Cryptos have suffered a brutal comedown in 2022, losing around $2 trillion in value since the peak of an incredible rally in 2021. Bitcoin has shaved off over 65% from a November all-time high of around $69,000.
The current market dynamics have pushed many experts to warn of a long bear market called crypto winter. Such an event last happened between 2017 and 2018. But, it is not all gloom with the date of the Ethereum Merge confirmed which has pulled the entire market into a relief rally.
This crash appears to be different from previous crypto winter occurrences since it has been marked by several events that have resulted in contagion across the sector due to their interconnected nature and business strategies.
Between 2018 And 2022
In 2018, Bitcoin and other tokens experienced a significant crypto winter after a sharp climb in 2017. The market then was dominated by the so-called initial coin offerings (ICOs) where people flooded money into various crypto ventures that had popped up all over. However, most of these projects eventually failed.
One research director at crypto data firm Kaiko, Clara Medalie, said:
“The 2017 crash was largely due to the burst of a hype bubble.”
But the current crash started earlier in 2022 due to macroeconomic factors including rampant inflation that pushed the US Federal Reserve and other major central banks around the world to hike interest rates. These factors were absent in the previous crypto winter cycles.
Bitcoin, Ethereum, and the crypto market more widely have been trading in a closely correlated fashion to many other risk assets, particularly stocks. Bitcoin posted its worst quarter in over 10 years in the second quarter of this year. During the same period, the tech-heavy NASDAQ lost over 22%.
The steep reversal of the market caught many investors in the industry from lenders to hedge funds unaware. As the markets started selling off, it became clear that many large entities were not prepared for the crypto winter.
Another notable difference is no big Wall Street players were coming in with “highly leveraged positions” between 2017 and 2018, as highlighted by Carol Alexander, professor of finance at Sussex University.
There are several parallels between the current crypto winter and those crashes in the past. The most notable one is the seismic losses suffered by novice traders who were lured into crypto investments by promises of massive returns.
But there is a lot that has changed since the last major bear market.
So, how did the current crypto winter become so severe?
TerraUSD (UST), was an algorithmic stablecoin, a kind of crypto supposed to be pegged one-to-one with the US dollar. It functioned through a complex mechanism governed entirely by an algorithm. But, UST lost its peg resulting in the severe crashing of its sister token LUNA.
That incident sent shockwaves in the whole crypto sector causing a knock-on effect to companies exposed to UST, mainly Three Arrows Capital (3AC) hedge fund, and many others followed. Medalie said:
“The collapse of the Terra blockchain and UST stablecoin was widely unexpected following a period of immense growth.”
The Nature Of Leverage
Crypto traders and investors set up huge amounts of leverage due to the emergence of centralized lending schemes and decentralized finance (DeFi). DeFi is a general term for financial products developed on the blockchain.
But the nature of leverage seems to be different in the 2022 cycle. In 2017, leverage was mainly offered to retail investors through derivatives on the crypto exchange, as highlighted by CEO of quant trading firm Cambrian Asset Management, Martin Green.
When the crypto winter happened in 2018, the positions opened by retail investors were liquidated automatically on exchanges since they could not meet margin calls that intensified the selloff. Green stated:
“In contrast, the leverage that caused the forced selling in Q2 2022 had been provided to crypto funds and lending institutions by retail depositors of crypto who were investing for yield. 2020 onwards saw a huge build-out of yield-based DeFi and crypto ‘shadow banks.’”
“There was a lot of unsecured or undercollateralized lending as credit risks and counterparty risks were not assessed with vigilance. When market prices declined in Q2 of this year, funds, lenders, and others became forced sellers because of margin calls.”
Interestingly, a margin call is a situation where investors commit more funds to avoid losses on a trade that was made with borrowed cash. The failure to meet margin calls has resulted in further contagion.
High Yields, High Risk
At the core of the recent turmoil in crypto assets is the exposure of many companies to risky bets that were highly vulnerable to “attack,” including terra, Sussex University’s Alexander stated. Here is what went down:
Celsius, a firm that offered users yields of over 18% for depositing their Crypto with the company, suspended withdrawals for clients in June. Celsius functioned like a bank taking the deposited crypto and lending it out to other investors at a high yield. The other investors would use it for trading and the profit Celsius made would be used to pay back the investors who deposited their crypto.
But when the crypto winter hit, the business model was threatened. For now, Celsius is still facing liquidity problems and has had to suspend withdrawals to effectively stop the cryptocurrency version of a bank run.
“Players seeking high yields exchanged fiat for crypto used the lending platforms as custodians, and then those platforms used the funds they raised to make highly risky investments – how else could they pay such high-interest rates?”
Another problem that has come up is that crypto companies relied heavily on loans from each other. For instance, Three Arrows Capital, one of the biggest victims of the crypto winter, had exposure to LUNA and suffered losses after UST collapsed.
