Crypto market crashing due to deleveraging
After the algorithmic stablecoin, Terra lost its peg to the US dollar, this was accompanied by a bank run that rendered $40 billion in tokens almost worthless. Crypto collateral valuable enough to cover loans one day became highly undervalued or illiquid, casting uncertainty on the fortunes of seemingly invincible hedge funds and other high-profile lenders.
What led to the crypto market crashing?
The seeds that spawned the crypto market crashing — greed, excessive leverage, and a delusional belief in price going up — are not new. They were there when almost every other asset bubble burst. However, crypto is a new and highly unregulated market, with boundaries blurred and failsafe weakened by the notion that everyone engaged can get wealthy together. Leveraged trades rely on borrowing, increasing the risks and profits. There are an estimated 1,900 crypto hedge funds, and the majority appear to utilize leverage to trade at bigger volumes with collateral that may not meet requirements of centralized financial regulation.
Analysis of crypto market crashing
In a December study, the Bank for International Settlements (BIS) highlighted the implications of decentralised financing's high leverage. The BIS noted that when debt decreases due to investment losses or depreciating collateral, investors are obliged to liquidate assets, exerting further downward pressure on prices. Crypto has had multiple large dips in its history, dubbed "crypto winters" by the community and a bear market by the rest of the financial industry. Still, the sector's expansion and increased acceptance from Main Street to Wall Street means more is at stake today.
Its expansion has further amplified the impact of this year's turbulence: After the expiration of the crypto market crashing in 2020, the industry peaked at $3 trillion in total assets last November before plummeting to less than $1 trillion.
If Terra led to this crypto market crashing and was the equivalent to Bear Stearns in the 2008 financial crisis, many believe that the Lehman Brothers moment is just around the corner. The failure of lenders to make margin calls was an early warning flag in the 2008 financial crisis, and crypto has experienced its counterpart this month: Celsius Network, Babel Finance, and Three Arrows Capital all disclosed severe issues when digital-asset values fell, causing a liquidity crunch that ultimately comes from the industry's interdependence.
Consumer confidence and perception of bad actors had a role in the crypto market crashing and the financial crisis, but what is occurring now is money flowing out of deployed, working systems due to over-leverage and irresponsible risk-taking."
Leverage allows investors to generate more returns with less investment during bull markets, but when the market falls, such positions swiftly unravel. Also, in crypto, such bets frequently include more than one type of asset, increasing the likelihood of a crypto market meltdown.
How Celsius contributed to the crypto market crashing
Over the last several weeks, a crypto news site has received many complaints from Celsius users. Some are concerned about losing their houses after being liquidated on millions of dollars of loans secured by the company's cratering CEL token. Celsius has been leveraging client assets to pay out 17 % APY utilising a variety of DeFi protocols, including Terra's Anchor and Ethereum mainstays Lido and Curve.
Given the danger of accepting crypto loans, particularly those via decentralised finance applications that do not use intermediaries like banks, sometimes ask borrowers to put up more collateral than the loan is worth.
Celsius began lending to human traders two years ago, managing risk by requiring collateral from these borrowers. Celsius leased financial assets to players that can profit from arbitrage, market making, or shorting specific equities or digital assets."
However, as market values fell, it led to the crypto market crashing. After Celsius started lending in the DeFi space, exposing borrowers to risky market fluctuations, whereas lending to a creditworthy institutional borrower is entirely different. The danger is not the same as relying on cryptocurrency market prices to remain stable or increase."
Loans that were previously over collateralised are now in danger of liquidation. This process is automated in DeFi, worsened by the increase of traders and bots looking for methods to make quick profits.
Views of Finance Professor on crypto market crashing
According to a finance professor, John Griffin at the University of Texas at Austin, the spike in cryptocurrency prices last year was fueled by leveraged speculation, possibly even more so since the previous crypto market crashing. A low-interest-rate environment and ultra-accommodative monetary policy helped set the scene.
With interest rates increasing and a lack of trust in leveraged platforms, the deleveraging cycle had the impact of unwinding these prices far faster than they grew, the finance professor added. Though traditional markets frequently rely on a slow and constant level of leverage to expand, the effect appears to magnify in crypto due to the concentration of speculation in the industry.
Regulators are watching the industry, looking for indications of instability that might jeopardise their fledgling ambitions to regulate cryptocurrency. Even laws proposed in the spring have changed in the aftermath of Terra's collapse, with some countries considering measures to mitigate the systemic impact of failing stablecoin systems.
He added that while there may be occasional bull rallies, he does not see the cycle reversing soon. He said that when the Nasdaq bubble burst, analysis indicated that wise investors were among the first to exit and sell when prices fell, whereas retail investors bought up and lost money.
Digital assets were the domain of affluent retail investors and a small handful of crypto-focused firms. Now, the industry has developed a greater appeal to pump-and-dump investors and hedge fund giants, prompting authorities to routinely intervene with comments warning consumers of the risks of trading such products.
After witnessing the crypto market crashing many times and broad acceptance, most investors now see crypto as another asset class and treat it like the rest of their portfolio. As a result, cryptocurrency values correlate with other asset classes, such as technology stocks.
The crypto market's experimental and speculative characteristic exacerbated the meltdown, knocking out small retail traders who put their life savings into unregulated projects like Terra which have no track record. Furthermore, the industry is overhyped by new generations of crypto cult members using social platforms like Twitter and Reddit. Exchanges have also contributed, with FTX, Binance, and Crypto.com investing in marketing and high-profile sponsorships.
Author: Emmanuel Baiden
7 years experience within the financial services sector most notably in Sales, Trading, research and writing articles within the crypto space. I have a bachelor's degree in International Business and a Master's in Investment and Risk Finance . I am also an associate member of the Chartered Institute for Securities and Investment.