For a generation of insane techies, the all-for-one philosophy of crypto was its biggest draw.
Now, panic is spreading through this universe – and that same philosophy poses what may be the greatest threat to its survival yet.
What started this year in crypto markets as a “risk-free” sell-off campaign fueled by a Federal Reserve suddenly determined to rein in the excesses has revealed a web of interconnections that looks a bit like the tangle of derivatives. that brought down the global financial system in 2008.
As Bitcoin slid nearly 70% from its all-time high, an array of altcoins also fell.
The collapse of the Terra ecosystem – a highly publicized experiment in decentralized finance – began with the loss of its algorithmic peg to the US dollar and ended with a bank run that returned $40 billion worth of tokens virtually without value.
Crypto collateral that seemed valuable enough to back loans one day has become greatly reduced or illiquid, casting doubt on the fate of a previously invincible hedge fund and several top lenders.
The seeds that spawned the collapse – greed, excessive use of leverage, a dogmatic belief in “increasing numbers” – are nothing new.
They were there when virtually every other asset bubble burst.
In the realm of crypto, however, and especially at this very moment, they suddenly land in a new industry that is still largely unregulated, with blurred borders and securities weakened by the belief that everyone involved could be scammed. enrich together.
If Terra was the Bear Stearns of this crypto winter, many fear the Lehman Brothers moment may be imminent.
Just as the inability of lenders to meet margin calls was a harbinger of the 2008 financial crisis, crypto has had its equivalent this month: Celsius Network, Babel Finance and Three Arrows Capital have all revealed major issues as digital asset prices plunged, triggering a liquidity crunch that ultimately stems from the interconnectedness of the industry.
In bullish periods, leverage is a way for investors to make bigger profits with less cash, but when the market crashes, these positions quickly unwind.
And because it’s crypto, these bets usually involve more than one type of asset, making market contagion even more likely.
Crypto loans – especially those in decentralized finance apps that do without intermediaries like banks – often require borrowers to provide more collateral than the value of the loan, given the risk of accepting such assets.
But when market prices fall, loans that were once over-collateralized suddenly become threatened with liquidation – a process that often happens automatically in DeFi and has been exacerbated by the rise of traders and bots looking for ways. to earn money quickly.
John Griffin, professor of finance at the University of Texas at Austin, said last year’s rise in crypto prices was likely fueled by leveraged speculation, perhaps more so than in the winter. precedent of cryptography. An environment of low interest rates and an ultra-accommodating monetary policy helped prepare the ground.
“With rising interest rates as well as lack of confidence in leveraged platforms, this cycle of deleveraging is having the effect of unwinding these prices much faster than they have been rising,” he said. he declares.
Although traditional markets often rely on slow and steady leverage to grow, this effect is apparently magnified in crypto due to the concentration of speculation in the sector.
Regulators are circling the sector, watching for signs of instability that could threaten their nascent plans to curb crypto.
Even the rules that were announced in the spring had to change in the wake of Terra’s collapse, with some jurisdictions preparing rules to mitigate the systemic impact of failing stablecoin systems.
Any further crypto failures could ultimately pave the way for tougher rules, making a market rebound at any time less likely.
On Monday, Bitcoin crashed along with much of the rest of the crypto market, falling around 3.5% to $20,650 as of 10:30 a.m. New York. The largest token in the world is down around 35% this month alone.
“There may be bearish rallies, but I don’t see a catalyst to reverse the cycle anytime soon,” Griffin said. “When the Nasdaq bubble burst, our research found that smart investors got out first and sold as prices fell, while individuals bought all the way down and continually lost money. . I hope history won’t repeat itself, but it often does.
Now back at around $1 trillion, the crypto market is only slightly above the roughly $830 billion mark it hit in early 2018 before the start of last winter. causing a downdraft that sent the market roughly $100 billion to its depths, according to CoinMarketCap Data.
Next, digital assets were the playground of dedicated retail investors and a number of crypto-focused funds.
This time around, the sector has created wider appeal for mom and pop investors and hedge fund titans, forcing regulators to intervene frequently with statements warning consumers of the risk of trading such assets.
As an infamous (now banned) advert on London’s transport network put it in late 2020: “If you see Bitcoin on a bus, it’s time to buy.
Unlike early crypto proponents, the massive adoption means most investors now view crypto as just another asset class and treat it much the same as the rest of their portfolio.
This makes crypto prices more correlated to everything else, like tech stocks.
Unfortunately, that doesn’t make most crypto betting any less complex to understand.
Although much of the financial world is battered in 2022, the recent crypto market crash has been amplified by its experimental and speculative nature, wiping out small-town traders who have tied up their savings in untested ventures like Terra with little recourse.
And the industry’s hype machine is howling louder than ever, using tools like Twitter and Reddit that have been bolstered by new generations of crypto sidekicks.
Exchanges have also done their part, with FTX, Binance and Crypto.com all spending on high profile marketing and sponsorships.
Sina Meier, managing director of crypto fund manager 21Shares AG, said the level of extreme risk shows exactly why crypto isn’t for everyone.
“Some people should definitely stay away,” she said during a panel discussion earlier this month at Bloomberg’s Future of Finance conference in Zurich.
Many retail investors “are lost, they just follow what they read in the newspapers. It is a mistake.
Prior to the previous crypto winter, many startups had used initial coin offerings, or ICOs, to raise capital by issuing their own tokens to investors.
They suffered when coin prices crashed because they kept most of their value in that same asset pool, plus Ether, and it got worse when regulators started cracking down on ICOs. as if it were offering non-registered securities to investors.
This time around, the funding landscape is very different.
Many startups born out of the last freeze, such as non-fungible token and gaming platform Dapper Labs, have sought venture capital funding as a more traditional way to raise funds.
Juggernauts like Andreessen Horowitz and Sequoia Capital have collectively pumped nearly $43 billion into the sector since late 2020, when the last bull market began, according to data from PitchBook.
This means that instead of relying on crypto wealth, some of its biggest players actually have vast reserves of stored hard currency to see them through the blizzard as they work to grow new blockchains. or building decentralized media platforms.
On the other hand, the recent end of the bull market means that they have spent that money much faster than it was coming in.
This month, Coinbase Global, Crypto.com, Gemini Trust and BlockFi are among the crypto companies to announce numerous layoffs, citing the general macroeconomic slowdown as having derailed their ever-expanding plans.
Coinbase, which had hired about 1,200 people this year alone, is now laying off about as many employees in an 18% reduction in its workforce.
But thanks to the heights that crypto has reached in the last boom, there is still a large amount of funds earmarked in Silicon Valley coffers compared to previous seasons.
Andreessen alum Katie Haun launched her $1.5 billion crypto fund in March, while Coinbase co-founder Matt Huang launched a $2.5 billion vehicle in November.
And while VCs may be more careful now about where they put their money, it still has to be spent somewhere.
“None of these businesses mature for many years,” said Alston Zecha, partner at Eight Roads. “Over the past two years, we’ve been blessed to see companies achieve these incredible gains after six or nine months. As the tide recedes, there will be many people who find themselves naked.