The Crypto Crash of 2022

A bubble finally burst, or just another hiccup?

Aug 06, 2022

Bitcoin. Ethereum. Binance. These are a few of the world’s most popular cryptocurrencies, and they have become household names in recent years. However, since the beginning of 2022, they’re down by 48.5%, 53.41%, and 43.82% respectively at the time of writing. Since April 2022, the crypto markets have collectively lost around $1.2 trillion. This giant collapse in value is particularly surprising in light of the fact that there were several voices in the finance community predicting for Bitcoin to hit $100k in 2022. Regardless, the crash has left crypto supporters aghast as they watch their portfolios turn red, and skeptics grinning ear to ear as they finally get their “I told you so” moment. So, what the heck happened?

Economic Policy

To understand this relationship, we must first turn to why crypto - and Bitcoin especially - took off during the pandemic. When the United States Congress and the Federal Reserve signed trillions of dollars’ worth of stimulus in response to COVID-19’s effect on the economy, a bunch of that cash made its way to digital assets such as Bitcoin. As such, it rose to a record high of almost $69,000 USD in November 2021. But due to rising inflation (6.8% in November 2021), pressure was mounted on both the Fed and Congress to take it easy with their expansionary policies. With the crypto markets realizing that the abundance of liquidity fuelling their asset prices will soon fade, things went from bull to bear real quick.

That’s why crypto has been doing nothing but go down since November, when the Fed turned to contractionary policies. For most of its history, Bitcoin was subject to easy monetary policy with low (sometimes even zero) interest rates, so when central banks suddenly start doing the opposite, that’s some dangerous territory for the crypto markets. But why is easy monetary policy a good thing for crypto? In this regard, stocks and cryptocurrencies are rather similar: low interest rates tend to discourage investing in bonds since low rates = low bond yield (see our article on the inverted yield curve). This means that investors end up looking for assets that will give a higher return, things like stocks, derivatives, or cryptocurrencies.

Ever since the Fed made it clear of their intentions to raise interest rates and decrease liquidity in the overall economy, people suddenly started flocking to bonds, since higher interest rates = higher bond yields (again, see our article on the inverted yield curve). Not only are bonds generally safer and less speculative than Bitcoin or Ethereum, but they’re now also offering higher yields, and so investors begin to favour bonds, thereby decreasing the demand for crypto and thus, their market value.

Russian-Ukraine War

Like the point on liquidity, this factor also demonstrates the similarity between crypto and stock prices. Put simply, when the overall environment appears riskier than usual, many investors prefer to move their money into safer and more stable assets, what’s sometimes called a “risk-off” trade. The onset of the Russian-Ukraine war signalled, if anything to investors, uncertainty, which is a big no-no in finance (which is also why stocks and crypto actually began to recover shortly after the invasion - people knew what had happened, and so there was greater certainty as to what was going on).

And if that wasn’t enough, Russian policymakers were beginning to seriously consider regulating or even outright banning the use and mining of cryptocurrencies in their country. When one of the biggest economies in the world proposes completely expelling your asset from their jurisdiction, that can’t be taken as a good sign. Investor sentiments and expectations kicked in, and the price plunge followed.

Terra’s UST and LUNA

The collapse of these 2 coins is among the major hallmarks of the 2022 crypto crash. Terra is a blockchain-based payment platform that allows users to spend, save, trade, or exchange Terra coins. The platform’s 2 main coins are UST and LUNA, both of which are stablecoins - cryptocurrencies where the price is pegged to another cryptocurrency or fiat money. So USD-pegged stablecoins such as USDC are supposed to have a price of $1 USD at all times, which is typically done by having the necessary cash or cash-equivalent assets in their reserves to back up the coin.

But here’s where things get a little weird: the UST is an algorithmic stablecoin, meaning although it’s still meant to maintain a 1:1 exchange rate with the USD, the Terra platform has algorithms on the blockchain facilitating changes in supply and demand between the UST and another cryptocurrency that props them up, namely LUNA. But how exactly does that work?

