The Great Crypto Crisis - Everything You Need To Know

What you just saw here is the great crypto crisis.

As you could clearly see, the collapse of FTX is not some isolated incident, it is part of a bigger story. A story that is all about speculation, debt, and, what economists call contagion.

And, while this story is shaking the crypto industry to its very core, the media has mostly focused on the individual scandals of people like Sam Friedman-Bank and not the bigger picture.

So, to get you up to speed, here’s everything you need to know about crypto’s great financial crisis.

Crypto’s Great Financial Crisis Started in the Summer of 2022

with the fall of crypto hedge fund three arrows capital.

It was just half a year earlier that the founders of three arrows capital, Kyle Davies and Su Zhu, were on top of the world. At a relatively young age, their fund had already made billions investing in crypto projects such as Ethereum, Luna, the Grayscale trust, and Blockfi.

No wonder that they were widely considered crypto geniuses.

Being a hedge fund, three arrows capital had mostly funded these investments with money from shareholders, including its founders. As the value of their crypto investments kept going up, so did the value of their fund.

Indeed, the founders of Three Arrows had discovered an age-old secret to quick financial success:

Leverage

Now, leverage sounds like a difficult concept. But, all that it means is that, besides having shareholders to fund your investments, you have also borrowed some money.

This practice is called leverage because, just like how a lever in real life can amplify your physical strength, leverage in finance can amplify your financial strength.

However, as mister Davies and Zhu would soon discover, leveraging your investments is a double-edged sword.

Sure, when asset prices went up, mr. Davies and Zhu looked like geniuses, receiving favorable press coverage, gaining a massive Twitter following, and being generally considered ‘the adults in the room.’ However, when crypto prices started going down, mr. Davies and Zhu quickly saw themselves becoming crypto villains instead.

Here’s how that worked:

Say that during a crypto rally, average crypto investments would double in value.

Let’s first look at a conservative non-leveraged hedge fund, let’s call it Straight Arrow Capital. When its investments doubled in value, so did the claims of the shareholders on these investments. Now compare this to a risky leveraged hedge fund, let’s call it Four Arrows Capital. Borrowing money, meant that it could invest twice as much in the market as Straight Arrow. It therefore would have made twice as much money. But, because debt claims are fixed, all of this growth now benefits the claims of the shareholders. So, while the shareholders of Straight Arrow capital doubled the value of their investment, the shareholders of Four Arrows capital almost quadrupled it.

This is the awesome power of leverage!

While the investment strategy of both funds is the same, the leaders of Four Arrow capital look like geniuses compared to their boring counterparts at Straight Arrow capital.

And this is not a new phenomena. It is exactly what happened right before the great financial crisis of 2008. I think that Steve Eisman, famous from the movie the Big short, put it really well when he said:

they thought they were making more money because it was them. But, really what was happening is that they were making more money because their institution was becoming more leveraged. And really what happened is that they mistook leverage for genius.

And, as we have seen leverage also made the founders of Three Arrow Capital look like geniuses during the good times. However, in the early summer of 2022, the good times were long gone. Crypto prices had been falling for roughly six months. Now mr. Davies and Zhu were about to discover that leverage is a multiplier of profits as well as of losses.

To understand why, let’s go back to our two hypothetical hedge funds. Let’s now say that the investment portfolio would lose half its value.

For Straight Arrow Capital, the calculation remains simple. Now, its investors lose half of their investment. However, the same price decrease has very different implications for the leveraged hedge fund. It had invested twice as much. Therefore it loses twice as much. But, since the fund will still have to repay its borrowers in full, the shareholders lose their entire investment. Leverage multiplied their losses. In this case it even means that the leveraged hedge fund, Four Arrows Capital, will go broke while Straight Arrow Capital is still standing.

For mister Davies and Zhu, the moment of reckoning came when the value of one of their biggest investments, the Luna - Terra tokens plummeted to virtually zero. At the same time, they had to take some big losses on its investment in the Grayscale Bitcoin Trust.

Now, the Greyscale losses and the Luna collapse, cost a lot of investors dearly. However, for the highly leveraged Three Arrows hedge fund, it cost them everything.

So, on July the first, they filed for bankruptcy because they couldn’t meet the lender’s demand, owing them more than 2.8 billion Dollars in unsecured claims!

