Second Quarter Market Recap — VegaX Research Report

While the crypto world was riding all-time highs in 2021, something sinister was brewing below the surface. Scammers and hackers took advantage of retail and sophisticated investors alike, to the tune of $670 million. More nefariously, undercollateralized, even unsecured loans were being doled out ubiquitously, and without adequate risk management protocols. Ultimately, all good parties come to an end, and the most recent bull market in crypto is no exception.

The second quarter of 2022 was characterized by worsening macroeconomic conditions, escalations of military conflicts, and accelerated global supply chain degradations that have abruptly “stopped the music,” so to speak, and have led to a liquidity dry-up not seen in over a decade.

Make no mistake: this is not a crypto-specific liquidity crisis. It is being felt across all asset classes. The thing is, when the margin calls begin to roll in, investors sell what they can and not what they want. This aphorism represents what may be going on in the crypto ecosystem — because assets like bitcoin and ether are liquid, they are being sold off first. Coupled with the belief in traditional financial spheres that crypto assets trade at a high correlation to risk-on tech assets, there was almost no possibility that crypto assets wouldn’t be the first to be sold.

Like all Ponzi schemes, when new liquidity is entering the market, systemic imbalances can be masked. But when investors begin to pull money out, the veracity of a firm’s reserves is tested.

This piece will recap the most impactful events of Q2, 2022, specifically focusing on the daisy chain of liquidations, capitulations, and subsequent insolvencies that began a few months ago. It will begin in a somewhat chronological manner but will try to cover as much of the collateral damage as possible.

TerraUSD, Luna, and Terraform Labs

By now, readers are likely familiar with the extraordinary collapse of Terraform Labs’ stablecoin: TerraUSD. But to quickly recap: TerraUSD (UST) was a stablecoin that was algorithmically pegged to the US Dollar. This was accomplished via a mint-burn system between the stablecoin (UST) and its sister token LUNA. For every $1 of LUNA redeemed for UST, that same $1 of LUNA would be burned. Concurrently, the Anchor Protocol was offering annualized returns of roughly 20% for staking UST on its platform. Many in the crypto space warned that offering 20% APY was an unsustainable business model, but the marketing tactic was largely successful in convincing investors to stake their funds for a perceived risk-free return.

The mint-burn mechanism was successful until it wasn’t; the so-called volatility cushion token LUNA managed to reach a high of $119.18 in early April before plummeting to nearly zero a month later. As long as there was sufficient demand for the stablecoin, LUNA would have been fine, but unfortunately for Terraform Labs (and countless retail investors) confidence waned in the Anchor marketing ploy, UST depegged significantly and from there, it was a race to the bottom. It is not clear who exactly was responsible for aggressively short-selling UST during a reshuffling period on the popular stablecoin trading platform Curve, but their timing was impeccable and likely led to the collapse of the fourth largest blockchain ecosystem by market capitalization as of late April.

Caught Bag-Holding

Several high-profile firms and individuals in the industry were holding a significant amount of Terra-based assets. In the days and weeks that followed the UST/LUNA meltdown, many in the community warned that certain operators in the space may have sustained substantial losses. Those community members were onto something.

The first to fall was the borrowing/lending platform Celsius. As it turns out, Celsius’ business model was not dissimilar to a traditional Ponzi scheme — users would deposit funds for an advertised rate of return (yield), and on the backend, Celsius would rehypothecate those funds for use in highly risky operations. This included irresponsible amounts of leverage on undercollateralized wBTC and stETH positions — both of which took major hits as the prices of BTC & ETH have fallen recently. Time has run out for Celsius, as the company filed for Chapter 11 bankruptcy on July 13th.

It is not clear whether or not Celsius had exposure to the UST/LUNA fiasco — but with regard to another whale in space, we can be relatively certain of their holdings. Singapore-based crypto hedge fund Three Arrows Capital had a self-reported sizable position in the Terra ecosystem, along with a massive position in GBTC — a Greyscale bitcoin trust product meant to provide institutional-grade access to the underlying asset. In fact, before dumping their entire position, Three Arrows owned more than 6% of the total supply of GBTC.

Through their years of experience, and seemingly infallible trading operations, many in the crypto industry were enamored by the fund — they could do no wrong. So powerful was the firm’s allure, that they managed to convince a multitude of institutions to provide loans — some undercollateralized or completely unsecured. To the chagrin of their supporters, the death knell for Three Arrows Capital turned out to be their preferred trading strategy: highly leveraged bets, collateralized (if at all) by illiquid token holdings, or assets that were plummeting in value i.e. BTC, stETH and GBTC. As a matter of fact, at the height of their power, 3AC’s 38,888,888 shares of GBTC represented roughly 94 times the current daily traded volume.

The Three Arrows Capital saga is not yet over, liquidators are currently petitioning Singapore courts to recognize the company’s British Virgin Islands bankruptcy; messy, drawn-out court proceedings are on the horizon. One thing is clear, though: when this whale went belly-up, the entire market went down with it.

Crypto Contagion

Recently, the lending/borrowing platform BlockFi has been in turbulent waters. Rumors throughout the industry implicated BlockFi as having significant exposure to 3AC — but nothing material had yet surfaced. That is until the Block released an article citing sources familiar with the situation at BlockFi. Apparently, BlockFi had loaned 3AC $1 billion, collateralized with 66.6% BTC and 33.3% GBTC, worth about $1.3 billion at the time — both assets’ prices have since plummeted, drastically reducing the collateral’s value.

