This 'crypto winter' is far worse in digital currency history

There are parallels between today's implosion and earlier crypto crashes, but much has changed since then.

"Crypto winter" is the only thing that crypto investors can talk about right now.

This year, the value of cryptocurrencies has dropped by $2 trillion since 2021, when they were at the top of a huge rally.

Bitcoin, the largest digital coin in the world, is down 70 percent from its all-time high in November, when it was worth almost $69,000.

Because of this, many experts have warned of a long-lasting bear market called "crypto winter." Between 2017 and 2018, this happened for the last time.

But the latest crypto crash is different from those that came before it. This cycle has been marked by a series of events that have spread throughout the industry because of how they are connected and how they are run as businesses.

Between 2018 and 2022

After a sharp rise in 2017, bitcoin and other tokens fell sharply in 2018.

The market was full of so-called "initial coin offerings" at the time, where people put money into crypto projects that were popping up everywhere. However, most of these projects failed.

Clara Medalie, research director at crypto data firm Kaiko, told CNBC that the 2017 crash was mostly caused by the bursting of a hype bubble.

But the current crash started earlier this year because of big-picture economic factors like soaring inflation, which has caused the U.S. Federal Reserve and other central banks to raise interest rates. In the last cycle, these things were not present.

Bitcoin and the cryptocurrency market as a whole have been trading in a way that is very similar to how other risky assets, especially stocks, have been trading. In the second quarter of this year, Bitcoin had its worst quarter in more than a decade. During the same time, the tech-focused Nasdaq fell by more than 22%.

This sudden change in the market caught many people, from hedge funds to lenders, by surprise.

Carol Alexander, a professor of finance at Sussex University, says that big Wall Street players didn't use "highly leveraged positions" in 2017 and 2018.

There are some similarities between today's crash and crashes in the past. The biggest is that new traders who got into crypto because of promises of high returns lost a lot of money.

But since the last big bear market, a lot has changed.

So how did we get here?

Stablecoin destabilised

TerraUSD, or UST, was an algorithmic stablecoin, a type of cryptocurrency that was supposed to be worth one U.S. dollar. It worked with a complicated set of parts that were controlled by an algorithm. But UST lost its dollar peg, which caused its sister token, luna, to fail as well.

This sent shockwaves through the cryptocurrency industry and had repercussions for companies with UST exposure, especially the hedge fund Three Arrows Capital, or 3AC (more on them later).

"After a period of huge growth, everyone was surprised when the Terra blockchain and UST stablecoin went down," Medalie said.

The way leverage works

Due to the rise of centralised lending schemes and so-called "decentralised finance," or "DeFi," which is an umbrella term for financial products built on the blockchain, crypto investors built up a lot of debt.

But this cycle is different from the last one in how leverage works. Martin Green, CEO of the quant trading firm Cambrian Asset Management, says that most leverage was given to small investors in 2017 through derivatives on cryptocurrency exchanges.

When the crypto markets dropped in 2018, retail investors' positions were automatically sold on exchanges because they couldn't meet margin calls. This made the selling go even faster.

"On the other hand, the leverage that caused the forced selling in Q2 2022 had been given to crypto funds and lending institutions by regular crypto investors who were looking for a return on their money," said Green. "After 2020, yield-based DeFi and cryptocurrency "shadow banks" grew a lot."

"There was a lot of lending without collateral or with not enough collateral because credit risks and counterparty risks were not carefully looked at. When market prices went down in the second quarter of this year, margin calls forced funds, lenders, and others to sell.

A margin call is when an investor must put up more money to keep from losing money on a trade made with borrowed money.

Not being able to meet margin calls has caused more spread.

High risk, high returns

Alexander of Sussex University said that the recent chaos in crypto assets was caused by the fact that many crypto firms, including terra, had risky bets that could be "hacked."

It's worth looking at how some of these things have spread by looking at some well-known cases.

Celsius, a company that gave users returns of more than 18% for putting their crypto with the company, stopped customers from getting their money out last month. Celsius was like a bank in some ways. It would take the cryptocurrency that was deposited and lend it to other players at a high interest rate. They would use it to trade with other players. And the money Celsius made from the yield would be used to pay back investors who put money into crypto.

But when the recession happened, this way of doing business was put to the test. Celsius is still having trouble with cash flow, so it had to stop withdrawals to stop a crypto version of a bank run.

"Players looking for high returns traded fiat for crypto and used lending platforms as custodians," said Alexander. "The lending platforms then used the money they raised to make very risky investments, because how else could they pay such high interest rates?"

Contagion via 3AC

Recently, it has become clear how much crypto companies depended on loans from each other.

Three Arrows Capital, also known as 3AC, is a crypto-focused hedge fund in Singapore that has been hit hard by the market drop. 3AC had exposure to luna and lost money when UST went bankrupt (as mentioned above). Last month, the Financial Times said that 3AC did not meet a margin call from crypto lender BlockFi and had its positions sold.

Then, the hedge fund didn't pay back a loan from Voyager Digital for more than $660 million.

Because of this, 3AC went bankrupt and went into liquidation under Chapter 15 of the U.S. Bankruptcy Code.

Three Arrows Capital is known for its highly leveraged and bullish bets on crypto, which failed when the market crashed. This shows how such business models were put under the pump.

The disease spread even more.

When Voyager Digital filed for bankruptcy, the company said that it owed crypto billionaire Sam Bankman-Alameda Fried's Research $75 million and that Alameda owed Voyager $377 million.

Alameda also has a 9 percent stake in Voyager, which makes things even more complicated.

"Overall, June and the second quarter as a whole were very hard for crypto markets," said Medalie of Kaiko. "We saw the collapse of some of the biggest companies, in large part because of very bad risk management and the ripple effect of the collapse of 3AC, the biggest crypto hedge fund."

"It is now clear that almost every large centralised lender didn't manage risk well enough, which led to a contagion-like event when a single entity failed. 3AC had borrowed money from almost every lender, but after the market crashed, they couldn't pay it back. This led to a liquidity crisis and a high number of clients wanting their money back.

Is the upheaval done?

It's not clear when the market will stop being so crazy. Analysts think there will be more pain, though, as crypto companies struggle to pay off their debts and handle withdrawals from clients.

James Butterfill, the head of research at CoinShares, says that crypto exchanges and miners could be the next dominoes to fall.

"We think that this pain will spread to the already crowded exchange market," Butterfill said. "Because the market is so crowded and exchanges depend in part on economies of scale, the current situation is likely to show more casualties."

Even big players like Coinbase have been hurt by markets that are going down. Last month, Coinbase let go of 18% of its workers to save money. The number of trades on the U.S. crypto exchange has been dropping along with the prices of digital currencies.

Also, Butterfill said that crypto miners who use specialised computers to settle transactions on the blockchain could also be in trouble.

"We have also heard that miners haven't paid their electricity bills, which could be a sign of stress and could be a sign of cash flow problems," he said in a research note last week.

"This is probably why some miners are selling their holdings."

Miners have to pay a lot for their jobs, not just for the gear they use, but also for the electricity that keeps their machines running around the clock.