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Crypto crash: Will crypto recover from Terra and 3AC collapse?

13:35, 24 June 2022

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Crypto crash: Will crypto recover from Terra and 3AC collapse?
Crypto crash: Will crypto recover from Terra and 3AC collapse? Photo: VideoFlow / Shutterstock.com

The first half of 2022 will not be easily forgotten by the crypto faithful as it shifted investor sentiment after a monster cryptocurrency rally in 2021 that saw bitcoin (BTC) and altcoins scale multiple record peaks.

Capital locked in decentralised finance (DeFi) protocols stood at near-record levels of over $170bn in the first quarter of 2022 as mouth-watering returns on platforms like Terra’s Anchor Protocol attracted yield-seeking investors from far and wide. 

The Terra blockchain, led by its outspoken South Korean founder Do Kwon, became the darling of DeFi in early 2022 with the help of its algorithmic stablecoin TerraUSD (UST) and near 20% returns on UST deposits.

Just as users were getting comfortable with their passive DeFi incomes, Terra and its non-collaterised stablecoin collapsed in a sensational turn of events. Data from DeFi Llama showed that capital flight of nearly $63bn from the cryptocurrency sector was recorded in May. 

Cascading effects from the Terra crisis engulfed a cryptocurrency market already weakened by difficult macroeconomic conditions. 

Three Arrows Capital (3AC), a crypto hedge fund that managed assets worth about $10bn at its peak, went bankrupt as falling crypto prices forced liquidations of collateralised loans and leveraged trading positions across the industry, aggravating the sell-off

Investor sentiment plummeted as crypto lending platforms like Celsius and Babel suspended withdrawals for clients. Bitcoin’s “generational bottom”, which analysts claimed to be around $23,000, looked distant as the bellwether crypto fell as low as $17,567 on 18 June. 

Ether (ETH) saw its 11th consecutive week of losses as the altcoin traded below the $1,000 mark for the first time in 18 months.

Bitcoin (BTC) to USD

Ethereum (ETH) to USD

For now, a relief rally has helped BTC and ETH rise above $20,000 and $1,000, respectively, as investors bottom fish and pick up their favourite tokens at beaten-down prices. 

The market will also be wary of not calling an end to this crypto crash too early as macroeconomic conditions have not changed for the better.

Yet what has caused the crypto market crash? Here we take a look at whether crypto will go back up in 2022 and what factors will influence cryptocurrency prices in 2022 and beyond. 

Recap: 2021 bull run and 2022 crypto crash

In 2021, cryptocurrency prices surged to new-highs, boosted by ultra-low interest rates, a growing retail investor base and increased institutional participation. By November 2021, BTC hit an all-time high of $68,789. 

The rest of the cryptocurrency market followed suit as ether (ETH), the second largest cryptocurrency, breached its record high level in November 2021 to peak at $4,891.

2022 has turned out to be a different story. High inflation in the US and globally has pushed central banks to reduce cheap liquidity. The US Federal Reserve (Fed) has embarked on an aggressive monetary tightening cycle, having followed up a 25 basis points (bps) rate hike in April and a 50 bps increase in May with a 75 bps hike in June.

“Despite the Fed's most recent rate hike being the largest since 1994, Powell [Jerome Powell, Chair of the Federal Reserve] expressed interest in a similar rate hike during the Fed's next FOMC meeting later this summer,” said San Francisco-based bitcoin brokerage and mining solution provider River Financial.

“After confirming the Fed's intent to continue raising interest rates, Powell dismissed the idea that the Fed was trying to induce a recession,” the company added.

Tight monetary conditions and fears of recessions have resulted in investors pulling their money out of risk assets. US equities are officially in a bear market. The benchmark S&P 500 (US500) index has fallen over 20% year-to-date (YTD), as of 22 June. 

S&P 500 price 2017 - 2022

In the crypto space, BTC is currently hovering near the $21,000 mark, having recovered from levels as low as about $17,500. 

BTC/USD price  2017 - 2022

Meanwhile, ETH saw prices plunge as low as $879 on 18 June, its lowest since January 2021. The second largest cryptocurrency by market capitalisation is down nearly 70% YTD, as of 22 June.

ETH/USD price 2017 - 2022

“Investors, meanwhile, are forced to weigh the risks of further contagion against the opportunity to buy assets at significant discounts,” said crypto asset manager Arca in a note.

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Crypto crash origins: Terra’s collapse

Let’s rewind to January 2022, when the non-profit Luna Foundation Guard (LFG) was created to establish a reserve to ensure UST maintains its dollar peg. Fast forward to May 7 and LFG had amassed over 80,000 BTC and other cryptos, including BNB, AVAX, USDT, USDC, UST and LUNA in its warchest.

