You’re probably aware that it’s been a tough year so far for stocks and bonds. But unless you’ve been following financial news closely, you may not know that those losses pale in comparison to what’s been happening with cryptocurrencies, related hedge funds and lenders, and other crypto-adjacent platforms. 

In June, Bitcoin recorded its worst month ever — by mid-month, it had plunged 70% from its high the previous November. The Terra LUNA (LUNA) coin crashed from a high of $117 in early April to near $0 a month later. And earlier this month, crypto lending platform Celsius filed for bankruptcy after being valued at $3.5 billion in November of last year. 

What in the world happened?

In a nutshell, two things. 

First: Despite crypto fans’ (vocal) belief that it was less correlated with the markets (at least, until this year came along), and therefore less connected to the impact of wider macroeconomic events, crypto is still considered a risky asset. When the threats of economic slowdown, high inflation, and rising interest rates loom, investors tend to flee risky assets for safer ones. The riskier the asset, the faster and farther it tends to fall in a downturn. 

Second, in early May, an unidentified investor (or maybe multiple people working together) pulled off a suspicious maneuver involving the cryptocurrency LUNA that spooked investors and set off a panicked sale, which depressed crypto prices even further. (More on that in a minute.) Institutional investors that had borrowed heavily to invest in crypto were caught short, scrambling to meet additional collateral and repayment demands from their lenders, even as their holdings in crypto continued to shrink. 

History is filled with examples of why borrowing money to invest is a bad idea — in stocks, in bonds, and certainly in high-risk assets like crypto. Excessive leverage (too much borrowing to invest) has been at the root of a number of market collapses, including the global financial crisis of 2008-09. While borrowing to invest can magnify your returns when prices go up, it can quickly prove disastrous on the way down. That’s why these lessons are hardest to learn when you feel like you’re sitting on top of the world and everything is going your way.

Some background on the crypto market

Over the last few years, the crypto market fired on all cylinders. The value of the entire crypto market reached $3 trillion in November 2021, and venture capital investments in crypto and blockchain start-ups topped $33 billion in 2021, more than all prior years combined. Crypto start-ups were attracting the best and brightest college graduates away from Wall Street banks, and even investment veterans were leaving their posts for new ones at crypto firms. Crypto was prominent in Super Bowl ads and touted by A-list celebrities on Instagram. The sky seemed the limit in crypto, and some insiders thought nothing could stop it. The founder of crypto hedge fund Three Arrows Capital (3AC), which had at one point $10 billion under management, called it the “super cycle,” where nothing would crash until Bitcoin hit $2.5 million per coin. At the time of his prediction, Bitcoin was trading at about $45,000 per coin. 

But everything abruptly changed in the first week of May 2022 when LUNA dropped from $86 per coin to $0 in about one week, dragging its associated stablecoin, TerraUSD (UST), down with it. Stablecoins are cryptocurrencies pegged to some other asset, typically the US dollar. They are designed to dampen the volatility of cryptocurrency by tying their values to a more stable asset, and to trade at or near $1 at all times. 

UST’s value was pegged to the US dollar, and its price was managed by an intelligent, if complicated, computer system. Basically, any time $1 UST was minted (created), $1 of LUNA would be burned (taken out of circulation), and vice versa. Burning LUNA coins (and adding to UST) lowers supply and increases LUNA’s value; adding to LUNA’s supply (and subtracting from UST) would lower LUNA’s value. 

This worked well for about a year … until someone figured out that a big enough withdrawal of UST might crash the algorithm and cause UST to “break a buck,” dragging it below $1. This is exactly what happened. When UST fell below $1 and the computer algorithm couldn’t stabilize its value back to $1, investors panicked and withdrew from UST en masse, bringing down the value of LUNA. All told, $40 billion in value was lost in LUNA and another $18 billion in UST.

The LUNA and UST collapses happened when crypto prices were already falling, and that put a major spook in the market, causing a domino effect in the crypto ecosystem.

What do you mean, “domino effect”?

Remember the 3AC founder who called crypto a super cycle where nothing crashes? Well it turns out that 3AC was a big investor in LUNA. 3AC also borrowed billions of dollars (the exact amount is unknown) from no fewer than seven crypto lenders, using its portfolio as collateral to purchase more crypto. When LUNA became worthless, driving the rest of the crypto market lower with it, 3AC’s lenders demanded either more collateral or full repayment on all those loans. Because the fund had borrowed so much, and because its assets were not sufficient to cover the amount it borrowed, it was forced to declare bankruptcy. Two of its lenders, cryptocurrency trading platforms Voyager and Celsius, were consequently also forced into bankruptcy when its loans to 3AC defaulted. 

The fact that this all happened in such a short (not to mention already volatile) period of time tanked selling prices — so much so that June 2022 was the worst month in Bitcoin’s 13 year history, with a decline of 38%. Ether, the second largest coin, fell 47%, while smaller, riskier coins declined even more. Compare this to other June losses on stocks (8%), bonds (1%), and gold (2%). 

What’s next?

The story doesn’t end here. We don’t know what will happen next in the crypto market. The news cycle from this fallout is still developing, and we may learn of more institutions suffering losses tied to the collapse in crypto and 3AC. But what’s happened so far is an important lesson and reminder that when it comes to crypto, risk only an amount you can afford to lose. Take time to understand what you are buying, and never, ever, ever borrow money to invest in risky assets.

Disclosures