Similarly to the spectacular rise and fall of Three Arrows Capital, Celsius network LLC was founded by three rising stars in the crypto world: mr. Alex Mashinsky, Daniel Leon, and Nuke Goldstein. They promised a better way of banking in which customers would receive sky high interest rates in return for depositing funds at their crypto bank. They claimed it would be even safer than regular banking. And, actually, during the crypto boom they were right. By funding high-return projects like the Three Arrows hedge fund, the founders could pay their depositors sky high returns while became fabulously wealthy and confident in the process.

Perhaps the best illustration of this confidence is this video message that Daniel Neilson posted on Twitter in 2021, addressing legendary investor Warren Buffet:

Yeah, let’s bring in the Big Shorts mr. Eisman again:

what happened is that they mistook leverage for genius.

And indeed, given that customer deposits are debt, Celsius was in fact highly leveraged. Not surprisingly, the bank quickly collapsed when its risky investments started losing value as the crypto market plunged.

But that is not where the story ended. Because as it later turns out, both the fall of Three Arrows and Celcius had already infected two other major crypto institutions: Voyager digital and Blockfi, something that economists typically refer to as

Contagion

But, before getting into that serious business, let’s talk about the sponsor of this video, Morning Brew.

Alright, back to how Voyager digital and Blockfi were the first to get infected through contagion.

But, first, I want to emphasize that in theory contagion shouldn’t affect a broker at all.

You see a broker, is typically just an intermediary between people like you and me, and an exchange, like FTX or Binance. It doesn’t borrow. It doesn’t lend. It just helps connect other people.

However, Blockfi and Voyager were more ambitious. So, besides them being a broker, they also had a little side hustle business as a bank.

Just like Celsius, they allowed customers to deposit money at sky high interest rates. At the same time, they would lend out money to trustworthy, totally not risky counterparties like, Three Arrows capital.

So, when three arrows defaulted on its loan, Voyager and Blockfi’s assets lost a ton of value, while their liabilities did not… Therefore, they were as good as bankrupt.

Economists would say that they were a victim of direct contagion, because basically any leveraged firm that lent directly to a distressed firm can potentially see their asset values drop below a crucial threshold at which it can no longer repay its own lenders.

Luckily, direct contagion can be stopped. And, this is where another golden boy genius of crypto came in, Sam Friedman-Bank, the owner of FXT, who over the summer became known for his

Great Crypto Bailout

If we visualize FTX’s bailout for BlockFi, you can see that by pouring enough money into the business, mr. Friedman-Bank basically deleveraged Blockfi, and therefore, rescued it from bankruptcy.

This meant that anyone who had lent to Blockfi, was saved. Direct contagion was stopped.

Sure, this was potentially a lossmaking investment for FTX. But, it could also quickly turn into a profit when the good times would return.

However, focusing only on the direct links between these two firms underestimates the real risk of the crisis, given that we miss out on what economists call indirect contagion.

Indirect contagion is much less talked about, because it is more abstract than direct contagion. But, that doesn’t mean that it is less important. In fact, economists from the European System Risk Board argue that indirect contagion was the key ingredient to understand the great financial crisis of 2007.

And, likewise, I argue that indirect contagion is the key ingredient if you want to understand the current great crypto crisis.

Okay, here’s how it works.

Let’s go back to our Celsius example. Unlike, three arrows, there was very limited direct contagion when Celsius collapsed. However, there was a ton of indirect contagion, via asset prices. You see, Celsius had a lot of assets such as Bitcoin, and when it got into trouble, it quickly had to sell them, driving the price of Bitcoin of down further.

And remember: the real reason that crypto’s leveraged golden boys turned from heroes to villains was that crypto prices started falling.

So, whenever, a big player fell, there was indirect contagion because they had to sell their assets. This then further decreasing asset prices, and this in turn meant that other leveraged institutions were no longer able to repay their borrowers, and so on, and so on.

And while mr. Friedman Bank stopped direct contagion, he was only able to slow down indirect contagion.

As summer turned to autumn, crypto prices kept going down.

And this ultimately led to the

Downfall of FTX

Like BlockFi and Voyager had not just acted as a broker, mr. Friedman’s exchange had not just acted as an exchange. No, it also had to run a little Celsius like banking business on the side, by accepting deposits at high interest rates, while making risky investments.

But, on top of that, FTX had also invested funds that it promised would not be invested. And, it did so by sending money to its sister company Alameda research, which was actually a hedge fund and not a research company.