When UST depegged on 9 May, bitcoin came under pressure as LFG sold its BTC reserves to support UST’s dollar peg. UST holders, who were once drawn to Terra’s passive income protocol, Anchor (ANC), for its 20% interest rate on deposits, started withdrawing their UST funds in a panicky exit from Terra's ecosystem.

Terra’s native token, LUNA, which was used as a balancing coin to maintain UST’s dollar peg via a network of arbitrageurs, plunged from about $64 on 9 May to $0.0001961 by 16 May. 

Terra Classic (LUNC) crashes after UST depeg 

By the end of it all, when LFG’s bitcoin reserves were unsuccessful in saving the UST peg, Terra’s LUNA crashed and the Terra community decided to abandon its algo-stablecoin to fork out, starting a new chain.

Celsius suspends withdrawals

Crypto’s latest winter was confirmed in early June as fears of insolvency at lending platform Celsius and hedge fund 3AC pushed a weakened cryptocurrency market lower.

There were speculations that Celsius had been exposed to insolvency risks due to Terra’s collapse. Alex Mashinsky, founder of Celsius, was quick to refute Celsius’ exposure to the fallen stablecoin on Twitter.

However, in a report dated 27 May, blockchain analytics firm Nansen claimed that Celsius had been a prominent player in the Terra ecosystem. The report also noted that a wallet linked to Celsius was among the seven wallets to withdraw significant amounts of UST from the Anchor Protocol that led to the “de-pegging” of UST.

On 13 June, market sentiment took another turn downward as lending platform Celsius announced that it was passing withdrawals due to “extreme market conditions”.

The future of Celsius still remains unclear. Investors are fretting over fears of forced liquidations of Celsius’ investments due to falling prices of collateral in a crypto bear market. According to Nansen data, a wallet linked to Celsius has debts worth over $450m.

Market watchers point to Celsius’ investment worth about $436m in staked ETH (stETH) as a liability. 

stETH is a token received after staking ETH on a protocol called Lido. stETH price is designed to be pegged to ETH price and can be redeemed for ETH in the future when the Ethereum network completes its transition to proof-of-stake (PoS) consensus mechanism.

As of 22 June, stETH is trading at a discount to ETH, with the stETH/ETH rate around 0.9467, data from CoinMarketCap showed. Moreover, the illiquidity of stETH means it cannot redeem it for ETH on Lido, and stETH holders could have to sell their tokens in the secondary market at current discounts to retrieve capital.

The market is also watching Celsius’ debt worth over $224.8 m in stablecoin DAI on Maker DAO’s lending protocol Oasis, which is collateralised with wrapped bitcoin (WBTC) worth over $500m.

As of 22 June, the liquidation price of Celsius’ collateral on its DAI debt stands at $13,605. The Oasis website showed that the wallet linked to Celsius paid back over $53m in DAI and added over 6,000 WBTC to its collateral.

“With a stETH liquidation run in play, the company must find a way to liquidate these holdings in order to satisfy withdrawal requests from customers,” said Bankless newsletter analysts in June.
“Given that on-chain liquidity is drying up, the price of stETH is falling. Redeeming the asset for locked ETH is not an option. Meanwhile, Celsius’ own CEL token has plummeted over 64% in the past week,” they added.

On 14 June, Wall Street Journal reported that Celsius has reached out to restructuring law firm Akin Gump Struass Hauer & Feld.

Three Arrows Capital dissolves

Soon, the world discovered that Three Arrows Capital (3AC), one of the biggest crypto hedge funds in the world, was insolvent.

On 17 June, Kyle Davis, co-founder of 3AC, said in an interview with WSJ that the firm had hired legal and financial help to pay back its investors and lenders.

Davis revealed that 3AC had invested about $200m in the Terra ecosystem earlier in 2022. It was further revealed by crypto analyst Miles Deautcher that 3AC had borrowed money and deposited about $560m in LUNA on Anchor Protocol.

“The Terra-Luna situation caught us very much off guard,” Davis told WSJ.

The slump in cryptocurrency prices that followed would bring 3AC, which held assets under management (AUM) worth about $3bn in April, to its knees as the fund’s collateralised loans and leveraged trades saw forced liquidations.

It had also been disclosed in January that 3AC held a position of about $1.23bn in Grayscale's Bitcoin Trust (GBTC). However, GBTC’s over 60% slump in 2022 meant that 3AC was not able to raise enough capital to keep it afloat.

To add to 3AC’s misery, Lido’s stETH derivative would trade at a discount as much as 8% to ETH in June, data from CoinMarketCap showed. 3AC was known to have a significant stake in the illiquid stETH on Lido.

Then came the margin calls which the 3AC was unable to meet, resulting in the firm suffering liquidations of its leveraged positions on crypto exchanges FTX, BitMex and Deribit, as reported by The Block.

