If 2021 was the year of ‘up only’ for crypto. This year was much more of a reality check for Web3, a serious one at that characterised by crypto contagion.
The unravelling started in May with the Luna collapse, followed by bankruptcies at other major institutions including 3AC, Celsius, BlockFi and Voyager.
As of July 2022, the the total cryptocurrency market capitalisation was effectively cut in half – down a whopping 55% since January 2022 – from US$2.2 trillion to US$1 trillion. Over the same period, benchmark index for the performance of the US stock market, the S&P 500, was down 17% over the same period, with the tech-heavy Nasdaq index down even more at 25%.
This upheaval was followed by months of unusual calm in the crypto markets. However, that ended abruptly in the first week of November when FTX spectacularly imploded. And so crypto contagion accelerated even faster.
By mid-December, the crypto markets have contracted a further 15%, bringing the total market capitalisation down to US$850 billion.
However, it is worth putting that all in perspective because as of January 2021 – the beginning of the bull run – the total crypto market capitalisation was just US$750 billion.
Therefore even with all the negative sentiment around crypto at present (and to be sure, there is a lot), the overall ecosystem is still valued higher than at the start of the bull run. See, so all is not lost.
Crypto Contagion: Rediscovering TradFi mistakes
Within the space of a short few months, crypto has endured two massive crises.
Matt Levine, the Bloomberg columnist often says that the crypto industry is re-learning lessons from TradFi, but on an accelerated timeline.
Act 1: crypto’s ‘GFC’
Building up all through the bull run and collapsing in May to June of 2022, the crypto sector has managed to replay a version of the Global Financial Crisis of 2008 (GFC), complete with excess levels of leverage and a system of opaque so-called ‘shadow banks’ – crypto lenders, but without a lender of last resort, aka the central bank.
There emerged a cohort of crypto firms like BlockFi, Voyager and Celsius with a proposition to provide a “safe” rate of return to customers who deposit their crypto assets with these companies.
Essentially these entities operated like traditional banks – they took retail deposits and lent them out to institutional clients. The difference between the interest rate charged to institutions for lending funds and that offered to retail clients for deposits represented the company’s margin.
Unlike traditional banks which would lend to clients engaged in rather ordinary activities such as real estate investing, within crypto, the ‘shadow banks’ lended to institutions engaged in much riskier activities. This included things like hedge funds, the exact opposite of ‘safe’ as they employ risky strategies to generate high returns.
But as you can see from the diagram above – the retail money was being funnelled into risky entities by a layer of shadow banks, all in the name of providing a ‘safe’ rate of return.
When the leveraged institutional investments collapsed, it was unfortunately the retail investors who were left holding the bag. One massive failure and the crypto contagion took hold and ran like the wind.
This was a massive failure of risk and credit management by the crypto ‘shadow banks’.
Earlier in the year, CNBC described the situation of one hedge fund, Three Arrows Capital (3AC), who made a ton of leveraged bets that didn’t pan out very well, saying, “[it] managed about $10 billion in assets, making it one of the most prominent crypto hedge funds in the world … the firm, also known as 3AC, is headed to bankruptcy court after the plunge in cryptocurrency prices and a particularly risky trading strategy combined to wipe out its assets and leave it unable to repay lenders”.
But unfortunately, it didn’t add there as the article notes that soon after, contagion spread: “Crypto exchange Blockchain.com reportedly faces a $270 million hit on loans to 3AC. Meanwhile, digital asset brokerage Voyager Digital filed for Chapter 11 bankruptcy protection after 3AC couldn’t pay back the roughly $670 million it had borrowed from the company. US-based crypto lenders Genesis and BlockFi, crypto derivatives platform BitMEX and crypto exchange FTX are also being hit with losses”.
This of course led many people to assume that crypto had failed, however in reality it was centralised crypto institutions (CeFi) that had actually failed. When everything was blowing up, DeFi worked as designed.