On July 1st, the CEO of BlockFi Zac Prince took to Twitter to announce that an updated term sheet had been signed with FTX — the exchange founded by the prolific trader Sam Bankman-Fried. The agreement would provide BlockFi with a $400 million revolving credit facility, as well as the option for FTX to acquire BlockFi at a price of $240 million, contingent on performance metrics. This news comes a week after FTX was reported as offering a $250 million emergency line of credit to BlockFi.

Mobile trading and yield app Voyager Digital has its feet close to the fire, as well. Per a CoinDesk report, the publicly traded firm has issued a default notice to crypto hedge fund Three Arrows Capital as part of its attempts to recover its loan of $673 million. Meanwhile, Blockworks reports that Alameda Research — the preeminent prop trading firm founded by Sam Bankman-Fried — has agreed to terms that would provide Voyager a roughly $500 million line of credit. On July 1st, Voyager announced via Yahoo Finance that after 2pm EST, the firm would be suspending its trading, deposits, withdrawals, and loyalty rewards. Voyager would subsequently file for Chapter 11 bankruptcy just five days later.

The vaporization of the most preeminent hedge fund illustrates that contagion in the crypto industry affects all involved, no matter how sterling their reputations. Rumors have been swirling about Genesis Trading — industry-leading trading, lending, and borrowing firm — and their potential exposure to 3AC. Shortly after 3AC’s creditors lined up to recuperate whatever losses they could, Genesis’ CEO Michael Moro took to Twitter to announce that Genesis had liquidated a ‘large client who had not met their collateral obligations’ (Three Arrows). With Genesis being the most stable lender in the space in terms of balance sheet health, the market had figured that the firm would be able to sustain the losses incurred. According to a 06/29 article from Coindesk, Genesis’ losses are estimated to be on the order of “a few hundred million dollars.”

A recent report from The Block indicates that Genesis had loaned roughly $2.36 billion to the crypto hedge fund, undercollateralized at ~80%. As mentioned earlier, the collateral that backed the loan was comprised of GBTC (Grayscale Bitcoin Trust), AVAX, and NEAR — all assets that have declined precipitously from their all-time highs. Fortunately for Genesis, as a subsidiary of the Digital Currency Group, certain liabilities and “unsecured borrows” have since been assumed by the parent company — this as an assurance that Genesis will be able to continue its standard business operations.

Three Arrows’ implosion is not solely responsible for Genesis’ losses, however. Early last week, Hong Kong-based crypto lender Babel Finance imposed a $1,500 monthly withdrawal limit on their users — citing liquidity constraints as the main catalyst for this decision. While it’s still unclear just how much exposure Genesis had to Babel, Coindesk’s report implicates the Hong Kong-based firm as adding fuel to the proverbial fire. Just one month prior, Babel raised $80 million in a Series B funding round with the firm’s valuation at $2 billion. Bear market valuations should be taken with a grain of salt, it seems.

Contagion stemming from wildly over-leveraged Three Arrows Capital is not limited to lending/borrowing firms. Danny Yuan, head trader at crypto market-making firm 8Blocks Capital, shared that his (and other firms) had engaged in a partnership with 3AC wherein 8Blocks would pay to used 3AC’s trading accounts for a fee. In doing so, the market-making firm was able to benefit from 3AC’s then sterling reputation and reduced trading fees, an important factor when considering the trading volume typically associated with market makers. Danny asserts that after having a withdrawal request ignored on 06/13, the team noticed roughly $1 million missing from their trading account. Attempts to reach anyone employed by 3AC have been categorically unsuccessful.

What Next?

Realistically, one has to imagine that there is more pain to come. Underlying liquidity constraints due to turbulent macroeconomic conditions are the primary driving forces. Add to those concerns the supply chain issues, as well as a seemingly global lack of energy grid security, and there is a potential multi-year global recession.

Two things to watch closely:

First, is the potential for widescale capitulation for large players in the bitcoin mining industry. In past cycles, miners experienced pain as a result of their assets — bitcoin and the hardware devices themselves — rapidly devaluing. Because these operations have overhead costs that must be paid in fiat currency, miner capitulation typically leads to consistent sell-pressure on bitcoin. Coindesk reports that this cycle, miners have anywhere from $2–4 billion in outstanding loans to repay. On top of that, many of these mining operations used leverage to finance their hardware devices. Which, again, are themselves devaluing in price and are by no means an easy asset to liquidate — especially not quickly.

The second thing this analyst is keeping an eye on is the United States Federal Reserve Bank’s rhetoric as it relates to quantitative tightening as a means to curb inflation. The thing is: by the head of the central bank’s own admission, the fed has basically no tools to curtail prices of food and energy — arguably the most important sectors for working-class families and individuals. It seems like a game of chicken — will the fed continue to talk tough and hike interest rates up until the point that “something big breaks?” The Fed will meet next at the July 27th FOMC meeting, and futures markets are currently pricing a 75–100bps rate increase.

Final Thoughts

It seems as though sentiment in the crypto markets could not get any more negative, and this may be true. But consider again the fact that when traders and investors need to sell assets to cover costs, they sell what they can and not what they want. Crypto markets are open 24 hours a day, 7 days a week, and 365 days a year — highly salable assets will be sold if macroeconomic conditions do not turn around. Conversely, it is likely that crypto assets will lead equities, real estate, and credit markets on the way up.

In the meantime, builders in the crypto space are continuing to build better infrastructure and products for users, and this will persist regardless of market conditions. For our team at VegaX, this period provides a unique opportunity to bolster our research and content offerings with high-quality educational pieces that we hope will be an asset for our clients going forward. We are working diligently to create investment products that best optimize for investors’ return and safety while gaining exposure to the fastest-growing asset class on the planet.

We hope you have enjoyed this Q2 2022 recap, stay tuned for more content!

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