Private Banking

Serial meltdowns are shaking crypto’s foundations

After peaking in November 2021, crypto currencies suffered a $3 trillion wipe-out in the following 12 months, with their combined market value tumbling to less than $0.9 trillion, according to the Bloomberg Galaxy Crypto index which is designed to measure the performance of the largest cryptocurrencies traded in US dollar (see the chart).

In the past, such collapses - also known as “crypto winters” - were triggered by events within the industry itself, such as the failure of an exchange or a regulatory crackdown. This one began with something external: central banks hiking interest rates to combat a post-pandemic surge in inflation, which reduced investor appetite for riskier assets including crypto.

The collapse exploded the idea that crypto enjoys a similar status to gold as a refuge in times of economic uncertainty by being decoupled from the fortunes of traditional financial assets (see the chart). It was a shock to pension and sovereign wealth fund managers - and millions of small investors - who embraced crypto in recent years on the conviction that it was becoming a mainstream asset class. It turned out that the crypto rally of 2021 was built on shaky foundations because many investors borrowed heavily to wager on digital coins and projects, often using other crypto as collateral. That interconnectedness spread the impact of high-profile failures.

The biggest explosion involved a so-called algorithmic stablecoin called TerraUSD - a digital token whose value was meant 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 as high as 20% for TerraUSD deposits. Sudden withdrawals from Anchor drove TerraUSD’s value down, and, within days, both it and Luna had entered a death spiral that wiped about $60 billion off their value. Companies that had invested in related tokens and derivatives, such as Three Arrows Capital, ended up going bankrupt, leading to failures of other companies, such as Voyager Digital, which had given Three Arrows a massive loan.

In November, there was yet another shock: the implosion of star entrepreneur Sam Bankman-Fried’s crypto empire, including one of the biggest digital-asset exchanges, FTX. The platform had played an important role in making crypto appealing to more mainstream investors. In the space of a few days, Bankman-Fried, who had bailed out other struggling crypto ventures and become an unofficial ambassador for the industry at conferences and in the US Congress, saw his $15.6 billion fortune evaporate. FTX had a tangled web of related entities, including trading house Alameda Research, with lax record keeping and poor centralized controls.

Critics said many crypto projects were doomed to fail as they relied in part on offering unsustainable returns. They likened some high-yielding ventures to new forms of Ponzi schemes, funding payouts to existing investors using deposits from new ones. The implosion of FTX underscored the dangers of contagion, in which problems in one corner of the industry spread fast and in unexpected ways, triggering huge losses elsewhere. All this could freeze investment in crypto for some time. 

Crypto was 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 crypto can be trusted, either. To many, the hope was that stricter regulation could restore confidence. But the FTX bankruptcy seemingly derailed legislation that had been lobbied for heavily by Bankman-Fried. It had been opposed by some operators of DeFi platforms, who saw it as skewed toward the interests of big, centralized exchanges like FTX. Tougher regulation may eventually make crypto a more stable and respectable investment. What’s not clear is how much of the industry can withstand the kind of scrutiny that would entail.