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The Crypto Market is Not Immune to Contagion Risk

box of cryptocurrencies
Credit: Photo by Executium on Unsplash

The past few months have been turbulent for most market sectors, but for the crypto market especially. Part of it is a result of the crypto winter we have been experiencing, but a significant cause of it relates to a spiral of events leading to what is known as "contagion" in the crypto market.

Investors will always chase what’s hot – whether it’s non-fungible tokens, meme coins, or lending platform offering unrealistic yields on deposits -- and then immediately think “get me out!” when it’s not. The common-sense indicator never fails. This rush “to get out” can spiral into market contagion.

What is Market Contagion?

Generally, in economics, a contagion is the spread of an economic crisis from one financial institution, market, or region to another. This can occur at both a domestic or international level. Because financial markets and many financial institutions are interdependent, events in one market or institution can impact other markets or institutions.

It is usually associated with credit bubbles and financial crises and can manifest as a crash in one market which would lead to a crash in other markets. When markets are robust, this can act as a buffer against negative economic and financial shocks; when markets are fragile, it can magnify negative shocks, like in the case of the 2008 Financial Crisis, which spiraled across the global economy.

Market or financial contagions are typically associated with the diffusion of economic or financial crises throughout a market, asset class, or geographic region. A similar effect can occur with the diffusion of economic booms but the impact is much more significant in a crisis.

Contagions occur both globally and domestically, and they have become more prominent phenomena due to the following reasons: (1) the global economy has grown; (2) economies in different regions have become more connected to one another; (3) and economies have become more financialized – i.e., an increase in size and importance of a country's financial sector relative to its overall economy.

Contagion in Traditional Financial System or Banking

According to Schoenmaker (1996), the risk of contagion in financial institutions or banking is a systemic risk which can be defined as the risk that financial difficulties at one or more financial institution(s) or bank(s) may spill over to a large number of other banks or to the financial system as a whole.

We have experienced this systemic risk during the 2008 Financial Crisis. The collapse of Lehman Brothers in October of 2008 led to a major systemic risk, which spread not only throughout the financial industry but across the global economy. It was a consequence of the interdependency and interconnectivity of Lehman Brothers with other financial institutions and counterparties, and the interdependency of those institutions with other counterparties. With this type of interconnectivity, it’s enough that if one fails, it triggers a domino effect that leads to the collapse of the entire financial system.

Contagion in the Crypto Market

There was a series of events that played a major part in the downturn of not only the price of bitcoin, but the entire crypto market. This series of events was triggered by the collapse of the algorithmic stablecoin Terra (Luna) starting in early May. 75% of the total circulation of Terra was held in a lending and borrowing system called the Anchor Protocol. Holders of Terra were rewarded for depositing their coins in the Anchor Protocol with a fixed 19.8% interest rate – an unrealistic and unsustainable interest rate.

Rumors that Anchor was changing their fixed interest rates to variable ones triggered massive withdrawals of Terra. As more people decided to sell their Terra, this caused the supply of Luna to shoot up. The oversupply led both Terra and Luna to a price crash. This vaporized about $40 billion of market value and left many hopeful crypto investors empty-handed.

In addition, the Luna Foundation Guard, a consortium whose job it is to protect the peg, had about $2.3 billion in bitcoin reserves, with plans to expand that to $10 billion worth of bitcoin and other crypto assets. In an attempt to stabilize the price of Luna (and TerraUSD), the Luna Foundation liquated its bitcoin reserves, which caused a significant downturn in bitcoin price and a further bitcoin sell-off of market participants.

But it did not end with TerrraUSD and bitcoin. The contagion spread.

Shortly after Terra’s initial drop, widespread worry over the situation spread to other stablecoins. Tether, the first stablecoin ever issued (and with the largest market share among all other stablecoins), pegged to the U.S. dollar, with a 1:1 backing, fell as low as 95 cents in the wake of Terra’s collapse and continued to be below 1 dollar until end of June. It was a clear sign that crypto investors had their confidence in stablecoins shaken.

The collapse of the Terra (Luna) ecosystem harmed a lot of crypto investors. But, in fact, the bigger problem was a crypto hedge fund called Three Arrows Capital (also known as "3AC"). 3AC had no retail customers, but it borrowed money from many crypto lending platforms such as Celsius and Voyager, which provided lending services, largely backed by their customers’ deposits. 3AC made a lot of risky bets with its borrowed money. Some of the money was invested in startups, but hundreds of millions went into crypto-based investment strategies, including $200 million in Terra (Luna.) When the Terra (Luna) ecosystem crashed to zero, 3AC suffered heavy losses and could not repay its creditors.

