The cryptocurrency market has dropped $2 trillion in value since November's mad ascent.
During crypto mania, bitcoin reached a record $69,044.77, according to data firm CoinGecko, while ether, the second digital currency by market value, registered a record price of $4,878.26.
But in just eight months, bitcoin has lost 71% of its value, while ether is down 77%. Other alt-coins are down 60% to 90%.
Investors are avoiding cryptocurrencies as they avoid risk. That's because they fear a recession as interest rates have jumped in the fight against inflation.
But the crypto industry also suffers from internal problems. Indeed, for the first time, the sector is experiencing a liquidity crisis, hurting both small players and established firms.
What's Going On Right Now?
To simplify things, imagine that you want to buy a house. You go to a bank and ask for a loan. The bank asks you to put up collateral for the loan. You put up as collateral an apartment you own in a city with high real estate prices.
But you then take out a second mortgage from another bank and use the same apartment as collateral. The second bank has no way to check whether you already have another mortgage on the property.
You then go to a third bank and repeat the same thing -- then a fourth bank and possibly a fifth. You end up with five mortgages taken out with five different banks, based on the same collateral.
A few months later, real estate prices in the city where your apartment is located drop sharply, which means the value of your collateral has plummeted. But the balances on your different loans remain the same. So you can't make your monthly payments when they come due, and you default.
In the meantime, fears of recession push the customers of the banks that have lent you money to claim their deposits from the banks.
Since you defaulted, the banks liquidate your collateral -- the apartment. Five banks are fighting over the collateral, and as real estate prices have fallen, your apartment has lost a lot of value. And the banks find themselves without cash on hand to satisfy their customers' withdrawal requests.
Now, let's apply this to the crypto industry. Change the borrower to hedge fund Three Arrows Capital or 3AC. And the banks to Voyager Digital, Babel Finance, BlockFi and Celsius Network, which are top-tier crypto lenders.
And keep in mind: Unlike the traditional banking sector, the crypto sector is unregulated and does not have a federal liquidity backstop.
That's the current situation.
More Pain Ahead
3AC is a Singapore-based hedge fund that had exposure of more than $200 million to the Luna coin. Luna and its sister coin, UST, collapsed in May, wiping out at least $55 billion of value. As a result, 3AC missed margin calls, meaning it couldn't come up with what it owed to its lenders.
"Three Arrows Capital: you can think of it as sort of the Archegos Capital moment because you have this large entity that had borrowed from a lot of people who were not aware that everybody else was lending to it," says Stan Miroshnik, partner and co-founder of 10T Fund, a private equity firm that invests in digital assets.
"That has caused sort of illiquidity because a lot of people had their collateral or their tokens hypothecated to 3AC or effectively stuck there.
"And that's what's causing a cascade through the industry because one group is unable to retrieve their cryptocurrency assets, whether it's bitcoin, ethereum or other, resulting in turn, in being unable to repay, its own liabilities, where they've also often borrowed this coin from somebody else."
Miroshnik adds:
"So you have these as kind of a daisy chain of rehypothecation, where one institution led to another and that institution led to another and that institution led to 3AC. And those coins are not coming back down the chain until they come out of whatever restructuring process takes place, and so you have illiquidity among all these people."
3AC was forced by a court in the British Virgin Islands to enter liquidation, an source told TheStreet on June 29.
Voyager Digital has just filed under the bankruptcy laws, Celsius is exploring its options, while BlockFi has just been bailed out by cryptocurrency exchange FTX.com. Many other lenders have suspended withdrawals.
"There's probably more cockroaches to come out," says Mike Boroughs, the head portfolio manager for the Fortis Digital Asset Fund.
"It's hard to say exactly which ones are going to potentially blow up. But it's often the ones that are not doing a great job of risk management and don't have a great process in place for how they're allocating the assets that they do have."
