Why This Crypto Crash is Different

One of my favourite journalists (Ryan Browne, CNBC) sent me some questions which were precipitated by his reading of this article.

There is an unattractive element of glee emanating from some Trad-Fi crypto sceptics during this latest crash. Anyway, as my answers to Ryan’s questions seeking to clarify certain comments grew, I began to think it was about time I published another blog ….

What’s different about this crypto booms and crash compared with previous bubbles?

Back in 2017/2018 we didn’t have Wall Street traders playing on the crypto markets, using highly leveraged positions on the bitcoin-tether perpetual to push the price of bitcoin up and down. But that trading activity is highly controlled. These highly sophisticated Trad-Fi traders make most of their profits from both volatility and directional bets on Deribit options, [1] but it also happens on spot markets which are not even leveraged. For instance, on Coinbase some recent research on limit orders during the market crash shows that extremely large sell orders (and their cancellations) are used to push the bitcoin price down.

Another difference this time around is the blatant attacks on De-Fi platforms, which didn’t even exist in 2017/2018. Nasen.ai published what is probably the most thorough, unbiased analysis of the Terra/Luna attack, naming Celsius as one of the seven whales involved. [2] But the main attacking wallet was rumoured to be owned by a Trad-Fi hedge fund with over $50bn AUM, which placed naked shorts on Luna and then withdrew a huge amount of UST liquidity on the UST-3 pool on Curve, forcing more and more Luna to be minted.

Having said this, a major point that bearish commentators like Frances Coppola miss is that some Ce-Fi players now have very much more at their disposal than the Trad-Fi hedge funds that seek to attack crypto. In fact, totally unsubstantiated rumours have it that the subsequent attacks on Celsius were simply a retaliation by Ce-Fi players for the Terra/Luna attack.

Three arrows capital (3AC) is (was) another huge hedge fund playing on crypto, but instead of jumping on the wagon that caused the bear market via whale sell trades, it stayed bullish (in the face of so many obvious bear signals) and got caught in the cross-fire. Deribit had loaned them $80m to place very large, leveraged bullish options positions, which Deribit automatically liquidated and then promptly called in the loan. Next came the contagion to Voyager Digital who, being owed over $350m by 3AC, have now filed for Chapter 11 bankuptcy. BlockFi is also in trouble, but Ce-Fi players have been working hard to restore the balance and I for one believe the worst is over now.

Why are exchanges facing all these problems with withdrawals, is it because they simply don’t have enough dollars?

Francis Coppola and Ethan Wu only have part of the story. Much better to follow nasen.ai's excellent forensic on-chain analysis directly than read reports from Trad-Fi crypto sceptic commentators. For instance, this nasen.ai article describes how the Terra/Luna attack caused Celsius and 3AC to withdrew $800m from Curve's main liquidity pool. Both firms were then further impacted by selling pressure on staked ether (stETH) which caused its price to drop well below the price of ETH and so further reduce the assets of Celsius and 3AC. Although isolated, these attacks have highlighted the vulnerability of staking-as-a-service platforms of which Lido is the market leader.

In fact, there are plenty more dollars in the crypto asset eco system than those crypto sceptics say, and only a small fraction is held by centralised exchanges (CEXs). The total value locked (TVL) in De-Fi fell from $250bn to $77bn today.

The three main stable coins are tether ($66bn), circle ($55.5bn) and Binance ($17.5bn) coins also have a combined market cap of $140bn. The two latter have always had plenty of fiat collateral. Maybe a year ago the collateralisation of tether was questionable, but not now. For instance, Tether holds about $40bn in US treasury bills.

Note that collateral is not so much the issue with those stablecoins as battles on CEXs! Very active arbitrage activity is what keeps the 1:1 USD peg of these coins. As soon as the price of tether deviates more than a fraction of a cent, arbitrageurs put buying or selling pressure on the USDT/USD perpetual to bring the tether price back to 1:1. There have been some recent counter-arbitrage activities on the tether peg, possibly by Trad-Fi hedge funds, who knows. [3] For instance, at the height of the Terra/Luna attacks the price of tether briefly fell to 97 cents. Funds to defend this have been identified, for instance, this is taken from the conclusion of nasen's stETH report mentioned above: "On May 8, a single entity bridged 74.7k stETH from Terra to Mainnet and sold it mostly into UST, probably to defend the UST peg." Counter-arbitrage activities have continued since then but they have hardly affected tether’s price. Indeed, all these attacks have done is to demonstrate how resilient tether is. Perversely, this probably increases confidence in the crypto asset eco system.

Is there a precedent for this in the traditional banking world?

