2022 was a year of black swan events and contagion fears that tested crypto markets. Will 2023 be the year of redemption or will it bring more pain?
A year ago, few would have heard of Three Arrows Capital (3AC) or Alameda Research. These proprietary trading desks chugged in the background, pumping up trading volume during crypto’s breathtaking bull run. In my previous stint as an institutional crypto trader, I was right in the middle of all this, interacting with these “crypto giants” on a daily basis as counterparties for millions of dollars in trades. Never in a million years could I have imagined that by the end of 2022 these firms would implode and usher in a harsh crypto winter!
For comparison, in January 2022, crypto market cap was >$2.25 trillion and daily trading volume was over $100 billion most days. Today, the market cap is just under $850 billion and daily trading volume rarely exceeds $25 billion. BTC and ETH, the “safe haven” crypto assets, are down more than two-thirds in price over the year. The sheer scale of the fictional wealth wipe-out – nearly $2 trillion from the market’s peak – is unlike the crypto winters of the past and comparable to the 2000s dot-com bubble burst or the 2008 financial crisis.
What happened? Who’s to blame? And what’s next? Let’s dive in:
The crypto bull run that followed the pandemic was unmatched in scale. The most “conservative” crypto-asset, Bitcoin or BTC, surged 20x from $3,000 to over $60,000, while newer and smaller project tokens surged 1,000x in price. Large-scale quantitative easing (central banks continued to print fiat) and strong fiscal support (retail gifts to the unemployed) were at play. This dovish macro backdrop encountered several crypto-specific “bullish” trends such as BTC halving, increasing institutional engagement, easy retail involvement, and growing developer interest.
The “Summer of DeFi” was set for 2020, followed by the NFT boom in 2021. But sustained bull runs like this lead to exuberance – the history of traditional markets tells us so. Leverage became the law of the country and stablecoins at 20% APYs became the norm. But that wasn’t sustainable. The easy liquidity supporting the global economy came at the expense of rising inflation. Then came another shocker: Russia’s invasion of Ukraine. Global energy and food supply chains were disrupted overnight, causing severe shortages in all countries. Central banks began the steepest rate hikes in human history. Crypto markets rattled. Ditto for other assets like tech stocks META, SNAP, and NETFLIX.
But the damage across the crypto industry has been exaggerated due to the unregulated leverage in the system.
Regulated assets are subject to leverage/collateral rules and limits as well as guardrails against contagion risks – nevertheless, core meltdowns occur. Just as the 2008 financial crisis was triggered by subprime mortgages and undercollateralized derivatives. However, in crypto, offshore entities and even DEXs operate without such protection. Additionally, several of these units are intertwined, and an explosion at one can quickly spread across the entire sector. The LUNA/Terra short was the first domino to fall as investors triggered a wave of redemption pressure that broke UST’s peg. What followed was a $60 billion hole in the ecosystem within days. The “liquidity crisis” that followed led to several bankruptcies.
The importance of liquidity (or rather lack of it) in this crisis needs to be underlined. Unlike regulated assets where custodians ensure adequate liquidity; With crypto, a majority of the project’s tokens are held by initial investors, teams, developers, and communities. The liquidity of these tokens depends on vesting and unlock schedules. So when there is a “run on the bank”, multiple investors hold “bags of unsellable assets” which they dispose of once unlocked. The liquidity crisis across various tokens has claimed several victims over the past year including but not limited to Terra, 3AC, Celsius, Voyager, BlockFi, Alameda and finally FTX.
Who’s to blame?
Innovation attracts capital, which then attracts risk takers and often scammers too!
Before the Terra debacle, its co-founder Do Kwon had highlighted a flaw in its algorithmic stablecoin. He said it has no “redemption” guard rails and can be depegged via a massive short. And that’s exactly how it played out.
Blockchain, crypto and web3 are monumental innovations that will push the boundaries of how we interact across the internet. But this technological revolution is still in its infancy and several experiments in this area need to be tested before wider implementation. In retrospect, it is clear that most of the above companies had poor risk management practices.
However, the turmoil in the markets was not just the result of poor risk management. There have been “crooks” who have diverted and used user funds without their knowledge. The ties between FTX and Alameda and their “risky trading” strategies were no secret. However, recent developments have raised accusations of “criminal intent” as they put user funds at risk to shore up their balance sheets and continued to hide behind the murky tokenomics of their exchange token FTT.
We’re still not over the hill, as crypto Samudra Manthan continues to write. But the industry will mature and “good actors” will dominate the next phase!
History doesn’t repeat itself, it certainly rhymes and Crypto OGs will draw parallels to 2018. Several projects were able to attract capital back in the ICO frenzy, but many of them are now “zombies”. Such cyclical purging ensures that only the best operators survive and speculators are replaced by builders. The current crisis has washed away unhealthy leverage from the market.
True master builders will be the heroes of this phase. I witnessed their strength and determination in person recently during ETH India, where 3,000+ developers built 400+ Web3 projects in one of the largest hackathons in the world. In fact, at the CoinSwitch Web3 Discovery Fund, where we invest in Web3 startups, we have been inundated with the number of applications.
In addition, institutional participation and mainstreaming of crypto and Web3 will continue. BNY Mellon to Custody Crypto; JPM Explores Institutional DeFi; Goldman Sachs looks to stake millions; and Fidelity is making every effort to introduce crypto to retail, including BTC for retirement. Brands like Nike have already made hundreds of millions in NFT sales, Reddit has millions of users using Web3 wallets, Starbucks has launched its NFT-based loyalty program, and Meta continues to pour billions into its Metaverse.
Could these lead to the next bull run? And when? Well, ideally, both the BTC halving and a rate cycle reversal could overlap in Q2 2024, but macro developments need to be closely monitored as several unknown factors are at play (Ukraine war, Covid resurgence).
The other key development to watch for is regulation, which may have accelerated the FTX fiasco. Developing standardized regulatory frameworks for crypto requires global coordination, and India has already embraced the issue as part of its G20 presidency. Hopium suggests that we could see such guard rails in 2023.
So safe flight to the moon!
The views expressed above are the author’s own.
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