Crypto financing is a speculative scam that exacerbates the instability of global capitalism

Rama Vasudevan

The pandemic gave the cryptocurrency a big boost as everyone was in lockdown mode in front of their screens. Its value shot through the roof, peaking with the Super Bowl commercials in 2022. This bull run came to an ignoble end in May of that year.

The pandemic gave the cryptocurrency a big boost as everyone was in lockdown mode in front of their screens.

It started with the collapse of paired crypto tokens called Terra Luna. You could think of this as a kind of “Minsky moment” for crypto – the moment when the bull market comes to an end after a long run. Terra was a stablecoin pegged to the Luna through algorithmic trading. This maintained his connection with the floating Luna.

There was a neat little game where Luna holders made a profit on their shares of Terra while demand for Terra was boosted by a new Terra lending platform called Anchor. This platform offered huge interest rates of around 20 percent, payable in Terra. This engine fueled its own demand in a way that seemed too good to be true.

Of course it was too good to be true. The prices were untenable. Eventually a retreat from Anchor began, leaving Terra in turmoil. Instead of maintaining its footing, Terra began to fall and the entire Terra-Luna system collapsed. By the way, Alameda, the venture arm of FTX that was part of Sam Bankman-Fried’s empire, was a large anchor depositor that pulled out early.

The waves of Terra Luna are spreading. Celsius, a crypto lender that offered high interest rates, did not have the crypto cash to pay depositors when they began withdrawing. They also had Three Arrows Capital, a crypto hedge fund that invested heavily in Terra. When asset prices fell, the fund did not have the value of the collateral it had provided.

As the response spread, one of the most important stablecoins, Tether, suffered a collapse in value – a moment equivalent to a money market fund collapse. The low point came with the spectacular crash of FTX. After Alameda initially proved to be a savior and invested money in crypto companies at the beginning of the crisis, it was revealed that he had diverted depositors’ funds from FTX to finance loans.

This unraveling reveals the fragile foundations of cryptofinance. It fell from $3 trillion to less than $1 trillion in a short period of time. What happened was very similar to the bank runs that have plagued the financial system since its inception. Traditional bank runs happen when depositors withdraw their deposits.

Crypto transactions are generally over-collateralized and the liquidation of a transaction when the value of the collateral declines is automatically forced, making them very vulnerable.

In 2008, when Lehman Brothers collapsed, a bank run of a different kind occurred. The trigger was the decline in the value of the assets that served as collateral. These assets had fueled the shadow banking system, which is based on borrowing and lending through the market rather than loans and deposits as represented by the traditional banking model. Falling collateral values ​​decimated the basis for interbank lending and credit creation. Investors began withdrawing money from money market funds and the system ground to a halt.

The crypto crash was another form of bank run in the new, unregulated world of crypto financing. Here too, collateral values ​​played a major role. This is very important because crypto transactions are pseudo-anonymous and therefore traditional forms of credit risk assessment are not possible for the borrower. Instead of risk assessment, collateral is becoming more important and plays an even greater role.

Crypto transactions are generally over-collateralized and the liquidation of a transaction when the value of the collateral declines is automatically forced, making them very vulnerable. This fragility becomes even greater as the practice of using borrowed crypto collateral as collateral for further transactions is widespread. You borrow collateral and then use it to borrow even more. This is the so-called collateral chain.

There are potentially huge returns to be made with this approach. This means that the initial collateral forms the basis for a huge mountain of debt. The crypto lending pyramid is built on the quicksand of volatile crypto collateral.

Another Achilles heel of traditional banking is the fact that there is a mismatch between your assets and your liabilities. A bank borrows in the form of short-term deposits but makes loans in the form of long-term loans. If depositors withdraw, the bank will not have the cash to repay because the loans are long-term.

Crypto is subject to the same type of discrepancy. Stablecoins like Tether have been issued in exchange for less liquid assets like commercial paper, which are used to finance short-term transactions by companies. Terra’s collapse showed that risky and volatile crypto tokens formed the basis of its lending. By the time it had to cash out, it was left with only volatile crypto tokens that had plummeted in value.

Once again we have seen that crypto financing is not very different from traditional financing. It has the same tendency towards fragility, and last year’s crash showed that.