This year started with such promise.
We entered 2022 with Bitcoin trading near $50,000, Ethereum sitting comfortably above $3,500, and the market looking remarkably healthy.
The prevailing macroeconomic climate made all bets look rosy. An ever-expanding money supply sat atop record-low interest rates, and the stage was set for another year of record growth in crypto.
By mid-March, some were starting to call out the canaries in the coal mine. Yet even then, we saw a local top for Bitcoin, with most tokens showing ongoing strength. But as we all know: it didn’t take long for the house of cards to topple.
Inflation bit. Then spiking interest rates halted riskier plays. Tightening monetary and fiscal policy forced markets into decidedly more cautious territory. And over the next twelve months, a once-buoyant ecosystem imploded.
By the start of December, the cryptocurrency market capitalisation had collapsed by over 50%, from $2.2 trillion to sub-$900 billion.
Today, we’ll dig into why it all happened.
Hold tight; it’s a bumpy ride.
Why Investors loved crypto in 2021
First, let’s set the scene.
Last year was huge for cryptocurrency. Tokens hit all-time highs over and over, boosted by the ongoing growth of decentralised finance.
In November 2021, the total crypto market value topped $3 trillion for the first time. Even NFTs had entered the mainstream, with the likes of the Bored Ape Yacht Club swapping hands for several-million dollars a piece.
It’s little wonder venture capital firms were throwing money at crypto. The challenge was that interest rates had been so low for so long that investors were hungry for yield. And the cost of capital was exceedingly low.
This is when centralised lending desks saw an opportunity to loan cryptocurrency to institutions, passing a little yield onto retail investors. Suddenly, yield-generating platforms like BlockFi and Gemini became household names.
At the same time, alt-layer one blockchains were finding an audience. And with its experimental algorithmic stablecoin, TerraUSD (UST), and sister cryptocurrency, Luna, the Terra ecosystem was all the rage.
TerraUSD also offered a remarkable 20% APY via the Anchor Protocol, and yield-starved investors piled in. Exuberance was rife, the good times looked set to roll on forever, and investors leveraged up to maximise their gains.
A credit-fueled frenzy was in full flight, but headwinds were fast-approaching.
The party wouldn’t last much longer.
Dominoes fell in 2022
As 2022 drew on, it became apparent inflation would cause economic pain. That’s when central banks reversed course and decided to raise interest rates.
As soon as rates ticked higher, speculative assets saw the first outflow of capital. And suddenly, low-risk investments offered a safe source of yield. That’s when the crypto market showed its first signs of weakness.
In early April, prices dropped across the board, and the market entered something of a sell-off. The sharks could smell blood, and they circled a perceived weak link in what many believed was a calculated attack.
Stablecoin UST saw massive redemptions in a short space of time, piling pressure on the Terra ecosystem.
This led it to become the first domino of 2022 to fall.
Domino #1: The Terra ecosystem
Terra created one of the first-ever algorithmic stablecoins.
The ecosystem had a unique mechanism whereby you could always redeem 1 UST for $1 worth of Luna (and vice versa), intending to maintain the stablecoin’s peg.
But as the market crashed, rumours spread about the solvency of the stablecoin. Rumours circled that its 20% yield was funded by marketing spend, not revenue. And that’s when users pulled money from UST in an effective bank run.
The rapid redemptions caused UST to lose its dollar peg. All the while, the rest of the market was losing value. Ultimately, circumstances caused the algorithm to fail, with Luna collapsing to near-zero in just a few days.
Some $40 billion in value disappeared from the market overnight. And the cataclysmic event piled pressure on already subdued prices.
Then toppled domino number two.
Domino #2: Three Arrows Capital
When crypto was riding high, there were profits to be had by lending money to big institutions.
Moreover, hedge funds like Three Arrows Capital (3AC) were seen as god-level traders, and centralised lending desks fell over themselves to offer credit. But when Luna collapsed, the scale of 3AC’s misgivings became clear.