In June, the Financial Times reported that 3AC failed to meet a margin call from BlockFi and its position was liquidated. The hedge fund later defaulted on a $660 million loan from Voyager Digital making it drop into liquidation and file for bankruptcy guided by Chapter 15 of the U.S. Bankruptcy Code.
Voyager also filed for bankruptcy owing Alameda Research $75 million and Alameda also owed Voyager $377 million. To complicate this scenario further, Alameda owns 9% of Voyager. Kaiko’s Medalie explained:
“Overall, June and Q2 as a whole were very difficult for crypto markets, where we saw the meltdown of some of the largest companies in large part due to extremely poor risk management and contagion from the collapse of 3AC, the largest crypto hedge fund.”
“It is now apparent that nearly every large centralized lender failed to properly manage risk, which subjected them to a contagion-style event with the collapse of a single entity. 3AC had taken out loans from nearly every lender that they were unable to repay following the wider market collapse, causing a liquidity crisis amid high redemptions from clients.”
Is The Crypto Winter Over?
It is not yet clear when the market turbulence will eventually settle. Nonetheless, experts and analysts believe that there is some more pain ahead as crypto companies strive to pay down their debts and process client withdrawals.
The crypto miners and exchanges might be the next ones to fall, as explained by the head of research at CoinShares, James Butterfill. He commented:
“We feel that this pain will spill over to the crowded exchange industry. Given it is such a crowded market, and that exchanges rely to some extent on economies of scale the current environment is likely to highlight further casualties.”
Even established operators like Coinbase has laid off employees trying to cut down costs as trading volumes collapse due to the falling digital currency prices. In the meantime, crypto miners that mostly rely on specialized computing equipment to settle transactions on the blockchain might also be in trouble if the crypto winter persists.
Butterfill said in a research note:
“We have also seen examples of potential stress where miners have allegedly not paid their electricity bills, potentially alluding to cash flow issues. This is likely why we are seeing some miners sell their holdings.”
Mining comes at a heavy price needed for the gear itself and a constant flow of electricity required to keep machines running 24/7.
Will Ethereum Merge Rally Continue, Or Is It A Bull Trap?
Ethereum has gained nearly 50% in the past week managing to pull the entire crypto market up with it. However, risky days lie ahead given the macroeconomic factors at play. As the market awaits the Merge upgrade, the bigger picture is still mainly bearish.
For now, the biggest altcoin is up by over 60% from its crypto bottom of $918 recorded on June 19, reaching $1,549 at some point. Nonetheless, the current Ether rally might be a bull trap as the macroeconomic clouds darken.
The Merge, scheduled for September 19, will minimize the network’s energy consumption by over 99%. But, it will not essentially reduce transaction costs considerably, since this will happen when scaling happens through sharding, expected sometime in 2023.
A recent Coinbase report on the Merge explained that the next major step is the Goerli testnet Merge, planned for August 11. Goerli is designed as the most battle-tested Ethereum environment that has the most user activity and the most practical simulation of the real thing.
— Arjun Solanki (@thearjunsolanki) July 19, 2022
There have also been worries that a considerable amount of ETH may flood the market after the Merge and its release from its staking smart contracts. But, Eliézer Ndinga, director of research at 21Shares, said that this is unlikely to happen:
“The withdrawals of Ether won’t occur until 6-12 months post Merge after the Shanghai upgrade. The withdrawals will be limited to six validators every epoch or ~ 6 minutes to avoid bank runs and keep the network secure.”
According to a recent study by Finder, there is a lot of negative sentiment about short-term Ether prices. The 54 industry experts polled believed that Ether would be worth $1,711 by the end of this year, rising to $5,739 by 2025, before reaching $14,412 by 2030. But, they also said that ETH would drop to $675 before 2022 was out.
Finder said that several macroeconomic factors might cause a retreat in the market. The US Federal Reserve is expected to hike rates again by 0.75% during their July 26-27 meeting. Another hike is considered bearish for the crypto markets. If Bitcoin plunges, Ether is sure to follow.
The US Bureau of Economic Analysis (BEA) will publish its advance estimate of Q2 2022 GDP growth on July 28. Another negative quarter is expected, meaning that the nation is in a technical recession which will prove detrimental for risk-on assets like Ether.
Bitcoin Is Still At Some Cross Road
Bitcoin has broken through the ceiling of a falling channel in the medium-long term. The currency has flashed a positive signal from the rectangle formation by a break up through the resistance at 22,824. Analysts expect that the biggest crypto will rise toward $26,174 in the medium term.
The currency has strong support at $18,300 and massive resistance formed at $35,000. A positive volume balance shows that volume is high on days with surging prices and low on days when the prices are falling, and that strengthens the currency.
The RSI curve shows a rising trend that might be an early sign of the start of a rising trend for the price. For now, Bitcoin is assessed as technically slightly positive for the medium-long term. However, the upcoming macroeconomic dynamics might change the trends in the market and some experts believe that the crypto winter is far from over.