"The Terra (Luna) situation caught us very much off guard," 3AC co-founder Kyle Davies told The Wall Street Journal. Top lending firms such as digital asset broker Genesis and crypto exchange BlockFi reacted by liquidating $400 million of 3AC's loans. 3AC's liquidity crisis spread to their lending counterparties, like Celsius and Voyager.

Since 3AC was not able to pay its creditors, Celsius and Voyager didn't have enough liquidity to serve their customers - thus they froze withdrawals. Voyager went a step further and froze all trading. Both Voyager and Celsius have filed for Chapter 11 bankruptcy, and customers with assets with those companies are stuck in limbo.

While Celsius and Voyager have received most of the attention, they weren't the only crypto companies hit by the 3AC breakdown. A court in the British Virgin Islands ordered 3AC into liquidation at the end of June, so its fate is sealed. A few days later 3AC filed for Chapter 15 bankruptcy in New York.

The impact is global, and here are some of the companies that are affected, either directly or indirectly:

  • Blockchain.com: Crypto exchange Blockchain.com has announced it could lose as much as $270 million as a result of its exposure to 3AC, although CEO Peter Smith said in a shareholder letter that "customers will not be impacted."
  • Genesis: Its role as major 3AC creditor means Genesis potentially faces hundreds of millions of dollars in losses.
  • Babel Finance: Hong Kong-based crypto lender froze withdrawals on June 17 due to "unusual liquidity pressures." Babel was recently reported to have hired restructuring specialist Houlihan Lokey to help determine its next steps.
  • CoinFLEX: A crypto futures exchange, CoinFLEX halted withdrawals on June 24 because of "extreme market conditions." The company is trying to fix a $47 million hole in its balance sheet by issuing a new token that offers a 20% interest rate.
  • 8 Blocks Capital: Hong Kong-based 8 Blocks is a crypto trading firm. In May it accused 3AC of improperly taking $1 million to answer their margin calls, then "ghosting" 8 Blocks when it repeatedly tried to contact 3AC for an explanation.
  • FinBlox: A crypto staking platform that had loaned an undisclosed sum to 3AC. The company temporarily imposed a $1,500 monthly limit on withdrawals on June 16, and in early July, FinBlox raised the limit to $3,000 as it worked to undo the damage and return to normal operations.
  • Deribit: The derivatives exchange Deribit reported in court filings that 3AC had failed to repay a loan of $80 million.
  • Vauld: Singapore-based crypto lending platform froze customer accounts on July 4. Recently, crypto lender Nexo has signed a term sheet to acquire the troubled firm.

Could the Contagion in the Crypto Market Spread to Traditional Financial Markets?

From Brussels to Washington, financial watchdogs are downplaying the risk of the turmoil spilling over to traditional financial markets and say their own actions have shielded banks from the crypto slide.

“This contagion has not spread to the traditional banking and financial sector,” Acting Comptroller of the U.S. Currency Michael Hsu told the Financial Times. “This is due, at least in part, to federal banking regulators’ continued and intentional focus on safety, soundness, and consumer protection,” he said.

Securities and Exchange Commission (SEC) officials said that there were no signs that the crypto selloff had sparked a cash rush from investors seeking the buyback of traditional securities to cover crypto losses, although the SEC was still monitoring this activity.

“For traditional asset managers, the direct impact of selling crypto is pretty minimal,” said Anne Richards, chief executive of Fidelity International. “Bitcoin has made its way into a small number of institutional wallets, but for most groups it is still very marginal.”

Andrea Enria, the European Central Bank’s chief banking supervisor, told a European Parliament committee, on June 30, that there were “still very limited” links between crypto and banks.

According to Clifford Chance partner Jeff Berman, “Banks do not hold crypto, and they have been very careful about lending against crypto. And in fact, most crypto lending has been done by crypto specialists. Overall crypto exposure is therefore low.”

It seems that as of now, due to the minimal-to-no exposure of traditional financial institutions to crypto transactions, the current crypto contagion poses no systemic risk for traditional financial institutions or banks. Bear in mind, though, that this could change. As the crypto market grows and more traditional financial institutions participate in the crypto market, a crypto market contagion could quickly transform to a global financial systemic collapse.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Merav Ozair, PhD

Dr. Merav Ozair is a global leading expert on Web3 technologies, with a background of a data scientist and a quant strategist. She has in-depth knowledge and experience in global financial markets and their market microstructure.

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