The price of bitcoin, the largest cryptocurrency, has fallen more than 70 percent since its peak in November, and the total value of crypto tokens has fallen from over $3 trillion to less than $900 billion.

While the market shrinks, the industry is cracking. A token called Luna and its sister Terra, a stablecoin that attempted to use computer algorithms to keep its price stable, collapsed in May; cryptocurrency lender Celsius stopped withdrawals earlier this month; and hedge fund Three Arrows Capital faced margin calls.

For the past few days, another lender, Voyager, has restricted withdrawals, while Exchange Coinflex has frozen client funds. Transactions and investments that seemed safe, liquid and profitable a few weeks ago have become dangerous and impossible to exit. Investors fear that more dominoes will fall.

At the heart of the boom has been the growth of decentralized finance known as DeFi, a corner of the crypto world that claims to provide an alternative financial system without central decision-making authorities such as banks or exchanges. Instead, users can transfer, lend, and borrow assets using contracts defined in computer code. Changes are not made by chief executives, but by votes of those who hold special governance tokens, often developer teams and early investors.

According to data from CryptoCompare, the amount of capital circulating in DeFi projects had risen to nearly $230 billion by the end of 2021.

During the last crypto boom, in 2017, buyers simply speculated on token prices. This time, small investors and some funds have also sought high returns from crypto asset lending and borrowing.

That appealed to advanced crypto traders as well as public lending platforms like Celsius, which took deposits from customers and paid out interest rates as high as 17 percent.

Investors can increase their returns by taking out multiple loans against the same collateral, a process called “recursive borrowing.” This freedom to recycle capital with little restraint led investors to pile up more and more returns in various DeFi projects, earning multiple interest rates at once.

“Like the subprime crisis, it’s something very attractive in terms of returns and it looks like a risk-free financial product to common people and is packaged like a risk-free financial product,” said Lennix Lai, director of financial markets at crypto exchange OKX.

The financial gymnastics rocked huge towers of loans and theoretical value on top of the same underlying assets. This continued as crypto prices sailed higher. But then inflation, aggressive interest rate hikes and geopolitical shockwaves from the war in Ukraine hit financial markets.

“It all worked during the bull run, where the prices of all assets only went up. When prices started to fall, many people wanted to take their assets away,” said Marcin Miłosierny, head of market research at crypto hedge fund ARK36.

Line Chart of Total Value Locked on Major Defi Networks ($Bn) Showing Decentralized Finance Suffering from a Credit Crisis

When the token values ​​plummeted, the lenders called in their loans. The process has resulted in the removal of more than 60 percent, or $124 billion, of the total value that has been locked onto the ethereal blockchain since mid-May in a “Great Deleveraging,” according to research firm Glassnode.

The first domino fell in May when Terra failed, eroding investor confidence. Next came lender Celsius, which froze customer accounts when it hit its books in a serious liquidity mismatch.

Last week, Three Arrows Capital, a major Singapore-based crypto hedge fund, ran into trouble after failing to meet margin calls. Voyager has confirmed that it can be exposed to Three Arrows’ default settings. BlockFi and Genesis have also liquidated at least some of Three Arrows’ positions, according to those familiar with the matter.

The situation has been exacerbated by the intensive use of loans by crypto traders to boost the advantage of their market betting. In a declining market, traders face calls for more funds to support their positions.

“There is a snowball effect. When bitcoin falls in price, more people are forced to sell bitcoin, exaggerating sales,” said Yves Choueifaty, chief investment officer of asset manager Tobam.

But some executives are wondering if crypto has already experienced its own “Lehman” moment, with Celsius the biggest name falling. They hope the mood shifts to action to stabilize the market.

Without a central bank in crypto, they are centering their optimism on intervention from the leading lights in the industry, especially Sam Bankman-Fried, the 30-year-old billionaire founder of exchange FTX.

Over the past nine days, Bankman-Fried has provided loans worth hundreds of millions of dollars through his companies to BlockFi and cryptocurrency lender Voyager to keep both companies stable and increase trust in the system.

Bankman-Fried’s steps to act as a lender of last resort contain an element of self-interest. His trading company Alameda Research is Voyager’s largest shareholder, holding an 11 percent stake after buying shares last month. It will also become the “borrower of choice” for future Voyager loans.

Over the past week, the price of bitcoin has held steady at around $20,000. But many wonder if the postponement is temporary.

“The risk of contagion in crypto markets remains high,” said Marion Labore, senior strategist at Deutsche Bank. “A tightening Fed will expose more crypto firms to excessive credit risk by withdrawing liquidity and raising rates, which will weigh on the value of the coins on which many of these leverage schemes depend,” she added.

Bitcoin was invented at the height of the 2008 financial crisis as an alternative to the financial system, often hailed by fans as immune to the impact of inflation and politically tinged monetary policy.

Many executives are now coming to the conclusion that the crypto industry can be subject to the same booms and busts as other markets.

Global central banks have kept interest rates ultra-low for a decade to boost economic growth, and pushed that policy even harder during the pandemic. Much of that cheap central bank money had seeped into crypto.

According to Dealroom data, only venture capital firms have plowed $38 billion into blockchain startups since 2020. Now the tide is turning as the Federal Reserve and other central banks shift to tackling intense inflation.

“In a higher-rate environment, the emperor has to wear some clothes to survive,” said Taimur Hyat, chief operating officer of $1.5 trillion asset manager PGIM.

That could prompt consumers, with little legal protection or transparency about the economic health of the companies behind crypto projects, to withdraw funds or exercise more caution.

“Everyone who will be in space in the coming years. † † will have a natural aversion to perpetual motion and things that sound too good to be true,” said Sidney Powell, chief executive of DeFi protocol Maple.

“When people go through a major asset depreciation and trust breaches, I think that’s what immunizes people for years to come, so in that sense it’s like crypto’s 2008.”

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