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It has been a rough week in crypto, with three major firms announcing layoffs, a lending platform facing a class action lawsuit and a crypto hedge fund once worth billions facing collapse.
Is all this damage of crypto’s own making or is crypto simply caught in the wrong place at the wrong time, as the markets turn, rate hikes hit and the reality of recession begins to bite?
As we shall see, both of these answers have some merit. The sugar high that markets had enjoyed since March 2020, when the US Federal Reserve opened the liquidity floodgates to prop up an economy in lockdown, is now well and truly over.
In Q3 last year, the Fed began to signal that it would soon reduce its $120bn per month asset purchase programme, and would issue its first rate hike in more than three years.
The “Fed pivot” from dovish to hawkish hit the markets immediately, precipitating a swift reversal across all risk assets.
At first, it was unclear whether crypto would follow. After all, if crypto was the hedge against inflation that its promoters claim it to be, surely this would be its time to shine?
With inflation at 40-year highs, surely fiat currency holders around the world would flock to crypto to preserve their wealth, or at least not sell the crypto they already had?
In the end, that is not how things turned out. At the time of writing, more than $2trn has been wiped off crypto markets since their peak in November last year, and things could well get worse.
It will be up to crypto evangelists to explain how this has happened, but perhaps there are some clues to be found within the industry itself?
Fraud, overleveraged, or both?
A key difference between this crypto cycle and previous ones is the availability of decentralised finance (defi) platforms.
These protocols, which sit primarily on the ethereum blockchain, allow anyone with an internet connection to lend their crypto to anyone in the world.
In a rising market, defi is a perfect place to park one’s crypto-assets, as it allows holders not only to make money from price appreciation, but also to get paid interest by lending out their assets to borrowers.
It also allows crypto investors to leverage what they already hold to generate additional liquidity.
Over the last two years, businesses such as Celsius, BlockFi, Nexo and crypto hedge fund Three Arrows Capital (3AC) ploughed vast sums of customer money into defi, bringing the total value locked (TVL) in these platforms from $10bn in mid-2020 to more than $100bn in late 2021.
By doing so, platforms such as MakerDAO built up enormous leverage within the crypto markets, by allowing users to, for example, deposit $50m worth of ethereum and “mint” $25m worth of DAI, a US dollar stablecoin backed by the ethereum as collateral.
So-called “degen traders” — short for “degenerate” in the crypto world — used this type of leveraged loan to buy more crypto than they could otherwise afford, while businesses such as Celsius used these loans to pay yields to their own depositors and service withdrawals.
Over time, Celsius became one of the largest single depositors to MakerDAO, and is believed to hold the largest single debt on the platform (currently worth about $280m).
Celsius offered users a centralised service through which to access the yields and liquidity of defi, while, in theory, keeping some of each transaction for itself as profit.
But for reasons that are still unknown, Celsius seems to have had no contingency plan for a crypto downturn.
As the value of its collateral throughout the defi world was in freefall, Celsius decided that disabling user withdrawals and borrowing money from other crypto-companies, such as Tether, to top up its collateral, was the best course of action.
Four whole days have now passed without an update from Celsius as to when its customers can get their money back, and patience, understandably, is wearing thin.
On Wednesday (June 15), crypto influencer Ben Armstrong, whose "BitBoy Crypto" YouTube channel had previously advertised for Celsius, announced that he will be opening a class action lawsuit against Celsius and CEO Alex Mashinsky.
Armstrong, who has a company account with Celsius, claims that a Celsius account manager told him that he must deposit more money to the platform to pay back his outstanding loans, even if he already has the funds in his account to do so.
Celsius’ withdrawal freeze coincided with the day BlockFi announced that it would lay off one in five of its staff; Coinbase followed one day later, also laying off one in five. Previously, the week before, Crypto.com said it would lay off 5 percent of its staff.
The timing of these announcements has led to suspicion of a growing liquidity contagion across the industry, as overleveraged businesses find themselves suddenly having to tighten their belts to meet their obligations.
So far, Binance, Nexo, Kraken and FTX have said they plan to keep hiring, but other major crypto players may not be so lucky.
