The shock waves from the cryptocurrency downturn in recent weeks have yet to impact the wider financial markets. But the contagion that has gripped crypto and its various decentralised finance (DeFI) platforms is of major concern to investors in Asia.
A mainland Chinese family investor, speaking anonymously, told AsianInvestor: “There’s a high correlation with the fears in the public markets; particularly US, European, and Asian equities. I didn’t expect this correction to happen so quickly. I knew crypto was going to come down a bit, but this is pretty shocking.”
Since the collapse of the Terra/Luna platform in May, the contagion has already taken down the value of the top 20 cryptocurrencies by 70% from their highs. Investor withdrawal pressure is putting a liquidity squeeze on crypto exchanges and there is growing number of class-action lawsuits from furious investors in the US.
Contagion in the crypto space would not, at this point, have much effect on the wider financial markets, according to Standard & Poor’s. At the time of the Terra/Luna collapse, S&P Global Ratings said the event would not have a material impact on traditional financial markets or the macroeconomy: “These assets are not yet systemically important. This is primarily due to the relatively small size of this emerging ecosystem, and its limited interconnectedness with traditional finance."
The total value of crypto assets, including the instruments known as stablecoins, reached a peak of close to $2.8 trillion in November 2021 — or about 5% of the US equity market capitalisation.
Last week’s shutdown of the Celsius Network, following so soon after the Terra collapse, was another major contributor to the contagion in crypto asset values.
The Celsius Network, which had $9 billion in staked assets in April 2022, appears to be close to running out of liquid funds to pay back big investors. These include its biggest backer, Alameda Research.
Singapore-based financier Edward Foo observed that Alameda was “a known concentration risk. When it comes to lending, there are usually models used for VAR (value at risk) and to prevent a collapse due to a bank run or massive redemption events.”
The bigger concern, he said, is that Celsius appears unable to manage risks internally. “I do wonder why they didn't gate redemptions earlier. Being unregulated means they can do whatever they deem necessary, right?”
The gating of withdrawals by Celsius is just the tip of an iceberg. “[This is] phase two of the crypto winter," said Foo. "But it is by no means a Lehman Brothers/Bear Stearns moment — yet."
The unregulated nature of the crypto space is now being laid bare. It has emerged, from statements by South Korean prosecutors, that the wallet generating the transaction that caused the Terra collapse was maintained by founder Do Kwon’s Terraform Labs. The Seoul Police are now investigating allegations of embezzlement of Terra's $3.5 billion in Bitcoin holdings.
“If this turns out to be true, the big question is why?” said Foo. “Did someone already know Luna was not working? Or was this an engineered collapse and if so, to what end?”
NO END IN SIGHT
The full extent of the contagion is yet to play out. Cuts are being made at leading crypto finance firms. The crypto lender BlockFi, backed by Peter Thiel, announced last week it is cutting 20% of its 850-strong workforce. Crypto.com has cut 260 workers and Gemini recently cut 10% of its staff.
Meanwhile, Binance.US, the sister company of cryptocurrency exchange Binance, is facing a class-action lawsuit from investors in California for allegedly fraudulent selling of Terra products.
Observers say it is too early to say how severe the crypto contagion will be. But the opaque nature of ownership and therefore credit-worthiness, means there is a very high chance that it will escalate.
Central to this play-out is the business of DeFi lending and the pro-cyclicality that occurs when the amount of lending provided (by the likes of Celsius) is weighed against the anonymous wallets of borrowers, driven largely by the mark-to-market value of crypto collateral posted, instead of the actual credit worthiness of the borrower.
In a bull market, as the value of the underlying crypto collateral rises, collaterisation ratios fall, borrowing limits naturally ease up, and lending volume expands. In a bear market, as the price of crypto assets fall, collaterisation ratios rise and margin calls and forced liquidations occur. The downward spiral continues.
But, in DeFi lending there is also an occurrence known as the collateral chain, which involves a borrower pledging crypto assets to a lending platform, which applies a margin to the collateral base and extends a lending facility, usually in the form of stablecoins, to the borrower.
The borrower in turn takes the stablecoins and pledges them as collateral to another platform, to borrow another crypto asset. And this may go on for several layers.
Because of this collateral chain, various parts of the DeFi market are inevitably linked. A shock to one part of the system will send shockwaves through the entire system.
"So, to answer the question 'are we at serious contagion risk levels in crypto', my answer is no, not just yet,” Foo said. “But I can say that all things considered, it is not a good situation and caution and prudence must be the order of the day. Regulations can help."