Signs of contagion from Terra’s collapse, 3AC’s meltdown and Celsius’ crisis soon came to light. Asia’s biggest lender to miners, Babel Finance, announced on 20 June that it had reached “preliminary agreements on the repayment period of some debts”, with major counterparties and customers after having suspended withdrawals citing “unusual liquidity pressures”.

Crypto lender BlockFi announced it secured a $250m revolving line of credit from FTX having run into trouble after a large client “failed to meet its obligations on an overcollateralized margin loan”.

Will crypto recover in 2022?

Crypto investors will be hoping that June will see an end to news of market falls.

Forced liquidations have pushed BTC and ETH prices to over 70% away from their record levels hit in November 2021. Cryptocurrencies rebounded on 19 June as investors picked up their favourite tokens at beaten-down prices.

“Although today and this past weekend likely will look like prime accumulation opportunities five years from now, it’s difficult to conclude that the worst is over and it's up only from here, with potentially more cryptocurrency-native contagion and macro headwinds ahead,” said Bitcoin Magazine in a newsletter dated 20 June.

Macro conditions will be an important factor that could decide when bitcoin will bounce back, having seen the bull run of 2021 fuelled by cheap liquidity and stimulus checks.

For now, inflation is running high. US consumer price index (CPI) inflation data for May came in at 8.6%, above estimates and at a 40-year high.

The Fed has signalled an ultra-hawkish stance to tame rising costs. According to the Fed’s economic projections published on 15 June, the central bank has raised its 2022 median interest rate expectations to 3.4% from the 1.9% estimate in March. The report also suggested that the Fed could start cutting rates by 2024 after seeing rates peak at about 3.8% in 2023.

“The Fed’s new forecasts sees them signal that the pace of policy tightening will remain intense over the next few months,” said James Knightley, chief international economist at ING.

Crypto asset manager Arca was optimistic about cryptocurrencies rebounding after the crypto crash of 2022. Jeff Dorman, chief investment officer at Arca, said stablecoins contributing about 20% to the total cryptocurrency market cap at the time of writing was a positive sign.

“That means cash in the market (as represented by stablecoins) represents 20% of all of the value of the digital assets that you can buy with this cash… stablecoin AUM represents a tremendous amount of built-up buy pressure that will eventually pour back into the market through a very small window,” said Dorman.

Dorman added that the crypto crash has cleansed the industry of the riskiest companies such as Terra, Celsius and 3AC with “others on death’s doorstep”.

“There are known risks - like swords hanging over the head of the market—and in the past month, three of those have fallen. When the overhangs are removed, that’s historically been a good time to buy,” said Dorman.

Meanwhile, crypto enthusiasts have Ethereum’s Merge to look forward to. The timeline for completion of Ethereum’s transition to proof-of-stake consensus mechanism has been pushed back a number of times due to the complexity of the move.    

“Ethereum has embarked on an ambitious journey by performing the largest transformation of a blockchain project ever attempted,” said Switzerland-based crypto investment firm Bitcoin Suisse in a report.

According to Ethereum’s website, ‘The Merge’ was expected to be finalised in the second half of this year. ‘The Merge’ is likely to be the most significant development for the crypto industry in 2022. Its outcome could affect market sentiment and prices given Ethereum’s dominant position as the smart contract platform leader.

The answer to when will crypto rebound remains elusive. Laith Khalaf, head of investment analysis at UK-based investment platform AJ Bell, shared a piece of advice for the next crypto bull run.

“Crypto investors might therefore hold on in the face of adversity, but if they are lucky enough to see soaring prices in the crypto market again, it would be prudent to at least consider heading for the exit doors with some profits in tow.”

Note that analyst predictions can be wrong. Forecasts shouldn’t be used as substitutes for your own research. Always conduct your own diligence and remember that your decision to trade or invest in high-risk crypto currencies should depend on your risk tolerance, expertise in the market, portfolio size and goals. 

Keep in mind that past performance doesn’t guarantee future returns. Cryptocurrency markets are highly volatile. Never invest or trade money you cannot afford to lose.

FAQs

Why has crypto fallen so much?

Tight monetary conditions and fears of recession have resulted in investors pulling their money out of risk assets. Crypto prices have slumped after Terra’s ecosystem collapse, crypto lending platforms suspending withdrawals and hedge fund 3AC’s forced liquidations of loans and leveraged trades.

Will cryptocurrency bounce back?

The answer to when will crypto rebound remains elusive. Macroeconomic conditions will be an important factor going forward as the US Federal Reserve embarks on an aggressive tigething cycle.

When will the crypto market go up?

Cryptocurrencies are high-risk, highly volatile assets and are still at a nascent stage. It is impossible to say when or if the cryptocurrency market will go up. Always conduct your own research and remember that your decision to trade or invest should depend on your risk tolerance, expertise in the market, portfolio size and goals. And remember to never invest money you can’t afford to lose.

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