Why Crypto Winter 2022 Is Different From Previous Bear Markets

There is something about the latest cryptocurrency crash that sets it apart from previous crashes.

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The two words that are now on the lips of every crypto investor are undoubtedly “crypto winter”.

Cryptocurrencies have experienced a brutal crash this year, losing $2 trillion in value since the massive rally peaked in 2021.

bitcointhe world’s largest digital coin, fell 70% from its all-time high of almost $69,000 in November.

This has led many experts to warn of an extended bear market known as the “crypto winter”. The last such event occurred between 2017 and 2018.

But there is something about the latest crash that sets it apart from previous downturns in crypto – the last cycle was marked by a series of events that caused the entire industry to become infected due to their interconnected nature and business strategies.

From 2018 to 2022

As the markets began to sell off, it became clear that many large companies were not ready for a quick turnaround.

Clara Medal

Research Director, Kaiko

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

There are certainly parallels between today’s crash and past crashes – the most significant of which are the seismic losses suffered by novice traders who were lured into cryptocurrencies with promises of high returns.

But a lot has changed since the last major bear market.

So how did we get here?

Stablecoin destabilized

TerraUSD, or UST, was an algorithmic stablecoin, a type of cryptocurrency that had to be pegged one-to-one to U.S. dollar. It worked through complex mechanism controlled by an algorithm. But UST lost its dollar peg, leading to collapse of its sister moon token too.

This caused a shock in the crypto industry, but also had an impact on companies exposed to UST, in particular the hedge fund Three Arrows Capital or 3AC (more on them later).

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

The nature of leverage

Crypto investors have accumulated massive amounts of leverage thanks to the rise of centralized lending schemes and so-called “decentralized finance” or DeFi, a general term for blockchain-based financial products.

But the nature of leverage in this cycle is different from the previous one. According to Martin Green, CEO of quantum trading company Cambrian Asset Management, in 2017 leverage was primarily provided to retail investors through derivatives on cryptocurrency exchanges.

When the cryptocurrency markets went down in 2018, positions opened by retail investors were automatically liquidated on the exchanges because they could not meet margin requirements, exacerbating the selling.

“In contrast, the leverage that triggered the forced sale in the second quarter of 2022 was provided to crypto funds and lending institutions by retail crypto depositors who were investing for income,” Green said. “Starting in 2020, there has been a huge surge in yield-based DeFi and crypto ‘shadow banks’.”

“There were many unsecured or undersecured loans as credit and counterparty risks were not assessed with vigilance. When market prices declined in the second quarter of this year, funds, lenders and others became forced sellers due to margin calls.”

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A margin call is a situation in which an investor must allocate more funds to avoid losses on a leveraged trade.

Failure to meet margin calls led to further infection.

High return, high risk

At the heart of the recent crypto asset turmoil is the exposure of numerous crypto firms to risky stakes that were vulnerable to “attacks,” including terra, according to Alexander of the University of Sussex.

It is worth seeing how this infection manifested itself in some high-profile examples.

Celsius, a company that offered users returns of over 18% for depositing their cryptocurrency with the firm. suspended withdrawals for customers last month. Celsius acted like a bank. He will take the deposited cryptocurrency and lend it to other players with high returns. These other players would use it to trade. And the profit made by Celsius from the yield will be used to pay out the investors who invested the cryptocurrency.

But when the economic downturn hit, that business model was put to the test. Celsius continues to face liquidity issues and had to put withdrawals on hold in order to effectively stop the bank’s crypto.

“Players looking for high returns exchanged fiat for cryptocurrencies, used lending platforms as custodians, and then these platforms used the funds they raised for high-risk investments – how else could they pay such high interest rates?” Alexander said.

Infection via 3AC

Three Arrows Capital is known for its bullish bets on highly leveraged cryptocurrencies that were reversed during the market crash, highlighting how such business models got under the pump.

The infection continued.

When Voyager Digital filed for bankruptcythe firm revealed that not only does it owe crypto billionaire Sam Bankman-Fried Alameda Research $75 million, but Alameda also owes Voyager $377 million.

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

“Overall, June and the second quarter as a whole was very challenging for the crypto markets as we saw the collapse of some of the biggest companies in large part due to extremely poor risk management and contagion from the collapse of 3AC, the largest crypto hedge fund. Medal Kaiko said.

“Now it is clear that almost every major centralized lender has failed to properly manage risk, subjecting them to the collapse of a single contagion-style organization. 3AC has borrowed from almost every lender, which they have been unable to repay following a wider market crash causing a liquidity crisis amid high repayments from clients.”

Is the shake over?

It is not yet clear when market turbulence will finally subside. However, analysts expect more challenges to come as crypto firms struggle to pay off their debts and process customer withdrawals.

According to James Butterfill, head of research at CoinShares, crypto exchanges and miners could be the next dominoes to fall.

“We feel this pain will spread to the overcrowded exchange industry,” Butterfill said. “Given that this is such a crowded market and that exchanges rely to some extent on economies of scale, the current situation is likely to result in further losses.”

Even experienced players love Coinbase suffered from falling markets. Last month, Coinbase fired 18% of its employees to cut costs. The U.S. cryptocurrency exchange has recently experienced a drop in trading volumes in tandem with falling digital currency prices.

Meanwhile, crypto miners who rely on specialized computing hardware to settle transactions on the blockchain could also run into problems, Butterfill said.

“We also saw examples of potential stress where miners were allegedly not paying their electricity bills, potentially hinting at cash flow issues,” he said in a research note last week.

“This is probably why we are seeing some miners sell their assets.”

The role played by miners comes at a cost, not only for the hardware itself, but also for the continuous flow of electricity required to run their machines around the clock.