And Alameda took leveraging to the next level. You see, normally a hedge fund has to post some kind of collateral to the lender to secure a loan.

Because if it cannot repay the loan, your lender then still has the collateral and does not lose too much.

Alameda however thought it was smarter than the other hedge funds. So, to guarantee its borrowing and pay a lower interest rate, it used tokens issued by FTX as collateral. And, that’s very problematic because these two companies were basically the same company.

So, it used collateral made up by it’s left hand, to insure borrowing by it’s right hand… or something like that.

Anyway, when CoinDesk informed the public about those dubious business practices, everyone tried to get their money out. So, just like Celsius and Blockfi before it, FTX and Alameda then faced a bank run. In other words, it’s wacky leverage had gotten the best of it and, it soon had to file for bankruptcy.

The crypto golden boy who embezzled customer money. The press loves a story like this.

But, I think it’s a huge distraction. Yes, it is a fraudulent play on leverage dependent on rising asset prices. But, it’s still leverage… that only works if crypto goes up.

And there are many many more companies that are in the same position. Remember Blockfi? Well, without its backer, Blockfi quickly filed for bankruptcy on November 28th. What’s more crypto lender Genesis reportedly lost 175 million in an FTX trading account.

So direct contagion is clearly back!

What’s more, FTX’s collapse was followed by big drops in all major crypto currencies.

So, indirect contagion is also clearly back!

And this is why crypto lender Genesis is now reportedly close to bankruptcy. Whereas direct contagion was manageable before, now that indirect contagion is out in full force, Genesis is now in big trouble. Which leads us to the question:

Who is Next?

Well, besides Genesis, hedge fund Grayscale is already in big trouble. It apparently did an audit of it’s reserves, in what is known as proof-of-reserves. But, it doesn’t want to share this with the public due to “security concerns.”

And that is a big deal, because it reportedly owns 3% of the World’s Bitcoin supply. Bitcoins that will have to be sold if the hedge fund goes under. What’s more, it could spark another big round of direct contagion because it’s parent company the Digital Currency Group, or DCG, owns many other companies like Genesis.

And, that is just the tip of the iceberg. Even companies that have submitted these proof-of-reserves are not in the clear. First of all, such proof-of-reserves can be manipulated by temporarily borrowing assets for the audit. But, what’s more, thanks to contagion, it could very well be that exchanges like Gemini and Binance, that have also offered deposits like Celsius, BlockFi and FTX, have enough reserves today. But, not tomorrow.

Indeed, Gemini already had to stop withdrawals for some of their programs.

And that is just the tip of the iceberg, there are also quite a few lesser known firms that are in big trouble.

And this makes sense, right. We know that so many more firms used leverage to bet on rising crypto prices. And sure, the most leveraged ones are the first to fall. But, if contagion continues, and crypto prices keep dropping, eventually ALL leveraged crypto firms will fall.

Not just the fraudulent ones like FTX.

So, crypto contagion needs be stopped. But, can it? In other words,

What’s next?

Well, let’s talk about the possibility of ending or even reversing the contagion. For this to work, the sector need another bailout. Remember how Sam Friedman-Bank was able to halt the contagion last summer. Well, now his main competitor CZ from Binance is giving it a shot. He recently announced a 2 billion dollar bailout plan for distressed crypto firms. But, given that this bailout wouldn’t even have been enough to save a single firm like Three Arrows capital, that is unlikely to stop contagion.

No, the best hope that the sector has is that the U.S. Federal Reserve will stop raising interest rates. Or even better, that it would completely reverse course and stimulate the entire financial sector.

But, yeah, that doesn’t look very likely at the moment.

But what about decentralized finance? Almost all institutions that I talked about in this video are what crypto enthusiasts refer to as centralized finance, or CeFi. These are controlled by a person or group of persons. These can go broke and cause direct contagion. Decentralized finance refers to algorithms that users can use to borrow money. Sure, fundamentally they also provided credit with the hope of rising asset prices. So, they do contribute to indirect contagion. But, since these algorithms cannot go broke, these loans can rapidly return as well.

But, in my opinion, it is most likely that crypto prices will fall by a lot more. How much more? Well, there is an economic theory that can help answer that question. If you are interested in that check out my video here about the possible end of crypto. Alternatively, if you were intrigued by the details of decentralized finance, check out this in-depth interview over here with an engineer who worked on crypto lending algorithm Liquity.