Matt Levine echoed these sentiments saying that, “The DeFi platforms mostly did fine: They had collateral, they had automatic liquidation mechanisms, they liquidated the collateral, and they got their money back. The centralised lenders did less well. It turns out a lot were less strict about demanding collateral than you might have wanted.”
If we were to think of decentralisation based on below factors:
- Transparency: Ability for anyone to see details of loans, terms, duration all on-chain.
- Permissionless: Ability for anyone to join the platform as a lender or borrower.
- Governance: Decentralised via a DAO or done more centrally by the management team.
From that, we can come up with a spectrum, illustrated below.
One can then overlay the regulatory oversight on top
TradFi institutions are not transparent or permissionless and have centralised management, however they are fully regulated – there is really strong oversight via audits, mandatory disclosures and very little room to engage in dodgy behaviour.
On the other end of the spectrum you have DeFi firms like AAVE and MakerDAO – who all managed to come out of the market meltdown unscathed. These entities do not have regulatory oversight but have high levels of transparency as all their loans can be tracked on-chain, and have automated risk management which ensures above board behaviour.
That leaves the shadow banks who operate in the grey zone. They are partially regulated and operate with very little transparency. This tends to allow all kinds of horrendous behaviour.
Act 2: Enron and Maddoff
If the mid-year crypto contagion driven by ‘shadow banks’ wasn’t enough excitement … crypto decided to do this:
FTX is (or was) a centralised cryptocurrency exchange (CEX) founded in 2019 by Sam Bankman-Fried (SBF). In January 2022, it was valued at US$32 billion.
Now its worth zero. It has filed for bankruptcy. And SBF has been arrested.
Incidentally, John J Ray III, the administrator who oversaw the investigation into the Enron fraud and who is now the CEO of FTX, said this:
FTX lost $US8 billion of client money … from compromised systems integrity and faulty regulatory oversight board, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.
He went on to say, “any FTX entities never held board meetings and the FTX group did not maintain centralised control of its cash…there were no accurate lists of bank accounts and not much attention was paid to the creditworthiness of banking partners. Ray has not been able to compile a list of who actually worked for the FTX Group”. Long story short, it was a complete shit show.
Clearly, the company failed to implement any transparency or have its balance sheet audited. It also used clients’ funds without their knowledge, and gave Alameda (its trading arm) special benefits.
Let’s call this what it was, fraud – plain and simple.
What’s happening to Web3 Australian companies?
Not surprisingly, these events have caused a massive trust deficit in the crypto ecosystem and Australian companies and investors have been caught in the cross-fire too with around 30,000 Australians impacted directly by the FTX collapse.
Furthermore, Brisbane-based cryptocurrency broker Digital Surge has gone into voluntary administration leaving its 30,000 customers high and dry. Admittedly, compared to what’s happening in the US, the fallout has been less severe in Australia.
However, the point remains that the FTX collapse had a massive global impact, spreading crypto contagion just about everywhere.
Crypto Contagion: Looking ahead
No doubt the crypto collapse and the aftermath will provide an ideal opportunity for regulators to formulate laws that would ensure investors are not caught again in a dodgy ecosystem like FTX.
Holding crypto assets in custody as a condition of an operating licence is one of the central proposals in the Digital Assets (Market Regulation) Bill 2022 proposed by Liberal Senator Andrew Bragg.
It will be interesting to see how the regulatory regime evolves in Australia and in other jurisdictions next year.
In conclusion, it is worth considering a scorecard from Bankless who attempted to capture the positive and negative social impacts of Web3.
The takeaway here is not whether or not Web3 is overwhelmingly good for the world right now, but that Web3 has incredible potential to regenerate the world if we continue to build upon Web3’s positive impact opportunities.
The underlying message is simple. The bad parts of Web3 have been very loud this year. However the underlying core technology still works and promises to provide many benefits to us all.
Hopefully 2023 is a year where the good parts of Web3 are amplified and elevated to new heights. We eagerly wait to see how next year pans out. Either way, it’s an exciting time to be alive.