How a series of crypto collapses is reshaping the industry

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The history of cryptocurrencies has rarely been dull, but the latest crash sent a series of shocks that shook the foundations of digital assets. A cascade of explosions, including the collapse of the so-called stablecoin in May and the epic unraveling of the FTX crypto exchange in November, left a wave of bankruptcies. The events eroded the confidence of most investors who wanted to capitalize on the growing interest in Bitcoin and the vision of decentralized finance. The turmoil has prompted calls for regulators to act more urgently to protect consumers.

1. What happened to cryptocurrency prices?

After peaking in November 2021, crypto assets suffered a loss of $2.2 trillion over the next 12 months, with their total market value falling by 73%, according to data from tracker CoinGecko. In the past, such collapses — also known as “crypto winters” — have been triggered by events within the industry itself, such as stock market failures or regulatory crackdowns. This one started with something external: central banks raised interest rates to deal with a post-pandemic surge in inflation, which reduced investor appetite for riskier assets, including crypto.

2. What is the meaning of it?

The collapse exploded the idea that cryptocurrencies enjoy a similar status to gold as a safe haven in times of economic uncertainty because they are disconnected from the wealth of traditional financial assets. It came as a shock to pension and sovereign fund managers — and millions of retail investors — who have embraced crypto in recent years with the belief that it is becoming a major asset class. Cryptocurrency in 2021 turned out to be built on shaky foundations as many investors went into heavy debt to bet on digital coins and projects, often using other cryptocurrencies as collateral. That interconnectedness has amplified the impact of high-profile failures.

The biggest explosion involved a so-called algorithmic stablecoin called TerraUSD — a digital token whose value was supposed to be pegged to the US dollar using a parallel currency, Luna. It became popular when users of a decentralized finance (DeFi) platform called Anchor were offered interest rates of up to 20% on TerraUSD deposits. The sudden withdrawals from Anchor reduced the value of TerraUSD, and within days both it and Luna entered a death spiral that wiped about $60 billion off their value. Companies that invested in related tokens and derivatives, such as Three Arrows Capital, ended up going bankrupt, which led to the failure of other companies, such as Voyager Digital, which gave Three Arrows a huge loan. November saw another shock: the collapse of star entrepreneur Sam Bankman-Fried’s crypto empire, including one of the largest digital asset exchanges, FTX. The platform, which played an important role in making cryptocurrencies more attractive to larger investors, had a tangled web of linked entities with poor record-keeping and poor centralized controls. The FTX collapse was still causing tremors in January when Genesis Global Holdco LLC, whose funds were stuck in FTX, filed for bankruptcy due to at least $3.4 billion in unsecured debt. The crypto lender suspended payments shortly after FTX was declared insolvent.

4. What were the consequences?

Critics have said that many crypto projects are doomed because they have relied in part on offering unsustainable returns. They likened some high-yield ventures to new forms of Ponzi schemes, financing payouts to existing investors using deposits from new ones. The implosion of FTX and the subsequent failure of Genesis highlighted the danger of contagion, in which problems in one corner of an industry spread quickly and in unexpected ways, causing huge losses elsewhere. All this could freeze investments in cryptocurrencies for a while.

5. Where does this leave the industry?

Crypto was invented after the global financial crisis of 2008, which eroded trust in traditional institutions. But a series of scandals in 2022 raises what amounts to an existential question of whether cryptocurrencies can be trusted. Many hoped that stricter regulations could restore confidence. But the FTX bankruptcy seemingly derailed legislation that Bankman-Fried had lobbied hard for. It was opposed by some DeFi platform operators, who saw it as skewed towards the interests of large, centralized exchanges like FTX. Stricter regulations may ultimately make cryptocurrencies a more stable and respectable investment. What is not clear is how much of the industry can withstand the kind of scrutiny it would entail.

More stories like this are available at bloomberg.com

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