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How a series of cryptocurrency crises is changing the industry

How a series of cryptocurrency crises is changing the industry

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The history of cryptocurrencies is rarely dull, but the 2022 downturn was more tumultuous than most. Billions of dollars in assets disappeared almost overnight in a series of business collapses, most notably the disappearance of the FTX cryptocurrency exchange in November. Each left behind a wave of related bankruptcies. These developments undermined confidence in the field, which itself was created in response to a loss of faith in core finance following the 2008 banking crash. Some investors have reacted to the crisis by calling for tough new regulation. Others blame the failures of crypto intermediaries for the bankruptcies and say the turmoil should speed up the transition to more decentralized platforms.

1. What happened to cryptocurrency prices?

After peaking in November 2021, the cumulative market cap of crypto assets fell by as much as 73% over the next 12 months, according to data tracker CoinGecko. This is less than the 88% crash of the previous “crypto winter” of 2018, but it wiped out a much larger value: more than $2 trillion. While previous cryptocurrency downturns were caused by problems within the industry itself, this one started from something external: central banks raised interest rates to combat a post-pandemic surge in inflation. This has reduced investor appetite for high risk, high return assets, including cryptocurrencies.

2. What does this mean?

The collapse undermined the idea that cryptocurrency has a similar status to gold as a safe haven in times of economic uncertainty, as it is decoupled from the wealth of traditional financial assets. This came as a shock to pension and sovereign fund managers, as well as to the millions of small investors who have adopted crypto in recent years, convinced that it is becoming a mainstream asset class. It turned out that the rise in prices of recent years was built on shaky foundations, because many investors took out large loans to bet on digital coins and projects, often using other cryptocurrencies as collateral. This interconnectedness propagates the impact of loud disruptions.

The first explosion involved a so-called algorithmic stablecoin called TerraUSD, which used complex automated transactions with its sister token, Luna, to maintain a peg to the US dollar. It became popular because a sister decentralized finance (DeFi) platform called Anchor offered interest rates up to 20% on TerraUSD deposits. The sudden withdrawal of funds from Anchor led to a “death spiral” that erased approximately $60 billion from the value of TerraUSD and Luna. Companies that invested in related tokens and derivatives, such as Three Arrows Capital, eventually went bankrupt, leading to the bankruptcy of other companies such as Voyager Digital, which provided Three Arrows with a large loan. November saw another shock: the collapse of celebrity entrepreneur Sam Bankman-Freed’s crypto empire, including FTX.com, one of the largest digital asset exchanges. Within days, the man who helped other struggling crypto businesses and became an unofficial industry ambassador at conferences and on Capitol Hill saw his $15.6 billion fortune evaporate. FTX is believed to have gone broke trying to save Alameda Research, a trading house owned by Bankman-Fried.

4. What were the consequences?

Terra’s critics said the system was doomed to fail because it relied in part on attracting investors with volatile interest rates. Some have compared Terra and other high-yield DeFi ventures to new forms of Ponzi schemes that have showered early investors with erratic profits to attract new investors. The collapse of FTX showed that even a seemingly solid crypto business can have hidden weaknesses and highlighted the danger of proliferation—when problems in one part of an industry spread quickly and in unexpected ways, causing huge losses in others. All this can freeze investments in cryptocurrency for some time.

5. What does this mean for the future of cryptography?

It was coined because people didn’t trust Wall Street, but a string of scandals raises an existential question about cryptocurrency: can it be trusted? Many hoped that stricter regulation could restore confidence. But the FTX bankruptcy seemed to derail legislation that Bankman-Fried had heavily lobbied for. It was opposed by some DeFi platform operators who believed it was misrepresenting the interests of large centralized exchanges such as FTX. Tight regulation could eventually make the cryptocurrency more stable and respectable. What is not clear is how much of the industry will be able to withstand the extra scrutiny that this will entail.

Other similar stories are available at bloomberg.com.

Written by khirou

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