Crypto companies acted like banks, then collapsed like dominoes

In recent years, a number of companies have attempted to act like the cryptocurrency equivalent of a bank, promising lucrative returns to customers who deposit their bitcoin or other digital assets.

In a span of less than 12 months, nearly all of the largest of these companies have failed spectacularly. Last week, Genesis filed for Chapter 11, joining Voyager Digital, Celsius, and BlockFi on the list of companies that have filed for bankruptcy protection or gone out of business.

This subset of the industry grew as cryptocurrency enthusiasts were trying to build their own parallel world in finance untethered from traditional bank currencies and government-issued currencies. But lacking safeguards and government support, these companies have failed like dominoes. What started with the collapse of one crypto company in May spilled over to one crypto lending company and then the next one.

Additionally, government regulators have begun cracking down on the ability of cryptocurrency lending companies to advertise their services, saying their products should have been regulated by securities regulators.

The crash is reminiscent of the 2008 financial crisis, but on a much smaller scale. There are no concerns that the collapse of these crypto companies will impact the broader economy.

Crypto lending companies like Voyager, Genesis, and BlockFi were trying to do what banks do in traditional finance: accept crypto deposits, give depositors a dividend on their stored cryptocurrency, and then lend for a profit. It’s what the banking industry has been doing for hundreds of years, but with government-sanctioned currencies.

The biggest disadvantage of cryptocurrency lending is the lack of collateral. There is no deposit insurance, government stopgap, or even a privately managed entity to protect depositors should their crypto bank fail. This was fine when cryptocurrency prices were moving higher because collateral banks were accepting loans in return that increased in value.

Demand for cryptocurrency deposits was so high that companies were willing to pay a 10% top yield on depositors’ cryptocurrency holdings.

But then the cryptocurrency prices started going down and kept going down. Bitcoin, for example, plunged from over $65,000 in November 2021 to below $17,000 last November. As a result, much of the underlying collateral these firms held became less than the loans they had issued, effectively rendering several “cryptocurrencies” insolvent.

The first two cryptocurrency lending companies to fail were Celsius and Voyager Digital. The companies had been exposed to both falling cryptocurrency prices and risky lending to cryptocurrency hedge funds such as Three Arrows Capital, which was forced to liquidate and go out of business in June.

BlockFi, another crypto lender, turned to then-crypto giant FTX and its founder Sam Bankman-Fried for a bailout. Bankman-Fried has given BlockFi a financial lifeline, one of several moves that have earned Bankman-Fried acclaim as a savior or financial backer for the cryptocurrency industry.

But FTX’s own bankruptcy in November, caused by high-risk loans to its hedge fund affiliate Alameda Research, blew away BlockFi’s financial lifeline. BlockFi’s failure has become inevitable. In a demonstration of how intertwined these cryptocurrency lenders have become, Genesis has made loans worth billions to Alameda.

Burdened with bad loans, many of these high-tech companies experienced a very old phenomenon: depositors wanted their money back and a bank run ensued.

WHAT’S NEXT?

The tens of thousands of customers of these crypto lending companies are now waiting to see if their assets can be recovered or found in bankruptcy court, which could take months or even years. At Genesis, more than $900 million in client funds are now stuck in bankruptcy.

It is unclear whether cryptocurrency lending will see a comeback anytime soon. Following the FTX bust, cryptocurrency exchange giant Binance announced it would launch its own fund to provide bailout funding to a struggling cryptocurrency firm, an idea that has its origins in the government-sponsored central bank or in deposit insurance.

Furthermore, the cryptocurrency industry seems to be moving towards the idea of ​​some sort of regulation, which would provide a minimum of guarantees to depositors or investors that does not currently exist. There were several bills pending in Congress last year, but with the change of control to Republicans in the House of Representatives, it’s unclear whether the broader GOP has an interest in regulating the cryptocurrency industry.

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