The history of cryptocurrencies has rarely been dull, but the slump of 2022 has been a wilder ride than most. Billions of dollars in holdings have been disappearing almost overnight in a series of business collapses, most notably the evaporation of the FTX crypto exchange in November.
Each left in its wake a wave of related bankruptcies. The events have eroded trust in a field that was itself created in response to a loss of faith in mainstream finance following the 2008 banking crash.
Some investors have responded to the crisis by calling for tough new regulations. Others blame the bankruptcies on the failures of crypto middlemen and say the turmoil should hasten a switch to more decentralised platforms.
1. What happened to crypto prices?
After peaking in Nov 2021, the combined market capitalisation of crypto assets fell by as much as 73 per cent in the following 12 months, according to figures from tracker CoinGecko.
That’s less than the 88 per cent collapse in the previous “crypto winter” of 2018, but it wiped out far more value: more than US$2 trillion.
Whereas earlier crypto slumps were triggered by problems within the industry itself, this one began with something external: Central banks hiking interest rates to combat a post-pandemic surge in inflation. This reduced investor appetite for assets offering high risks and high returns, including crypto.
2. What’s the significance of that?
The collapse exploded the idea that crypto enjoys a similar status to gold as a refuge in times of economic uncertainty by being decoupled from the fortunes of traditional financial assets. It was a shock to pension and sovereign wealth fund managers - and millions of small investors - who embraced crypto in recent years on the conviction that it was becoming a mainstream asset class.
It turned out that the run-up in prices of recent years was built on shaky foundations because many investors borrowed heavily to wager on digital coins and projects, often using other cryptos as collateral. That interconnectedness spread the impact of high-profile failures.
3. What blew up?
The first explosion involved a so-called algorithmic stablecoin called TerraUSD that used complex, automated operations involving a sister token, Luna, to maintain a peg to the US dollar. It became popular because a related decentralised finance (DeFi) platform called Anchor offered interest rates of up to 20 per cent for TerraUSD deposits.
Sudden withdrawals from Anchor led to a “death spiral” that wiped about US$60 billion from the value of TerraUSD and Luna. Companies that had invested in related tokens and derivatives, such as Three Arrows Capital, ended up going bankrupt, leading to the failures of other companies, such as Voyager Digital, which had given Three Arrows a massive loan.
In November, there was another shock: The implosion of star entrepreneur Sam Bankman-Fried’s crypto empire, including one of the biggest digital-asset exchanges, FTX.com. In the space of a few days, the man who had bailed out other struggling crypto ventures, and had become an unofficial ambassador for the industry at conferences and on Capitol Hill, saw his US$15.6 billion fortune evaporate.
FTX is believed to have gone under while trying to bail out trading house Alameda Research, owned by Bankman-Fried.
4. What were the consequences?
Critics of Terra said the system was doomed to fail as it relied in part on luring investors with unsustainable interest rates. Some likened Terra and other high-yielding DeFi ventures to new forms of Ponzi schemes, which showered early investors with unsustainable returns to attract new investors.
The implosion of FTX showed how even seemingly solid crypto businesses could have hidden weaknesses and underscored the dangers of contagion - in which problems in one part of the industry spread fast and in unexpected ways, triggering huge losses elsewhere. All this could freeze investment into crypto for some time.
5. What does it mean for crypto’s future?
It was invented because people didn’t trust Wall Street, but the string of scandals raises what amounts to an existential question for crypto of whether it can be trusted too. To many, the hope was that stricter regulation could restore confidence.
But the FTX bankruptcy seemingly derailed legislation that had been heavily lobbied for by Bankman-Fried. It had been opposed by some operators of DeFi platforms, who saw it as skewed toward the interests of big, centralised exchanges like FTX.
Tough regulation may eventually make crypto more stable and respectable. What is not clear is how much of the industry can withstand the added scrutiny this would entail.