June was the worst month for Crypto markets ever. A huge drawdown in Bitcoin pricing, bankruptcies and scandal dominated the headlines. But there is one big bright spot, one thing within the industry that can tell us that this technology isn’t going away. To understand why this is an important marker for investors we need to go through the list of what got broken in the Crypto industry in June and why it broke.
Luna and Three Arrows Capital
Patient Zero for this entire collapse was the Terra/Luna ecosystem and its stablecoin UST. There are plenty of longer form descriptions of the collapse but the point is that when the stablecoin depegged and collapsed a large portion of the industry who had been relying on the peg ended up with a massive hole in their books.
The largest example of this was Singapore based hedge fund Three Arrows Capital (3AC) who was running a highly leveraged strategy using UST. This strategy had a significant part of the fund’s assets committed to it, but the UST collapse wasn’t enough to end the fund by itself.
3AC also had large positions in the Grayscale Bitcoin Trust (GBTC) and staked Ethereum (stETH). The Grayscale position would have paid off if the Trust had been converted to an ETF this month, allowing the huge discount on GBTC to be arbitraged away to more closely reflect the pricing of the Bitcoin held in the Trust.
GBTC was the last hope for the troubled fund, but 3AC collapsed before the SEC could even make a ruling on the ETF conversion. The stETH depeg was what really put the nail in 3AC’s coffin.
stETH is a form of Ethereum that represents tokens deposited in the Proof of Stake beacon chain. This allowed stETH holders to gain a yield while still being able to use stETH in DeFi. For a long time it traded at the same price as regular Ethereum, but in mid May prices began to diverge with stETH trading at a discount.
Unlike a stablecoin peg, there were no implicit guarantees from the company that issued stETH that the two assets would trade at parity. There was no one to defend the peg.
Despite this, most Crypto companies and funds treated the two assets as interchangeable.
In a similar way to the ETF conversion being the hope for salvation on the GBTC trade, the Ethereum merge into the Proof of Stake network was the way out for the underwater stETH trade. The merge is looking good, but it has been severely delayed from projections made in late 2021. It didn’t arrive fast enough to bail out 3AC.
3AC was by far the most prominent and dominant fund in the industry. This wasn’t some small operation, nor were they unknown. Everyone in the industry loaned funds to 3AC.
As it became clear that 3AC would not be able to close their bets on GBTC and stETH in profit, whispers of insolvency grew louder. Some counter parties even warned that 3AC had stopped communicating. The lenders that had given collateralized loans to 3AC began liquidating collateral. Those that had allowed 3AC to access credit based purely on reputation looked to the courts.
The unwind was brutal. Liquidation of collateral led to more loans going bad which led to further liquidation of collateral. Once the dust settled Celsius, Voyager, Babel Finance and scores of smaller Crypto lenders were forced to limit or block user withdrawals. Crypto prices tanked. Liquidity dried up. Retail investors who had placed their trust in these lenders to safeguard their assets suffered.
The pain is real and not to be taken lightly. Huge amounts of people lost investments in Crypto banks that they trusted.
The real take away from the collapse of Crypto lenders is a lesson in knowing your counterparty. It was always clear that these lenders were lending user funds out to Crypto hedge funds and market makers. The risk of this was not well understood and it’s now highly questionable whether the yields on offer were high enough to compensate for the risk being taken.
What was not so obvious was the concentration of risk. Now that we have seen Voyager’s books via their bankruptcy application we can see that 3AC was by far their largest counterparty, representing almost two thirds of their total loans outstanding. It’s beginning to look like none of the Crypto lenders were aware of how large each other’s 3AC exposure was, nor how much debt 3AC had accessed in total. There’s no way to soften this, concentrating that much risk on one counterparty was irresponsible and a complete failure of risk management.
This fallout will scar the industry for years.
Depositing your Crypto into a lending platform will never be seen as a low risk move again. Even the companies that weren’t affected as badly will have their operations scrutinized and questioned. Yields will need to justify the risk being taken. Especially as we come to see that Crypto deposits are no way near as safe as bank account deposits during a bankruptcy.
Opportunity out of Crisis
So once all the bankruptcies have been processed and the dust settles, what comes out the other side of this debacle?
The large signpost is that DeFi survived.
Through all of the turmoil major DeFi protocols functioned exactly as intended. Collateral was liquidated, yields adjusted, nothing broke, there was no impairment.
This bull run has been a rough growth phase for DeFi with frequent hacks and dysfunction, but the core, large protocols have performed spectacularly well considering these systems hadn’t been properly stress tested before. A big part of this resiliency was that DeFi loans on major platforms are over-collateralized. Losses are not possible from bad loans.
This era of contagion was a baptism of fire for DeFi and it passed with flying colors. We can take this knowledge with us to the next bull run. We now know that companies offering access to DeFi to customers who hand over their Crypto are risky. We can use this experience to inform our decisions moving forward. We also know that the undercollateralized DeFi lenders that will inevitably show up in the next cycle will be significantly more risky than overcollateralized lenders, meaning that much higher yields will need to be offered to compensate for that risk.
What this means for DeFi tokens is still up in the air. Most tokens do not offer a share of revenue from the protocol and will struggle to activate dividends until US Crypto regulations allow it. Until then these tokens simply offer a vote in how the protocol is governed which may or may not be valued by the market.
The thing we know for sure is that Crypto based financial systems work.
This is the proof of concept that the entire industry has been looking for and should mean that these systems will continue to be built, expanded and used once market conditions recover. A major factor in the losses from the 3AC collapse was their ability to take loans from multiple counterparties without disclosing their total debt position. This is impossible in DeFi where all positions and trades are transparent and auditable, preserved on blockchains for anyone to verify. The next cycle seems likely to involve much more on-chain finance as firms look for better ways to provide assurances of solvency.
In an increasingly low trust world, finance may move on-chain.
One Big Survivor
The main thing that survived this Crash is Bitcoin.
Not Bitcoin the asset. That obviously got smoked. Bitcoin the network.
Blocks kept getting mined. Transactions kept moving. The cold wallet under your bed kept your coins secure. The network survived this, just like it always does. Cementing the idea in another cohort of new Crypto traders that amongst all of the leverage and nonsense the core and solid innovation is Bitcoin. Everything else is built around it.
The catastrophes even overshadowed a major announcement from Jack Dorsey’s Bitcoin skunkworks built within Block (formerly known as Square). The company would be building out the Bitcoin infrastructure necessary to launch DeFi protocols based on Bitcoin.
The foundations of the next Crypto bull run are being laid in the crater of the previous run.
We’ve also seen the collapse of prominent negative narratives. “Governments will ban it”. China tried. It didn’t go so well. “It’s all frothy speculation”. Third world countries continue their adoption in the face of out of control inflation and a threatening IMF.
Using the Bitcoin network I can send value nearly instantly to anyone in the world, even if their country’s banking system has collapsed. That technology is powerful and will become increasingly useful as we see more governments collapse in what is shaping up to be a decade of turmoil.
This is the third major collapse of Crypto asset markets, but the value of the underlying technology has never been more obvious.