How a series of crypto crises is reshaping the industry

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The history of cryptocurrencies has rarely been dull, but the latest crash has brought about a series of shocks that have shaken the foundations of digital assets. A cascade of explosions, including the crash of a so-called stablecoin in May and the epic unraveling of cryptocurrency exchange FTX in November, has sparked a wave of bankruptcies. The events have eroded the confidence of more traditional investors eager to capitalize on the growing interest in Bitcoin and the vision of decentralized finance. The turmoil prompted regulators to move more urgently to protect consumers.

1. What happened to cryptocurrency prices?

After peaking in November 2021, cryptocurrencies suffered a $2.2 trillion write-off over the following 12 months, with their combined market value tumbling 73%, according to data from tracker CoinGecko. In the past, such crashes, also known as “crypto winters,” have been triggered by events within the industry itself, such as the failure of an exchange or a regulatory crackdown. This started with something external: central banks raised interest rates to combat a rise in post-pandemic inflation, which reduced investor appetite for riskier assets, including cryptocurrencies.

2. What is the meaning of this?

The crash has sparked the notion that cryptocurrencies enjoy a gold-like status as a haven in times of economic uncertainty by being decoupled from the fortunes of traditional financial assets. It came as a shock to pension and sovereign wealth fund managers – and millions of small investors – who have embraced cryptocurrencies in recent years in the belief that it was becoming a mainstream asset class. It turns out that the 2021 cryptocurrency rally was built on a shaky foundation as many investors borrowed heavily to bet on digital coins and projects, often using other cryptocurrencies as collateral. This interconnection has spread the impact of high-profile bankruptcies.

The biggest explosion involved a so-called algorithmic stablecoin called TerraUSD, a digital token whose value was to be pegged to the US dollar through the use of a parallel currency, Luna. It became popular when users of a decentralized finance (DeFi) platform called Anchor were offered interest rates of up to 20% for TerraUSD deposits. Sudden withdrawals from Anchor reduced the value of TerraUSD, and within days, both it and Luna entered a death spiral that wiped some $60 billion off their value. Companies that had invested in tokens and related derivatives, such as Three Arrows Capital, ended up going bankrupt, leading to the bankruptcy of other companies, such as Voyager Digital, which had given Three Arrows a huge loan. In November, there was another shock: the implosion of the cryptocurrency empire of the famous entrepreneur Sam Bankman-Fried, including one of the largest digital assets exchanges, FTX. The platform, which had played a major role in making cryptocurrencies attractive to more traditional investors, had a tangled web of related entities with lax record keeping and poor centralized controls. The FTX crash was still causing aftershocks in January, when Genesis Global Holdco LLC, which had funds tied up in FTX, filed for bankruptcy owing at least $3.4 billion in unsecured debt. The cryptocurrency lender had suspended withdrawals soon after FTX was declared insolvent.

4. What were the consequences?

Critics said many cryptocurrency projects were doomed to fail as they relied in part on offering unsustainable returns. They likened some high-yield ventures to new forms of Ponzi schemes, funding payments to existing investors using deposits from new ones. The implosion of FTX and the subsequent bankruptcy of Genesis underlined the dangers of contagion, where problems in one corner of the industry spread rapidly and in unexpected ways, resulting in huge losses elsewhere. All of this could freeze crypto investments for some time.

5. Where does this sector end up?

Cryptocurrencies were invented in the wake of the 2008 global financial crisis, which eroded trust in traditional institutions. But the string of scandals in 2022 raises what amounts to an existential question of whether cryptocurrencies can even be trusted. For many, the hope was that stricter regulation could restore confidence. But FTX’s bankruptcy apparently derailed legislation that was strongly urged by Bankman-Fried. It had been opposed by some DeFi platform operators, who saw it skewed towards the interests of large centralized exchanges like FTX. Tighter regulation could eventually make cryptocurrencies a more stable and reputable investment. What isn’t clear is how much of the industry can withstand the kind of scrutiny that would entail.

More stories like this can be found at bloomberg.com

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