Why today’s crash is different from previous ones – Huge leverage

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The crypto market has lost about $2 trillion or two-thirds of the market capitalization it had at the end of 2021 and the bankruptcies of major companies in the industry, most recently Celsius, have intensified the turmoil.

Bitcoin has lost 70% of its value from its highs of $69,000 last November, with many experts warning of a prolonged “crypto winter”.

The last time a similar phenomenon was observed was in 2017-2018.

Only this time there are some elements that make the crisis different, such as the combination of persistent inflation and high market leverage through so-called Decentralized Finance (DeFi) by shadow banks using the blockchain mechanism.

In 2018, bitcoin and other cryptocurrencies took a big dive after a sharp rise in 2017. “The 2017 crash was mainly due to a big bubble bursting,” Clara Medalie, research director at crypto data firm Kaiko, told CNBC.

Rising interest rates a drag and high leverage

The current crash started this year as a consequence of macroeconomic factors, such as very high inflation, which led the Fed and other central banks to raise their interest rates.

Moreover, this time cryptos had a high coefficient of covariance with stocks. Bitcoin posted its worst performance in more than a decade in the second quarter this year, with the Nasdaq posting a loss of more than 22% in the same period.

The market’s sharp decline took many companies in the sector by surprise, from hedge funds to banks, who were not prepared for this development.

Another difference is that in 2017/2018 there were no big Wall Street “players” with “very leveraged positions”, as Carol Alexander, professor of economics at the University of Sussex, said.

There are, of course, common elements in the two crashes, the most important being the huge losses of new investors attracted by the promises of fast and high profits.

Triggered by the collapse of Terra

The new crisis gained new momentum after the collapse of TerraUSD, a stablecoin, as cryptocurrencies are called, which theoretically have a stable one-to-one exchange rate with regular currencies such as the dollar. Terra operated through a complex algorithmic mechanism, but failed to maintain its parity with the dollar , leading to the collapse of its “sister” cryptocurrency, luna.

This event caused a tsunami in the crypto industry and had an impact on companies exposed to Terra, such as the hedge fund, Three Arrows Capital.

Deposits and loans in crypto

Crypto investors have placed huge amounts of money in the market thanks to the possibility of decentralized funding. Unlike in 2017, the leverage that caused the forced sales in Q2 2022 was offered to crypto funds and crypto banks by small depositors seeking large returns.

“There was widespread lending with no or insufficient collateral as credit and counterparty risks were not carefully assessed. When market prices fell in the second quarter of this year, funds, banks and other companies became forced sellers due to margin calls,” said Martin Green, managing director of Cambrian Asset Management.

A margin call is a situation where investors have to commit more equity to avoid losses on borrowed money positions.

At the heart of the recent crypto turmoil lies the exposure of many companies in the industry to risky bets that were vulnerable to “attacks”, the Sussex professor said.

Celsius was giving a return of 18% to depositors

How the domino effect came about is most typically seen in the case of Celsius, which offered returns of over 18% to users to deposit their crypto with it and then lent it to other players at high returns. As the crisis unfolded and the risk of a bank run was visible, Celsius suspended withdrawals.

With information from CNBC

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