The fund had bet millions on the Terra ecosystem, so when the token crashed to zero, it lost a whole lot of capital. As a result, it didn’t have the collateral to back its debts, resulting in margin calls on its loans.
But 3AC had taken on more debt than it could service, largely backed by illiquid tokens, and it now, too, was headed to collapse.
As a result, multiple lending desks were looking over the precipice.
Domino #3: Multiple centralised lending desks
With 3AC unable to repay its debt, the likes of Hodlnaut, BlockFi, and even the exchange Voyager Digital, were in very hot water.
Two of them entered Chapter 11 bankruptcy protection. But BlockFi found a saviour in an unlikely source. The seemingly invincible FTX was the white knight for a day, riding to the rescue of several failing firms.
And despite the collapse of many centralised operators, people felt that the worst of the fallout was over because FTX had plugged the gaps.
Little did we know.
Renewed confidence was short-lived
The end of summer saw a more stable market.
An over-leveraged ecosystem had been cleansed, leaving it on firmer ground; investor confidence now dared to return.
After all, FTX was flying high: one of the few centralised players to have come out of the drama looking stronger than ever. It even continued to make fresh investments and promote its services worldwide.
But then something strange happened. CoinDesk revealed frailties in the balance sheet of a hedge fund with close ties to FTX. A few days later, Binance CEO ‘CZ’ tweeted his company would be liquidating an outstanding position that Binance held in FTX.
Suddenly, the market questioned FTX’s solvency. And despite the exchange’s best efforts to reassure investors, traders withdrew funds. FTX’s native token (FTT) fell from around $26 to just $1 within just a few days.
And then, the unthinkable happened. The exchange paused withdrawals, and crypto’s white knight really was insolvent. Revelations suggest it had mishandled deposits, moving client funds to Alameda Research (the aforementioned hedge fund).
By late November, FTX had filed for bankruptcy protection, a move that left BlockFi without a white knight. It was once again staring into the abyss.
Only now did the extent of the credit crunch become clear.
We’re not quite out of the woods
The original crypto lending desk is called Genesis. And since the FTX collapse, rumours have circled about its financial health.
On top of this, Genesis’ parent company, DCG, is battling troubles of its own. DCG runs the Grayscale Bitcoin Trust, which has been trading at a discount since early this year, signalling the broader industry concerns.
Altogether, ongoing events signal how much credit had been circulating throughout the crypto ecosystem — alongside the extent to which particular lending desks, hedge funds, and institutions were intertwined.
That said, the unwinding of all this leverage is likely a positive for crypto in the long term. It will flush greed from the system, allowing the most promising businesses to flourish. And importantly, the failures are far from a failure of blockchain technology.
They are failures of corporate governance. They are failures resulting from bad bets made with borrowed funds. So while this year has been treacherous for the crypto industry, green shoots abound.
There’s every reason to feel optimistic about what lies ahead, so let’s end our last article of the year on an upbeat note.
Why we’re excited about 2023
This last year has seen crypto take monstrous positive strides.
First, crypto showed its value as an instant, borderless payments network, with $54 million in various tokens sent to help Ukraine defend itself against Russian invaders.
Ethereum also successfully merged in September, transitioning from proof of work to proof of stake. That upgrade alone reduced the blockchain’s carbon footprint by over 99.9% (while making it deflationary during times of increased activity).
Moreover, while centralised lending desks collapsed, decentralised finance held up remarkably well. And that’s why Elitium relies exclusively on DeFi protocols to generate yield for clients, not on opaque centralised systems.
And talking about Elitium: we’ve got some exciting projects lined up early in the New Year, offering yet another reason to feel optimistic for 2023. So make sure you’re following us on Twitter to be first to know when they launch.
Now, let’s end by saying the industry survived this torrid but much-needed reset, and we’re ready to rebuild. On that note, from all of us here at Elitium.
Have a very Merry Christmas and a Happy New Year!
See you in 2023 👊