For those who remain invested in cryptocurrency after 2022, my admiration goes out to you. With record-low interest rates and an abundance of monetary printing by central banks, the crypto market saw an influx of institutional and venture capital funds. This led to the development of many centralized and decentralized finance platforms, offering returns not found in traditional financial markets. However, as demand for risky assets created a self-reinforcing cycle of upward price movement in 2020-2021, monetary and fiscal tightening policies put pressure on emerging asset classes like cryptocurrency, contributing to a decline in the total market cap of cryptocurrency from $3 trillion in January 2022 to $800 million by the end of the year. Investors were intently following Federal Open Market Committee meetings and Consumer Price Index reports, much like sports enthusiasts, and sharing their thoughts and predictions. But much of 2022 was marked by the collapse of institutional players and projects, leaving many retail investors questioning what went wrong and what the future holds. Will the crypto market ultimately collapse and become worthless?
The first major crisis to hit the cryptocurrency market was the collapse of LUNA and its algorithmic stablecoin, UST, developed by Do Kwon and Terraform Labs. As demand for UST increased, the stablecoin’s peg to one US dollar was maintained by burning one dollar of LUNA for every dollar minted of UST. The Anchor protocol, which promised a 20% annual percentage yield in UST and an attractive savings account for retail investors looking to avoid crypto price volatility, created a self-reinforcing cycle that propelled LUNA’s price upward through its LUNA/UST tokenomics design. However, as Anchor’s reserves began to dwindle in May after receiving additional infusions of capital, institutions began to exit the Anchor protocol, selling UST for other non-algorithmic stablecoins and putting pressure on the peg. As the peg began to fall, one UST was redeemed by minting one dollar of LUNA, thereby creating a death spiral for both LUNA and UST, as investors lost faith in UST’s ability to maintain its peg. On May 12th alone, LUNA fell by 96%, wiping out its $40 billion market cap ecosystem overnight. Today, LUNA (now rebranded as LUNC) trades at $0.000145, down from its all-time high of $146. Do Kwon, the creator of LUNA, is reportedly evading authorities by hiding in Serbia. While the LUNA collapse sparked a mass liquidation event across the entire crypto market, retail investors soon learned that it was just the tip of the iceberg for a long and severe crypto bear market, as many institutional funds began to redeem their investments or recall their loans.
Retail investors who preferred a passive approach to cryptocurrency investing were attracted to depositing their assets with centralized finance institutions (CEFIs), such as Celsius, Blockfi, and Voyager, in exchange for high annual percentage yields (APYs). However, these customer assets were often loaned out to hedge funds like Singapore-based Three Arrows Capital (3AC), which was believed to have held approximately $18 billion at some point in 2022. 3AC had previously profited from an arbitrage trade involving the Grayscale Bitcoin Trust (GBTC), an equity-traded stock that provided institutional exposure to Bitcoin. GBTC had a significant positive premium, which helped establish 3AC’s reputation as a profitable crypto hedge fund, convincing CEFIs to give little-to-no collateralized loans to 3AC, which used those funds to leverage long positions and make large deposits into the Anchor Protocol. Following the collapse of LUNA, numerous funds began to unwind their long positions or recall their loans to 3AC, which further stressed 3AC’s margin requirements and forced it to liquidate holdings into thin-order books. Meanwhile, Celsius halted customer withdrawals, exacerbating fears of major institutional collapse and insolvency due to the loss of customer funds. This led to a second mass liquidation event as the price of Bitcoin and Ethereum fell to around $17,700 and $887, respectively. Celsius declared bankruptcy and 3AC’s collapse sparked concerns among retail investors that other CEFIs like BlockFi and Voyager also had significant exposure to 3AC liquidations, which were confirmed when each halted customer withdrawals and sought buyouts. Su Zhu and Kyle Davies, the co-founders of 3AC, initiated bankruptcy and liquidation proceedings, vacated their Singapore offices, and are rumored to be hiding in Dubai. Meanwhile, their unpaid $50 million superyacht, “Much Wow,” remains docked in Italy.