Consider the case 3AC, once widely believed to be the largest hedge fund in crypto, with $18bn assets under management at its peak in November 2021.
Bear in mind that the crypto markets have shed about 70 percent of their value since then, with obvious effects on the 3AC portfolio.
Over the years, 3AC has invested in defi platforms such as Aave, blockchains such as Terra, Solana and Avalanche, and also holds equity in BlockFi and crypto options platform Deribit.
Last month, 3AC was exposed to the collapse of the TerraUSD stablecoin, although it is unclear to what extent.
What we do know is that on May 5 the Luna Foundation purchased roughly $500m worth of bitcoin from 3AC in exchange for LUNA, the collateral token that backed TerraUSD
Four days later, LUNA had crashed almost to zero and the foundation announced that it would sell $750m worth of bitcoin from its treasury in an attempt to revive the two failed tokens.
The LUNA collapse was easily the most high-profile crypto implosion to date, but it was not the start, or the end, of 3AC’s troubles.
In January 2021, 3AC became the largest shareholder in the Grayscale Bitcoin Trust (GBTC), a closed-end fund to which bitcoins can be deposited but cannot be redeemed.
Shares in GBTC can, therefore, trade at a discount or premium to net asset value (NAV), i.e. bitcoin’s market price, depending on demand.
In January 2021, shares in GBTC traded at a premium of up to 30 percent. This meant that an investor could buy one bitcoin on a separate exchange for $20,000, deposit it with GBTC and receive shares worth $26,000.
3AC put $1.2bn into this arbitrage trade, and although the price of bitcoin moved spectacularly in its favour over the next year, making the investment worth more than $2bn at its peak, the GBTC premium moved in the opposite direction.
After going negative in February 2021, it stayed negative for the rest of year, and has levelled out at between 25 and 30 percent for most of 2022.
3AC never sold its shares in GBTC, and to do so now would result in losses of hundreds of millions of dollars.
Perhaps 3AC has enough liquidity on hand to carry its GBTC position into the red, but it has clearly had to raise cash in a hurry from other sources this week.
On Tuesday (June 14), 3AC appears to have sold $40m of staked ethereum on the Lido defi platform — the proceeds of which appear to have been put towards paying back debts on platforms like Aave and MakerDAO where its collateral is now at risk.
One analyst shared a screenshot from Nansen, a blockchain analytics platform, showing that wallets associated with 3AC were linked to five of the largest defi transactions this week.
According to industry sources quoted by The Block and FT, 3AC’s liquidations totalled more than $400m for the week, including at least one forced sale to BlockFi.
Elsewhere, at the Bitfinex crypto exchange, 3AC’s official trading account was revealed to have taken $31m in realised losses last month, although this admittedly could be a hedge for another position on a separate platform.
In any case, and perhaps feeling the heat of speculation about the fund’s solvency, founder and CEO Zhu Su took to Twitter on Wednesday (June 15) to try and get ahead of the news: “We are in the process of communicating with relevant parties and fully committed to working this out,” he said.
Nonetheless, rumours that 3AC is close to collapse have continued to spread, leading platforms such as Nexo to issue disclaimers confirming that they have no exposure to the fund.
“Nexo has $0 exposure to Three Arrows Capital,” the company said in a tweet. “Nexo has always differentiated itself from others as being a very conservative lender with stringent risk management and strict over-collateralisation requirements, regardless of borrowers' reputation.”
Although major exchanges such as Binance and FTX may be in healthy shape from a liquidity perspective, there is still a feeling of “who’s next?” throughout the industry.
Disclaimers are multiplying by the day and, in many cases, it is unclear why.
If the price of bitcoin — the most widely-held asset among crypto investors and businesses — drops further, we can expect to see the crypto winter claim more victims.
Already, this bitcoin crash has been unprecedented, bringing the asset all the way down to $20,000 — the high from its previous halving cycle in 2017.
Until this week, such a reversal in bitcoin's price had not been seen in its 13-year history.
Expect to see more tears if bitcoin goes lower, more calls for redress from broke crypto firms and more class action suits.
