Is the cryptocurrency sector facing its own Lehman Brothers moment?

Cryptocurrency collateral that seemed valuable enough to support loans one day became deeply discounted or illiquid, putting the fates of a previously invincible hedge fund and several high-profile lenders in doubt.

The seeds of the meltdown — greed, overuse of leverage, a dogmatic belief in “numbers go up” — are not new.

They’ve been present when just about every other asset bubble popped. In cryptocurrencies, though, and particularly at this very moment, they are landing in a new and still largely unregulated industry all at once, with boundaries blurred and failsafes weakened by a conviction that everyone involved could get rich together.

Cryptocurrencies have gone through several major drops in its history — known by its cognoscenti as “crypto winters” and to the rest of finance as a bear market — but the market’s expansion and increasing adoption from Main Street to Wall Street means more is at stake now.

Kim Kardashian hawking a cryptocurrency that tanked shortly afterwards is one thing, but Fidelity’s plans to offer Bitcoin in 401(k)s could affect an entire generation.

Its growth has also made this year’s turbulence that much stronger: after the sector’s last two-year hibernation ended in 2020, the sector spiked to around $3 trillion in total assets last November, before plunging to less than $1tn.

“It’s got a different flavour this time,” says Jason Urban, co-head of trading at Galaxy Digital Holdings.

Galaxy, the $2 billion digital-asset brokerage founded by billionaire Mike Novogratz, benefited immensely from cryptocurrencies’ rise — but was also one of the industry’s most prominent investors in the Terra experiment.

If Terra was this crypto winter’s Bear Stearns, many fear that the Lehman Brothers moment is just around the corner.

Just as the inability of lenders to meet margin calls was an early warning in the 2008 financial crisis, cryptocurrencies this month had their equivalent: Celsius Network, Babel Finance and Three Arrows Capital all revealed major troubles as digital asset prices plunged, triggering a liquidity crunch that stems from the industry’s interdependence.

“In 2022, the downturn looks far more like a traditional financial deleveraging,” says Lex Sokolin, global FinTech co-head at ConsenSys.

“All the words that people use, like ‘a run on the bank’ or ‘insolvent’, are the same that you would apply to a functioning but overheated traditional financial sector. Consumer confidence and perception of bad actors definitely played a role in both cases, but what is happening now is about money moving out of deployed, functional systems due to over-leverage and poor risk-taking.”

In bullish periods, leverage is a way for investors to make bigger profits with less cash, but when the market tanks, those positions quickly unwind. And because it’s cryptocurrencies, such bets usually involve more than one kind of asset — making contagion across the market more likely to occur.

Cryptocurrency loans — particularly those in decentralised-finance apps that dispense with intermediaries like banks — often require borrowers to put up more collateral than the loan is worth, given the risk of accepting such assets.

But when market prices sour, loans that were once over-collateralised become suddenly at risk of liquidation — a process that often happens automatically in DeFi and has been exacerbated by the rise of traders and bots hunting for ways to make a quick buck.

The rise of cryptocurrency prices last year was likely to have been fuelled by leveraged speculation, perhaps more so than in the previous crypto winter, says John Griffin, a finance professor at University of Texas at Austin.

An environment of rock-bottom rates and ultra-accommodative monetary policy helped set the stage.

“With interest rates rising, as well as lack of trust in leveraged platforms, this deleveraging cycle has the effect of unwinding these prices much more rapidly than they rose,” he says.

While traditional markets often rely on a slow and steady amount of leverage to grow, that effect is seemingly amplified in cryptocurrencies because of how speculation concentrates in the sector.

Regulators are circling the sector, watching for signs of instability that might threaten their infant plans to rein in cryptocurrencies. Even rules that were announced in spring have had to change after Terra’s collapse, with some jurisdictions preparing rules to ease the systemic impact of failed stablecoin systems.

Any further cryptocurrency failures could ultimately pave the way for tougher rules, making a market rebound soon less likely.

On Tuesday, Bitcoin slumped along with much of the rest of the cryptocurrency market, declining about 2.02 per cent to $20,768.39 as of 9.45am in the UAE. The world’s largest token is down about 35 per cent this month alone.

“There may be some bear rallies, but I don’t see a catalyst to reverse the cycle anytime soon,” Mr Griffin says.

“When the Nasdaq bubble burst, our research found that the smart investors got out first and sold as prices went down, whereas individuals bought all the way down and continually lost money. I hope history doesn’t repeat itself, but it often does.”

With capital of around $1tn, the cryptocurrency market is only marginally above the approximately $830bn mark it reached in early 2018 before the last winter set in, spurring a downdraft that sent the market to as low as about $100bn at its depths, according to CoinMarketCap data.

Then, digital assets were the playground of dedicated retail investors and a select number of cryptocurrency-focused funds.

This time around, the sector has built a broader appeal to both “mom and pop” investors and hedge fund titans alike, causing regulators to frequently intervene with statements warning consumers of the risk of trading such assets.

As one infamous (now banned) advert on London’s transport network read in late 2020: “If you’re seeing Bitcoin on a bus, it’s time to buy.”

Unlike cryptocurrency’s early believers, mass adoption means most investors now view them as just another asset class and treat them in much the same way as the rest of their portfolio. That makes cryptocurrency prices more correlated to everything else, like technology stocks.

Unfortunately, that doesn’t make most cryptocurrency bets any less complex to understand.

Although most of the financial world is taking a beating in 2022, the recent cryptocurrency market crash was amplified by its experimental and speculative nature, wiping out small-town traders who stuck their life savings in untested projects like Terra with little recourse.

And the sector’s hype machine is blaring louder than ever, utilising tools like Twitter and Reddit that have been strengthened by new generations of cryptocurrency acolytes. Exchanges have also done their part, with FTX, Binance and Crypto.com all spending on marketing and high-profile sponsorships.

That extreme level of risk demonstrates exactly why cryptocurrencies are not for everyone, says Sina Meier, managing director at crypto fund manager 21Shares.