2022 marked a significant period in the world of cryptocurrency. After a meteoric rise in the years prior, the crypto industry found itself embroiled in a sudden state of crisis. In this article, we dissect the troubles crypto has faced in the past year, and provide insight on its future outlook.
Collapse of Terra and stETH
The first major cryptocurrency to collapse was Terra, a cryptocurrency ecosystem with two key securities: Luna and TerraUSD (UST). Luna is the cryptocurrency for transactions made on the protocol Terra. Meanwhile, Luna and TerraUSD are both stable coins that are designed to maintain a fixed value relative to the US dollar, meaning that their price is pegged to one US dollar per token.
The Mundell-Fleming trilemma is a macroeconomic theory that explores the relationship between exchange rate stability, capital mobility, and monetary policy autonomy. According to the Mundell-Fleming trilemma, it is impossible to achieve all three of these goals at once.
Figure 1: The Mundell-Fleming Trilemma (Source: The Economist)
Contrary to the trilemma, Terra wanted to achieve all three goals at the same time. To attract investors to hold UST, Terra set up the Anchor protocol, which paid skyrocket-high yields if investors bought UST and lent it to Anchor. Terra did this with the goal of having UST maintain a fixed exchange rate with the US dollar without any barriers to capital flow but yet still having control over interest rates. Under this framework, although the Luna Foundation Guard (LFG) held billions of dollars worth of other cryptocurrencies as foreign exchange reserves for Terra, it did not ultimately serve as a safety net when the system collapsed.
Moreover, the high interest rate paid by Anchor was not sustainable. When Terra started to lower interest rates, this immediately led to a huge increase in the supply of Luna in the exchange market. As a result, the price of Luna fell, which further incentivised people to sell it, creating a vicious sell-off cycle.
When panic selling occurred, the LFG deployed all of its foreign exchanges into the market to stop the vicious cycle. While it is possible to prevent the vicious cycle from happening, just like what the Hong Kong Monetary Authority (HKMA) did to bring up the value of Hong Kong dollars under the pressure of George Soros and other speculators during the 1997 Asian Financial Crisis, the result for Terra this time was unfortunately the opposite. Instead, it mirrored the fate of the Bank of Thailand, which had to accept the plunge in the exchange rate of the Thai baht to US dollars after selling all its foreign exchange during the crisis. As a result, Terra collapsed on 9 May.
Figure 2: The Collapse of Luna and TerraUSD (UST) (Source: CoinMarketCap)
As both UST and Luna collapsed, so too did many other cryptocurrencies, including stETH. Ethereum 2.0 is a series of upgrades to the Ethereum Blockchain that will improve its speed, efficiency, and scalability. During the upgrade, people could stake their token ether (ETH), as staked ether (stETH). StETH cannot be sold or spent during the upgrade until the network opens.
For those who wanted to maintain their liquidity during the upgrade, the Lido Finance protocol provides an alternative method. For every ETH given to Lido, a token will be given, which can be exchanged for one stETH. Seeing this, many investors went on to use yield farming: they would deposit ETH at Lido, obtain stETH, and use it as collateral again to borrow ETH through lending platforms, such as Parallel Finance, and repeat the process. The 1:1 exchange at Lido seems safe, but the liquidity problem is that depositors are unable to take back stETH before the Ethereum 2.0 upgrade is over. If depositors wanted to unwind the trade before the upgrade is finished, they can only trade it below parity, especially when the upgrade is delayed or demand for liquidity increases following the UST crash. This illiquidity of stETH was another main contributor to the crash of the Celsius Network and Three Arrows Capital (3AC).
Collapse of Major Crypto Institutions — Celsius, 3AC & FTX
The collapse of UST and stETH hit key crypto financial institutions hard, and Celsius Network was one of the biggest institutions to fall under the hit.
Celsius was one of the largest cryptocurrency lending companies in the world. Customers can either deposit crypto to earn interest or borrow crypto from it, akin to a commercial bank. What makes Celsius different from a commercial bank is that it offers lenders higher interest rates than the market, as well as lower interest rates to borrowers through rehypothecation. Rehypothecation means that Celsius not only lends out depositors’ money but also the collateral from its borrowers, including lending UST on Anchor and yield farming the stETH. Hence, Celsius is exposed to both UST and stETH.
When Celsius got hit by UST, stakeholders were in a panic and started to withdraw money. This worsens the situation when stETH decouples, as the ETH-denominated assets are illiquid for Celsius in terms of stETH or locked up for Ethereum 2.0. However, the ETH-denominated liabilities still need to be paid. Given the size of Celsius, all Centralised Exchanges (CEX) were not liquid enough or did not want to be ‘trapped’ by holding stETH. The only option left for Celsius was to perform Over-the-Counter Trading (OTC Trading) with the brokers at a low price. All these led to the further withdrawal of customers from Celsius, which ended up going bankrupt.
Figure 3: Fall in the Price of Celsius (Source: Bloomberg)
Another major victim of the crash was Three Arrows Capital (3AC), which was one of the largest cryptocurrency hedge funds in the world based in Singapore with around $10 billion in assets under management (AUM). Similar to Celsius, 3AC was exposed to both UST and stETH. Moreover, 3AC was also one of the organisations that backed LFG by buying up Luna in exchange for other assets. When the collateral falls in value, it is difficult to be liquidated, especially if leveraged. Other firms such as Centralised Exchanges (CEX) FTX and Bitmex, lenders such as Celsius and BlockFi, and brokers were also exposed to 3AC’s collapse, having performed OTC trading with 3AC. Worse still, these counterparties did not have enough buffers to bear the loss of liquidating assets from 3AC, and eventually, 3AC bore the bulk of the losses. As a result, 3AC lost around $3 billion in 2021 and 2022, which is considered to be one of the biggest hedge fund trading losses of all time.
FTX’s collapse took place in November 2022 over a series of events. On November 2, CoinDesk revealed that Alameda Research, a quantitative trading firm run by Sam Bankman-Fried (the former CEO of FTX), held $5 billion worth of FTT, the token of FTX. Since Alameda Research’s investment foundation is based on the tokens of its sister company but not on any government-issued currency or other cryptocurrency, concerns were raised regarding FTX’s leverage and solvency. On November 6, the world’s biggest crypto exchange, Binance, announced it would sell all of its FTT tokens, worth $530 million, due to risk management following the collapse of Terra.
Soon after Binance revealed its move, $6 billion worth of withdrawals were demanded, and the value of FTT fell by more than 80% in two days. FTX was able to avoid bankruptcy as Binance reached a non-binding agreement with FTX to buy all of its non-US businesses on November 8. Unfortunately, the buyout was soon cancelled the next day due to concerns over mishandling customer funds and other issues. On November 10, FTX had its assets frozen, and the California Department of Financial Protection and Innovation stepped in for an investigation. The next day, Bankman-Fried stepped down as CEO, and FTX filed for bankruptcy. Sources at the New York Times said the exchange owes as much as $8 billion.
Looking Forward
From UST to Celsius and 3AC to FTX, the key question investors want to know is what will happen next. Some posit that the crash of Celsius and FTX marks the Lehman Brothers moment for crypto, but then again, Lehman Brothers did not mark the end of the 2008 Global Financial Crisis, but instead acted more like the beginning of a string of collapses. The same applies to crypto, we never know what will be the next to topple.