The cryptocurrency market began to recover as FTX, the second-largest crypto derivatives exchange announced plans to acquire Voyager and extend a line of credit to Blockfi. In September, Ethereum completed the largest upgrade in blockchain history, successfully moving $30 billion from a proof-of-work to a proof-of-stake blockchain without any issues. However, market confidence was shaken when a leaked balance sheet from Alameda Research, a quantitative crypto trading firm, revealed unusual amounts of FTT, a token issued by FTX. While it was known that FTX and Alameda had close ties (both were co-founded by Sam Bankman-Fried, also known as SBF), the balance sheet raised concerns that Alameda had used nearly $8 billion in FTT as collateral for rehypothecated user funds from FTX. Speculations quickly spread that Alameda had been insolvent since May, when LUNA collapsed, due to absorbing toxic flow and lenders recalling their loans to Alameda. Binance CEO Changpeng Zhao (CZ) publicly expressed concerns about FTX’s solvency and announced Binance’s intent to sell its FTT holdings, as part of its exit from FTX equity. Despite SBF’s assurances that customer withdrawals would be honored, Caroline Ellison, Alameda’s CEO, joked on Twitter that she would be happy to buy Binance’s FTT holdings for $22, fueling customer fears that Alameda was defending $22 to prevent the liquidation of their long positions. This led to a bank run of more than $5 billion in customer withdrawals in one day, due to fears that FTX was insolvent. As a result, FTT’s price collapsed and Alameda was liquidated, FTX paused customer withdrawals. SBF finally announced that Binance would be acquiring FTX, pending due diligence, but Binance decided not to proceed with the acquisition, FTX declared bankruptcy, and the price of Bitcoin fell to a new yearly low of $15,500. Recently, Gary Wang (FTX co-founder) and Caroline Ellison pleaded guilty to multiple counts, including wire fraud, commodities/securities fraud, and money laundering. They are cooperating with authorities to build a case against SBF, who is currently living with his parents after reversing his decision to oppose extradition from the Bahamas.
The bankruptcy of Alameda revealed a potential crisis for Digital Currency Group (DCG), which manages subsidiaries Grayscale (GBTC) and Genesis. Genesis was a major institutional lender that had significant exposure to this year’s black swan events, by managing a lending book to create liquidity for both GBTC and BTC. More significantly, there were speculations that prior to its collapse, 3AC and DCG had the scheme to drive up management fees for DCG and give 3AC massive leverage using borrowed funds from Genesis. As previously noted, this was profitable when GBTC traded at a premium to BTC but started to unravel when GBTC traded at a discount and LUNA collapsed. DCG was forced to use assets and raise money to buy back GBTC shares, which ultimately failed and left DCG with roughly $2 billion in debt. At the moment, it is unknown what DCG’s path forward will be if they are unable to service their debts and if they will liquidate their holdings of BTC and ETH.
Where do we go from here in the cryptocurrency market? It is likely that we are nearing the bottom, but we may see further declines with low volatility and infrequent, small increases. Many alternative coins are likely to drop another 30-50% as more tokens for seed investments are unlocked. Bitcoin and Ethereum may also fall another 15-20% as more institutional funds begin to redeem their investments or declare bankruptcy. It will likely take a decrease in inflation and a change in interest rates by the Federal Reserve for the market to recover. It is better to wait and deploy funds when there is a return of demand for risk assets, rather than trying to catch the majority of the upward move now. Until then, it is important to be cautious, keep your funds in your own custody, and make responsible investment decisions.
Quick takes:
- NFTs: Similar to alternative coins, they have decreased in value both in terms of Bitcoin and Ethereum and in US dollars. Despite this, there are exciting developments being made, such as NFT perpetual futures, lending platforms, and liquidity pools. NFTs will likely experience a resurgence, but this does not mean that previously unprofitable investments will recover.
- Gamefi: There has been little development and most tokens are considered vaporware with seed unlocks still priced multiple times higher than the current market value. The only positive development is the MAGIC token, which has seen a slight recovery after a 95% drop. It has the potential to produce entertaining web3 games, as seen with Beacon and Realms.
- DeFi: Many Ponzi schemes have deflated, and platforms with real use cases and solid tokenomics are beginning to emerge. GMX and GNS have been bright spots in the bear market due to the ability to self-custody funds while trading futures. However, trading fees and advanced orders may prevent widespread adoption. On-chain options are still in development and it will be interesting to see if they drive retail adoption in 2023. Stablecoins will likely come under regulatory scrutiny, so developments to watch include Aave and Curve stablecoins. Liquidity pools have been a persistent issue for asset management, so platforms like GammaSwap and other options protocols that address impermanent loss will be worth watching. Decentralized exchanges on Arbitrum will also be interesting to watch, once more retail funds begin to onboard Arbitrum for the next bull market. Platforms to watch include Camelot, Orbital, and Trader Joe. Institutional adoption will be key and Umami is an interesting option for risk-adjusted yields.
- L1/L2 wars: The narrative of finding an Ethereum killer has largely dissipated, and L2s have begun to create their own ecosystems. L2s are a major advantage and Arbitrum is likely to emerge as the winner in L2 DeFi, as it has captured around 50% of L2 total value locked without a native token incentive. MATIC is noteworthy as it has been the most successful in terms of retail adoption and should be monitored for long-term holdings.