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Analysis | How a series of crypto meltdowns are reshaping the industry

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The history of cryptocurrencies has rarely been dull, but the 2022 slump has been a wilder ride than most. Billions of dollars in holdings vanished almost overnight in a series of corporate collapses, most notably the vaporization of the FTX crypto exchange in November. Each left behind a spate of related bankruptcies. The events have eroded confidence in a field that itself grew in response to a loss of confidence in mainstream finance following the banking crash of 2008. Some investors have responded to the crisis by advocating tough new regulation. Others blame the bankruptcies on the failure of crypto intermediaries and say the turmoil should precipitate a move to more decentralized platforms.

1. What happened to crypto prices?

After peaking in November 2021, the combined market capitalization of crypto assets dropped by as much as 73% over the following 12 months, according to figures from tracker CoinGecko. That’s less than the 88% collapse in the previous “crypto winter” of 2018, but it destroyed much more value: over $2 trillion. While previous crypto slumps were caused by problems within the industry itself, this one started with something external: central banks raised interest rates to counter a post-pandemic surge in inflation. This reduced investors’ appetite for high-risk, high-reward assets, including crypto.

2. What is the meaning of that?

The collapse exploded the idea that crypto enjoys a similar status to gold as a haven in times of economic uncertainty by being disconnected from the fate of traditional financial assets. It came as a shock to pension and sovereign wealth fund managers — and millions of small investors — who have embraced crypto in recent years in the belief that it was becoming a mainstream asset class. As it turned out, the price appreciation of recent years was built on shaky foundations as many investors borrowed heavily to bet on digital coins and projects, often using other cryptocurrencies as collateral. That interconnectedness spread the impact of high-profile failures.

The first explosion involved a so-called algorithmic stablecoin called TerraUSD that used complex, automated operations with a sister token, Luna, to maintain a peg to the US dollar. It gained popularity because a related decentralized finance (DeFi) platform called Anchor offered interest rates of up to 20% for TerraUSD deposits. Sudden withdrawals from Anchor led to a “death spiral” that wiped out about $60 billion from the value of TerraUSD and Luna. Companies that had invested in related tokens and derivatives, such as Three Arrows Capital, eventually went bankrupt, leading to the bankruptcies of other companies, such as Voyager Digital, which had given Three Arrows a huge loan. There was another shock in November: the implosion of star entrepreneur Sam Bankman-Fried’s crypto empire, which included one of the largest digital asset exchanges, FTX.com. In the space of a few days, the man who bailed out other struggling crypto ventures and became an unofficial ambassador for the industry at conferences and on Capitol Hill saw his $15.6 billion fortune evaporate. FTX allegedly went under while attempting to bail out the Bankman-Fried-owned trading house Alameda Research.

4. What were the consequences?

Terra’s critics said the system was doomed to fail because it relied in part on luring investors with unsustainable interest rates. Some compared Terra and other high-yield DeFi ventures to new forms of Ponzi schemes that shower early investors with unsustainable returns to attract new investors. The FTX implosion showed how even seemingly solid crypto companies could have hidden weaknesses and underlined the dangers of contagion – with problems in one part of the industry spreading rapidly and in unexpected ways, and causing huge losses elsewhere. All this could freeze investments in crypto for some time.

5. What does it mean for the future of crypto?

It was invented because people didn’t trust Wall Street, but the series of scandals raises an existential question for crypto as to whether it can be trusted. For many, the hope was that stricter regulation could restore confidence. But the FTX bankruptcy seemingly derailed legislation that Bankman-Fried had been heavily lobbying for. It had been opposed by some DeFi platform operators, who saw it as skewed towards the interests of large, centralized exchanges like FTX. Strict regulation can ultimately make crypto more stable and respectable. What is not clear is how much of the industry can withstand the additional scrutiny that this entails.

More stories like this are available at bloomberg.com

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