If the UST is worth more than a dollar, the Terra algorithm would allow its users to trade $1 worth of LUNA for a UST, essentially “destroying” a dollar’s worth of LUNA and “creating” a UST, which users can then sell for more than a dollar (because it’s worth more than one) and pocket the difference. But if the UST was worth less than $1, then the opposite happens: users will be allowed to swap their USTs, which are currently trading for less than a dollar apiece in this scenario, each for a dollar’s worth of LUNA. This exchange would destroy 1 UST, create a dollar’s worth of LUNA and generate the trader a profit of the difference between the UST and the LUNA. The thinking behind this system was that the Terra protocol could continuously destroy and create as many USTs or LUNAs necessary to bring the UST back to a 1:1 exchange rate with the dollar.

While this system sounds beneficial to everybody, there’s in fact a fatal flaw. If the demand for crypto as a whole dries up enough, the UST could irreversibly depeg from its 1:1 exchange rate with the dollar. The reason is because if people don’t want anything to do with crypto, then they’re not going to want to trade their $1 worth of LUNA for another cryptocurrency, nor are they going to want to purchase a UST and exchange it for a dollar’s worth of LUNA.

When 1 UST became cheaper than a dollar, the price of the LUNA was also still falling, preventing users from profiting off their trade. And so people lost interest in buying UST, meaning the supply of UST couldn’t be cutback (if the UST was worth less than $1, users are allowed to swap their USTs each for a dollar’s worth of LUNA each, thereby destroying each exchanged UST, which is needed to increase the price back to a 1:1 exchange rate with the dollar. Remember: lower supply, ceteris paribus, means a higher price). When UST was under $1 for too long, holders lost faith in the coin and sold their positions, further decreasing its price. Meanwhile, LUNA continued to be created by the algorithm in an attempt to rescue UST from further devaluation, but the increasing supply of LUNA just ended up rapidly reducing its price.

This death spiral continued until LUNA was worth a fraction of a fraction of a penny, and the UST lost 95% of its value in a matter of days.

Terraform Labs (the company that manages the blockchain as well as the various coins on it) was very well aware of this problem which is why they bought $1B worth of Bitcoin in early 2022 - to back up UST’s price. In May 2022, however, everything was gone. Terra tried to bring it back up by creating more LUNAs and cashing in their Bitcoin reserve, but it wasn't enough; $45 billion in market caps from the 2 coins had just been wiped into nothing.

Three Arrows Capital (3AC)

A cryptocurrency hedge fund, 3AC peaked with $10 billion in assets under management. There were 3 key decisions that ended up plummeting the company into bankruptcy. The first was buying over $200 million in LUNA, all of which went to $0 after the coin’s collapse described above.

The second was their investment in staked ETH or stETH as in “staked ether.” Keep in mind that ether and Ethereum are 2 very different things: Ethereum is a blockchain network that runs smart contracts (a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code), whereas ether is the cryptocurrency paid to use said smart contracts. But if someone wants to say, buy some more ether, they’ll usually say “I want to buy more Ethereum.”

Each stETH represents a unit of ether that’s been deposited on the beacon chain (Ethereum is in the process of being upgraded to a better version, and the “beacon chain” is a testing environment for it). When investors stake their ether through Lido Finance, they receive stETH and can earn 4% annual percent yield (APY). They cannot, however, redeem their stETH for ETH (and thereby earn money) until after the Ethereum network has officially upgraded. At least not officially; investors can trade their stETH for ETH using liquidity pools, a concept that will get us way too lost in the weeds if we go any further into.

Turning all this back to 3AC, the fund tied up a lot of money into stETH but when the crypto bear market arrived, many investors swapped their stETH for ETH, including 3AC. Eventually, the liquidity pool didn’t have any ETH left, so trades were no longer possible. This caused for stETH’s price to fall and thus rapidly decrease the value of 3AC’s assets.

