$2-trillion crypto free fall portends Lehman moment

For a generation of alienated techies, crypto’s all-for-one ethos was its biggest draw. Now panic is spreading across this universe — and that same ethos is posing what may be the biggest threat yet to its survival.

What started this year in crypto markets as a “risk-off” bout of selling fuelled by a US Federal Reserve suddenly determined to rein in excesses has exposed a web of interconnectedness that looks a little like the tangle of derivatives that brought down the global financial system in 2008. As Bitcoin slipped almost 70 per cent from its record high, a panoply of altcoins also plummeted. The collapse of the Terra ecosystem began with its algorithmic stablecoin losing its peg to the US dollar, and ended with a bank run that made $40 billion of tokens virtually worthless.

The seeds that spawned the meltdown — greed, overuse of leverage, a dogmatic belief in “number go up” — aren’t anything new. In crypto, though, and particularly at this exact moment, they are landing in a new and still largely unregulated industry all at once, with boundaries blurred and failsafes weakened by a conviction that everyone involved could get rich together.

Crypto has gone through several major drops in its history — known by its cognoscenti as “crypto winters” and to the rest of finance as a bear market — but the market’s expansion and increasing adoption from Main Street to Wall Street means more is at stake now. Kim Kardashian hawking a cryptocurrency that tanked shortly afterward is one thing, but Fidelity’s plans to offer Bitcoin in 401(k)s could impact an entire generation.

If Terra was this crypto winter’s Bear Stearns, many fear that the Lehman Brothers moment is just around the corner. “In 2022, the downturn looks far more like a traditional financial de-leveraging,” said Lex Sokolin, global fintech co-head at Consensys.

In bullish periods, leverage is a way for investors to make bigger profits with less cash, but when the market tanks, those positions quickly unwind. And because it’s crypto, such bets usually involve more than one kind of asset — making contagion across the market even more likely to occur.

John Griffin, a finance professor at University of Texas at Austin, said the rise of crypto prices last year was likely fuelled by leveraged speculation, perhaps more so than in the previous crypto winter.

“With interest rates rising as well as lack of trust in leveraged platforms, this de-leveraging cycle has the effect of unwinding these prices much more rapidly than they rose,” he said.