The cryptocurrency sector is showing early signs of stabilisation after two successive implosions – the collapse of the Terra Luna ecosystem and crypto hedge fund Three Arrows Capital – which unleashed a tidal wave of contagion across the broader digital assets market.
In the following weeks, around a dozen crypto participants, including lending platforms, brokerage firms, custodians, hedge funds and exchanges, suffered margin calls, liquidations and some filed bankruptcy proceedings – much of which can be traced back to these two initial events. The resulting fallout created the still unravelling ‘cryptopocolypse’ and is reminiscent of the systemic risk that ricocheted throughout global financial markets after the US subprime mortgage market collapsed in 2008.
The cryptocurrency industry is still in its infancy – and it is unregulated. Consequently, there is relatively little precedent for insolvency and bankruptcy proceedings, which makes the early casualties in the current ‘crypto winter’ invaluable case studies. In this article, we aim to explain the events that caused the cryptopocolypse, assess the contagion spread so far, and identify the failings in risk management, governance and unsustainable business models.
The onset of the Covid-19 pandemic in February 2020 triggered a precipitous market crash throughout global markets and asset classes as the effects of the pandemic weighed on the outlook for the world economy. The S&P 500 plunged 34% between 12 February and 23 March 2020, while the Dow Jones Industrial Average lost 37% during the “Covid crash”. Bitcoin slumped 50% in the same period to approximately $3,850. The worldwide response by central banks and governments was swift and substantial. Huge quantitative easing policies and government fiscal stimulus programmes flooded global markets, creating enormous liquidity, which supercharged returns on equities, real estate and cryptocurrencies over the following 18 months. The price of Bitcoin surged more than 1,700% to peak at around $69,000 in November 2021. This environment led to massive growth in investment across blockchain projects, which caused the broader crypto market to balloon to $3.2 trillion last November.
The peak of the cryptocurrency market coincided with the Federal Reserve’s pivot on its outlook for inflation – from a narrative that postulated supply-side inflation would prove transitory to accepting that inflation was more likely to be persistent. The new year has delivered historic levels of volatility across all asset classes. Inflation has soared to 40-year highs in the US, the UK and the major European economies, prompting central banks to reverse over a decade of ultra-accommodative monetary policy and hike interest rates. Rising inflation has coincided with a weakened economic outlook and tightened financial conditions. Russia’s invasion of Ukraine on 24 February added more fuel to the inflationary fire, prompting energy, commodity and food prices to spike. These factors decisively dampened the risk-on environment, which supported the crypto bull market.
All cryptocurrencies have suffered substantial losses in the first half of 2022. The entire market fell to under $900 billion in June – from a high of $3.2 trillion just eight months earlier. Bitcoin plunged around 63% to an 18-month low of $17,651 at the onset of the cryptopocolypse in June when Terra/Luna collapsed.
Terra Luna: the first shoe to drop
Terra is an open-source blockchain protocol created by Do Kwon and Daniel Shin of Terraform Labs in 2018. Terra issued Luna, a smart contracts-based cryptocurrency similar to Ethereum, to execute transactions across its blockchain. At its peak, Luna was briefly the sixth-largest cryptocurrency, priced at $119, representing a market capitalisation of $41 billion in April. Terra also issued TerraUSD (UST), an algorithmic stablecoin pegged to the US dollar and backed by Luna.
UST maintained its peg to $1 using an arbitrage mechanism. The first principle was the guarantee that $1 of Luna was always redeemable for $1 UST and vice versa. It worked as follows: whenever UST slipped below $1, arbitrage traders were incentivised to buy UST and redeem UST for discounted Luna tokens; conversely, when UST nudged above $1 peg, the incentive was to “burn” Luna for UST and then flip UST for any other stablecoin to crystalise an immediate profit. The mechanism was designed to balance out fluctuations in over or undersupply in either Luna or UST, supporting the stablecoin’s peg and demand for Luna. In this way Luna acted as a shock-absorber. Traders were further incentivised to burn Luna with the offer of 19.5% yield by “staking” UST, payable in UST. Staking is a means of accumulating interest on digital assets by locking coins on platforms and exchanges for fixed periods.
On May 7, a complex coordinated attack managed to destabilise UST from its $1 peg when $2 billion of UST was unstaked and immediately sold, prompting UST’s price to slump to $0.91. Terra’s arbitrage mechanism proved to be the ecosystem’s Achilles heel and ineffective during severe price volatility. The mechanism had a daily cap on how much Luna could be burned to rebalance UST’s peg, limiting the influence of arbitrage traders.
Many UST holders responded to the stablecoin’s de-pegging by unstaking and selling their coins, triggering tremendous selling pressure, which created a “death spiral” for both Luna and UST. Investors redeemed UST for Luna and then sold Luna, which inflated Luna’s supply and decreased its price. In response, the Luna Foundation Guard (LFG), the non-profit organisation responsible for maintaining UST’s peg, reportedly sold off $2.2 billion in Bitcoin reserves to try to re-peg UST and stabilise Luna, but it failed. The price of Luna fell from $82.55 to virtually zero within a week. The event contributed to a cascade of selling across the crypto sector, culminating in Bitcoin’s price tumbling to around $17,615, a price last seen in December 2020.
Terra was deeply integrated across the entire crypto ecosystem; many crypto projects and funds relied on UST as a stablecoin which created a domino effect in losses and layoffs. The most significant casualty was Three Arrows Capital.
