The three horsemen of crypto winter 2022

2022 has been the year of the crypto winter. While prices have been already falling from November 2021’s highs, a series of high-profile black swan events have added fuel to the fire, triggering even more massive sell-offs and further increasing investor panic.

Out of all negative market events, three stand out from the crowd: the Terra blockchain’s downfall in May, the bankruptcy of the crypto lender Celsius in July, and the recent collapse of the FTX digital asset exchange.

The mentioned black swan events aggravate the crypto winter with an even more significant drop in digital asset prices. 

At the same time, all three companies painted a negative image of the industry for a broader audience and substantially damaged the trust between cryptocurrency service providers and their users.

Most importantly, the cases of Terra, Celsius, and FTX highlighted some of the most crucial underlying problems the cryptocurrency industry has been facing lately. 

From unsustainable business models to a lack of oversight, we must solve these issues to restore trust in crypto and avoid causing irreparable damage to adoption.

Terra: the consequences of flawed tokenomics

As you may already know, Terra was a blockchain ecosystem that centered around its UST algorithmic stablecoin backed by an algorithm instead of any fiat or crypto reserves.

However, while UST remained stable during the bull market, this year’s crypto winter was enough to reveal the flaws in its design, which ultimately led to its fall after the removal of $250 million of liquidity triggered a huge bank run.

What made things worse is that the project used $450 million of reserves held by the Terra-backed Luna Foundation Guard (LFG) to finance the artificial and unsustainably high-interest rates (up to nearly 20% APY) for UST deposits on Anchor Protocol.

As a result, the algorithm emptied out Luna Foundation Guard’s $3.5 billion BTC pool and started minting massive amounts of the native LUNA token in an attempt to stabilize UST.

Consequently, LUNA crashed from $82.58 on May 5 to $0.000115 by May 14, wiping out $30 billion of its market cap and destroying Terra’s $20 billion DeFi TVL in the process.

Terra’s crash revealed the first crucial industry problem: unsustainable tokenomics and business models among major projects. As a result, a bear market was enough to wipe out tens of billions of dollars of market cap in just a few days.

The easiest way to prevent the crash would be to replace UST’s algorithm with direct (and transparent) fiat or crypto reserves. While USDT, DAI, USDC, and most stablecoins with direct fiat- or cryptocurrency-backing survived the bear market, algorithmic assets are simply not sustainable in the long run.

Celsius Took Too Great Risks

Celsius’ case is also a devastating one. Celsius Network was a major custodial crypto lender that – just like Terra’s Anchor – offered unsustainable interest rates on its platform for a variety of digital assets.

However, due to the bear market and increased exposure to the Terra crash in May, Celsius filed for bankruptcy in July. According to the case’s documents, the lender had $5.5 billion in liabilities, from which $4.7 billion was owed to its users.

Like in the case of Terra, a $1 billion bank run was what led to Celsius’ downfall. But it seems like customers’ mass withdrawals only shed light on the company’s underlying problems.

As numerous state regulators are currently investigating the case in the United States, the Vermont Department of Financial Regulation stated that the crypto lender’s operations resembled a Ponzi scheme. The firm reportedly financed the yields of existing investors with the deposits of new users “at least at some points in time.”

Furthermore, Celsius allegedly used at least $534 million of customer funds to execute high-risk leveraged trading strategies that resulted in $350 million in losses between August 2020 and April 2021.

Celsius’ case reveals a crucial problem of the industry: the lack of oversight of the custodial service providers’ activities. As a result, the lender was able to finance overleveraged positions and unsustainable APYs on its platform with customers’ funds without anyone’s knowledge.

With a solid regulatory framework around crypto, the lender’s bankruptcy could have been easily avoided. 

The FTX Disaster Leading to Criminal Charges

Co-founded and led by Sam Bankman-Fried, FTX was a major cryptocurrency exchange that handled billions of dollars of trading volume on its platform every day, featuring numerous sponsorship deals and investments in over 200 startups.

However, all the above practically disappeared after a CoinDesk report triggered $6 billion bank run, leading to FTX’s bankruptcy on November 11 and a $600 million hack the next day.

The report revealed that FTX used its native FTT token as collateral for loans through its sister quant-trading firm Alameda Research. News also emerged about the exchange breaking its terms with users by lending over half of its customers’ funds to Alameda, from which SBF likely received a $1 billion personal loan. This was very likely the reason why Binance, which wanted to save the exchange via an acquisition, backtracked from its deal.

Just like Celsius, this case highlights the lack of real oversight on crypto and how a centralized provider like FTX can exploit this situation. As a result, the company caused massive losses for investors and significantly damaged customer trust. Another example of why the industry needs stricter and more effective crypto regulation.

Solving Crucial Problems With Joint Initiatives

There are several important lessons to learn from the collapse of FTX, Terra, and Celsius. The first is to never leverage highly volatile assets and take on too much high-risk debt. At the same time, companies with stable business models and working risk management will prevail even during the hardest of times.

Due to the three incidents’ significant consequences, market players must act to address and solve the underlying problems to regain the trust of users, regulators, institutional clients, and other stakeholders.

For example, initiatives like Binance’s recovery fund could help minimize the impacts of recent and future major black swan events.

Furthermore, to restore user trust, I believe that we need to set up a more comprehensive and stricter set of standards CeFi and CEX services must adhere to. These can be introduced through new regulatory frameworks and also by a joint initiative of market players (e.g., Binance’s push for proof of reserves).

On the one hand, we should put increased focus on transparency, so we can assure stakeholders that our company has the reserves, working capacity, and other resources that allow us to fulfill our obligations even in such unstable times.

At the same time, we also have to offer the necessary safeguards for our customers, assuring them that our company, external business partners, and sister firms would never use their funds for investment or trading activities. Instead, clients’ money should be stored in secure wallets, preferably storing most of the assets in cold storage solutions.

In 2023, we will likely see significant developments in these fields, especially as regulators are putting more focus on crypto after the FTX case. This might increase the scrutiny around the industry, yet a more comprehensive digital asset regulatory framework will likely do more good than harm in the long run.

Of course, restoring trust in crypto will take quite some time. However, if market players are dedicated to working together to make the industry a better and safer place, adoption will eventually take off in the coming years as we tackle crucial challenges more efficiently.

Author:

Dmitry Ivanov, CMO at the crypto payments ecosystem CoinsPaid