The third blunder was 3AC’s investment in Grayscale Bitcoin Trust (GBTC) - a financial vehicle that allows investors to invest in trusts (a relationship wherein a party gives another the right to hold title to property or assets) that hold large amounts of Bitcoin. This means that as the price of BTC rises (or falls), shares in these trusts track the value of the cryptocurrency accordingly.

For a long time, GBTC shares traded at a premium to Bitcoin’s price because there were so many investors who couldn’t hold Bitcoin directly. But when Canadian regulators approved several Bitcoin ETFs (exchange traded funds, baskets of investments that allow people to put their money into a lot of securities at once) that more closely tracked the price of Bitcoin compared to GBTC, a bunch of people sold their GBTC shares to buy these ETFs. As a result, GBTC began trading at a discount, and so the company asked the Securities and Exchange Commission (SEC) to list it as a Bitcoin ETF. 3AC saw this as a massive opportunity: they could buy GBTC shares at a discount and make a profit when the price went up after the ETF got approved. However, the continuing crypto bear markets and Bitcoin’s rapidly declining price compelled 3AC into closing their GBTC position at a massive loss. At the time of writing, GBTC still hasn’t been listed as an ETF.

On top of that, 3AC had also invested using borrowed money (what’s called leverage, a practice that was a major contributor to the 2008 financial crisis as detailed here and here) from Voyager, a dominant crypto lender. When they saw what was going on, they demanded their money back - money that 3AC no longer had due to their terrible investments. The hedge fund went from being the largest in the crypto world to filing for bankruptcy in early July.

Celsius

This disaster is perhaps the easiest to understand. Celsius is basically a crypto bank that offers you 10% APY just for keeping your cryptocurrencies with them. Like 3AC, however, Celsius put a large investment into stETH - around $400 million to be exact. At this point you can probably guess what happened - when stETH collapsed, so did the value of Celsius’s investment. The worst part is that this investment consisted of depositor money, so when people started demanding their savings back, Celsius literally had nothing to give them. They had no choice but to pause withdrawals for all of their 1.7 million customers.

What’s next?

The 2022 crypto crash was a huge hit for investors to take, eviscerating hundreds of billions of dollars in value into thin air. It’s no secret that crypto is indeed a highly speculative investment with a long history of ups and downs (this crash is by no means the first) despite its rapidly increasing popularity overall. The recent rise in crypto, however, along with other bullish economic indicators could signal a recovery on the horizon.

Although it’s likely that several coins such as penny cryptos (coins with a price under $1 USD) will effectively cease to exist, the more industry-standard ones such as Bitcoin and Ethereum have a much better chance of surviving and perhaps even reaching new record highs. But skeptics aren’t so optimistic - some argue that 2022’s crash was different from the previous ones that the market recovered from because this time represents a changing macroeconomic paradigm.

Because the crypto markets thrived under easy money policies, and because central banks around the world are going full speed ahead with monetary tightening, crypto simply won’t be able to flourish like it once did under the incoming conditions. As Frances Coopla wrote in Yahoo! Finance:

The era of plentiful dollars is coming to an end. And that will mean persistently lower prices for cryptocurrencies.

Econ IRL:

Of the many questions puzzling both economists and social scientists alike for decades, a big one is why kids in some neighbourhoods rise out of poverty whereas kids living in other comparable areas stay behind. This week’s paper, but together by a team of 8 economists, may have arrived at least part of the explanation.

Using a data sample that represented over 70 million people and 21 billion friendships on Facebook, the researchers were able to, among other things, measure and analyze the socio-economic profile of people’s friends on the platform. They find that the amount of high-SES friends among low-SES individuals, what’s called “economic connectedness” is one of the strongest predictors of upward income mobility. In other words, low-income kids who live in neighbourhoods with greater class heterogeneity have a much better chance of rising out of poverty than those who don’t.

‘Till next time,

SoBasically