Three Arrows Capital
Three Arrows Capital (3AC) is a crypto hedge fund founded in Singapore by Kyle Davies and Su Zhu in 2012. As recently as March, 3AC managed around $10 billion in crypto assets. In mid-June, 3AC confirmed the fund had incurred significant losses due to its staked Luna position. On 27 June, Voyager Digital, a crypto brokerage, custody and lending firm, issued a notice of default to 3AC for payments on a crypto loan worth approximately $670 million, comprising 15,250 Bitcoin and $350 million in USDC, a US dollar-pegged stablecoin. 3AC also missed margin calls from other crypto lenders, including by BlockFi and Genesis.
The default prompted a court in the British Virgin Islands to order the hedge fund to commence liquidation proceedings. Days later, on 1 July, 3AC filed for Chapter 15 bankruptcy proceedings in the US Bankruptcy Court for the Southern District of New York to protect its US assets from creditors. The significance of 3AC’s bankruptcy filing is that it represents the beginning of the crypto contagion. Like Terra, 3AC was deeply intertwined with the crypto sector and had extended loans and received loans from, among other things, crypto lending platforms, exchanges and publicly listed crypto companies.
Contagion spreads: Voyager, BlockFi, Genesis and Celsius
Voyager Digital filed for Chapter 11 bankruptcy on 5 June, citing the “prolonged volatility and contagion in the crypto markets … and the default of Three Arrows Capital on a loan” issued by a Voyager entity. BlockFi and Genesis Trading, two crypto financial services groups, have liquidated some of 3AC’s positions by selling the crypto assets that backed the bankrupt hedge fund’s loans. BlockFi reportedly liquidated $1 billion in Bitcoin after 3AC defaulted on its loan payments. It received received a $250 million bailout from crypto exchange FTX in order to fulfil customer withdrawal requests. The loan allows FTX the option to acquire the crypto lender for up to $240 million. Genesis Trading is facing hundreds of millions in losses connected to 3AC.
Celsius, the centralised crypto lending platform, suspended withdrawals on 13 June, citing “extreme market conditions”. One month later, Celsius finally filed for Chapter 11 bankruptcy.
Lawyers representing Celsius suggested macro turbulence, the collapse of Luna/Terra, the failure of several crypto funds and exchanges, and false rumours led to customers seeking to withdraw crypto from its platform “in large amounts and at a rapid pace”.
Documents submitted alongside the Chapter 11 filing reveal the extent of Celsius’ insolvency. Celsius’ digital asset holdings fell by $12.8 billion between end of March to July 14, 2022 – from $14.56 billion to just $1.75 billion in 14 weeks. The crypto lender has around 500,000 creditors which are owed $5.5 billion, of which $4.7 billion is owed to its customers – almost three times what it holds in digital assets.
Celsius offered customers the ability to lend their crypto as collateral to other crypto projects and investors in return for double-digit annual yields. However, to generate these yields, Celsius lent borrowed assets multiple times and issued under-collateralised stablecoin loans. Celsius amassed significant stablecoin holdings through several strategies. First, by borrowing ether (the native token on the Ethereum protocol) from its customers in exchange for yield. Celsius then deposited the ether on DeFi protocols, such as Compound and Aave, in exchange for stablecoins and then issued under-collateralised stablecoin loans to institutional traders, funds and exchanges. Second, Celsius borrowed USDT, the largest crypto stablecoin issued by Tether, also a Celsius shareholder, under a facility that required the crypto lending platform to post Bitcoin as collateral. Bloomberg reported in October 2021 that Celsius was paying an interest rate of 5%-6% on a $1 billion loan. Tether liquidated the overcollateralised loan, crystallising a $900m loss for Celsius, bankruptcy documents reveal. Third, Celsius incentivised customers to accept interest payment in its native CEL token, which has fallen by around 87% year-to-date. These types of lending activities compounded risk upon risk. Celsius had an assets-to-equity ratio of $19 billion to $1 billion as of mid-2021, according to documents reported by Wall Street Journal. For a firm simultaneously exposed to crypto, leverage and lending, this ultra-high-risk profile is plain to see. The WSJ noted that, according to FactSet data, by comparison the median assets to equity ratio for all US banks in the S&P 1500 Composite index was 9:1, approximately that of Celsius.
Contagion also spread to Asia. Hong Kong’s Babel Finance and Singapore’s Vauld, two crypto lenders, both paused withdrawals and redemptions between mid-June and early July, citing market volatility and liquidity pressures. We are unlikely to have seen the last shoe to drop. Elsewhere, Tesla, one of the earliest corporate adopters of Bitcoin as part of its treasury management strategy, disclosed a 75% disposal of its original $1.5 billion purchase, in the firm’s second-quarter earnings report.
Crypto’s meltdown shows the need for policymakers to craft regulation. The possible first phase of regulation could be to impose collateral and increased disclosure requirements on investors issuing or receiving crypto-backed loans, to prevent potential future fund or platform failures from cascading into systemic risks throughout the market.
The inherent risks in crypto should be disentangled from the utility of Bitcoin as a fledgling asset class. Arguably, the unwinding of exuberant leverage, sentiment and outlook is a healthy, self-cleansing mechanism for the crypto economy. This ongoing process will take time and possibly lead to the demise of hundreds of cryptocurrencies now in circulation, making room for new crypto protocols, as well as funds, exchanges and other crypto businesses with better risk management, governance and more robust business models. Ultimately, recent events will add to regulatory scrutiny and hasten action to create better protections for investors and prevent future crypto contagion from spilling over into broader financial markets.
If your firm operates in the cryptocurrency space and you would like to talk to us about your strategy, liabilities and options, please do not hesitate to contact us today.