Yes, indeed! The credit boom in 2007 was fuelled by the search for yield. Alan Greenspan kept interest rates too low for too long, and banks were deprived of their normal business which is to make loans and receive good interest on those loans. So, they did what bankers always do, which is to find yield elsewhere. That time it was by US banks selling mortgages to people who couldn’t afford them, in Alabama etc. Then came the contagion. The US banks securitised these mortgages into tranched instruments called collateralised debt obligations (CDOs) then colluded with rating agencies to fake A-ratings for upper (last-to-default) tranches of the CDOs and sold them on to other banks via their London offices, to Germany and the PIGS – Portugal, Italy, Greece and Spain. When the mortgage defaults eventually came they precipitated a banking crisis which decimated those economies. It was rather like an economic bomb from the US to Europe.

The De-fi credit boom and bust is similar. Only the bomb is from Trad-Fi to De-Fi, targetting weakenesses in Curve's liquidity pools in particular. [4] For instance, Voyager was offering 12% interest on crypto deposits, and Terra, Celsius and BlockFi were offering even greater yields. So, just as in the credit boom of 2007, investors seeking higher yields than available in the Trad-Fi low ineterst rate environment simply exchanged fiat for crypto and used lending platforms to get 12% or more return. As custodians those platforms used that crypto to make highly risky investments – how else could they pay such high interest rates? For instance, Voyager Digital loaned 3AC over $350m.

Then came the contagion. The TVL in De-Fi fell from a high of over $250bn in January to about $77bn today. What we are seeing now is not the major DEXs, or lending, CDP, yield, or staking platforms going bust. During the bitcoin boom of 2021 De-Fi expanded too quickly and the events of May and June have simply precipitated a much-needed clean up of the badly managed projects. The best of them are being defended by Ce-Fi players who are already bigger than most Trad-Fi hedge funds.

What we are seeing now is the contagion of the attack on Terra/Luna via lending platforms like Celsius and hedge funds like 3AC. The nasen report on stETH concludes: "In the case of Celsius, the ability to remain liquid in order to meet customers’ redemptions was likely its main priority..... 3AC however, appears to be a victim of the contagion ..... the lack of sound risk management coupled with excessive leverage was simply a ticking time bomb" So, it is clear that the De-Fi attacks which started with the cleverest Trad-Fi hedge funds have ended with the insolvency of the weakest.

Could there be an even more serious collapse in the near future? Could an exchange like Coinbase go bust?

Coinbase are a public company that is fully regulated in the US, licenced in other countries like the UK, and FDIC insured (but only for the fiat held in a Coinbase wallet [5]). So I would be very surprised if Coinbase went bust, but they may seek additional funds when next bull run starts.

I’m slightly more concerned about Bullish Global and Lido. Re Bullish, most of its $10bn funding from Block.one was in crypto not fiat, and is worth less than half of that now. Also it failed to go public at the height of the crypto boom, as planned. The EOS blockchain is also disappointing, given how much it raised in its ICO – maybe Block.one management is not what it should be, who knows? Re Lido, its liquid staking protocols are clearly vulnerable to attacks which destablize the prices of stAssets such as stETH. Value locked in Lido and similar staking-as-a-service platforms fell from about $23bn at the time of the Terra/Luna attack to $9bn today, and after reading the nasen report I think this will take some time to recover.

[1] See Alexander, C., Deng, J., Feng, J. and H. Wan (2022) Net Buying Pressure and the Information in Bitcoin Option Trades. Journal of Financial Markets

[2] A whale is an entity holding very large amounts of crypto for the purpose of trading

[3] Maybe large banks are seeking favour from the Fed who (rightly) fear their tightening of monetary policy is threatened by the unstemmed issuance of stablecoins.

[4] The Collateralized Debt Positions (CDPs) offered by MakerDAO should not be confused with CDOs. They have virtually nothing in common. CDOs are based on tranching loan portfolios according to the time it takes to default. MakerDAOs CDP is based on the stablecoin DAI which is issed in return for crypto. It the main example of the non-custodial/over-collateralised stablecoin. Unfortunately, this model has been largely superceded by the custodial/collateralised stablecoin such as USDT and USDC. Terra/Luna was the main example of a third type of 'algorithmic' stablecoin which maintained the peg using on-chain arbitrage rather than the CEX arbitrage favoured by the custodial variety.

[5] The Coinbase website states: "To the extent U.S. customer funds are held as cash, they are maintained in pooled custodial accounts at one or more banks insured by the FDIC. Our custodial accounts have been established in a manner to make pass-through FDIC insurance available up to the per-depositor coverage limit then in place (currently $250,000 per individual). FDIC pass-through insurance protects funds held on behalf of a Coinbase customer against the risk of loss should any FDIC-insured bank(s) where we maintain custodial accounts fail. FDIC insurance coverage is contingent upon Coinbase maintaining accurate records and on determinations of the FDIC as receiver at the time of a receivership of a bank holding a custodial account.” Many thanks to Bob Seeman for pointing out that FDIC insurance only protects upon the failure of a bank, not of Coinbase. The Coinbase wallet itself is not FDIC insured, only the banks where Coinbase keeps its cash are FDIC insured.