The first crypto financial crisis

Blockchain Chronicle. No central bank for last resort liquidity, no government to recapitalize the banks. No brakes in case of falls.

Digital currencies are experiencing their first major financial crisis. The market value has been divided by three, and bitcoin has lost almost 70% of its value compared to its record high. What lessons can we learn from this crisis, which in many respects is reminiscent of the 2007-2008 crisis?

This is not the first time that the crypto universe has crashed. The last crash goes back to 2018, when the market value fell by eight from $ 800 million to $ 100 million in twelve months. Seen from this angle, the current crisis seems less dramatic, as the market value has only been divided by three, from almost $ 3,000 billion to $ 900 billion today. In absolute numbers, the destruction of value is colossal: USD 2000 billion has risen in 6 months.

Similar to the global financial crisis of 2007-2008, the first crypto-financial crisis unfolded in two phases. First, the Fed raises interest rates and the price of financial assets falls. Second, a major financial player is declining and the entire financial system is destabilized. In 2008 the big financial player is called Lehman, in 2022 it is called Terra.

Another parallel can be drawn between the two crises: deregulation or absence of regulation and financial innovation. The global financial crisis is rooted in the deregulation of the US financial system, which allows banks to offer new financial instruments through the securitization of illiquid assets such as subprime loans. The crypto-financial crisis is growing with the advent of decentralized financing (DeFi) and the creation of digital tokens. In both cases, there are significant leverage effects in the markets.

A scenario of stagflation is emerging and central banks are tightening their interest rates.

Bitcoin was the first asset to respond to the change in monetary policy. In fact, the highest price observed for a bitcoin is USD 68,789, on November 10, 2021, the same day as the figures for US inflation, which for the first time in 40 years passed on a psychological threshold of 6%. From then on, digital assets begin their decline, followed by Nasdaq technology stocks and eventually the S & P500.

In addition to the fact that US monetary tightening is spreading to other central banks, the decline in purchasing power due to inflation, the downturn in the Chinese economy caused by COVID and finally Russia’s invasion of Ukraine at the end of February are making growth prospects. while accelerating inflation. As a result, a stagflation scenario arises and central banks tighten their interest rates.

In May, the second phase of the crisis begins, the actual digital financial crisis. Terra blockchain is innovative and offers two digital currencies. The first is called LUNA and the second is an algorithmic stablecoin (UST), the price of which is linked to the US dollar. These two currencies are supposed to evolve harmoniously, like the earth and the moon, in a dynamic and delicate balance.

Just before the crisis, LUNA is the eighth currency in terms of market value and UST the tenth, making this blockchain a heavyweight of almost $ 50 billion. In early May, UST disengages from the dollar, LUNA loses its trajectory and crashes. This event corresponds to the Lehman moment in September 2008. With the fall of LUNA, the market value of digital currencies contracts with USD 900 billion.

Then it is Celsius and Babel’s turn, lending and lending platforms, that play the role of banks in this crisis. They provide financial leverage to investors. As prices fall, their balances deteriorate and become insolvent. The system freezes. Ultimately, it is the large crypto-hedge funds like Three Arrows Capital that bear the bulk of the evaporation of liquidity.

Unlike 2008, there is no central bank to provide last resort liquidity, or a government to recapitalize banks. This is one of the reasons why prices have been corrected so massively.
A common feature of financial crises is that good quality assets can now be traded at bargain prices, far below their real value. There is no reason why the digital financial crisis should be an exception to the rule. It is certainly difficult to value these assets, but there are good reasons to believe that some are attractive.

Bitcoin has not passed either the inflation test or the stability test that digital gold should have offered. Yet its technology continues to work beautifully, separating block after block like well-oiled machinery, despite the large price fluctuations of its currency.

Activity measured by block filling rate has been constant during the fall in prices. The hash rate, which measures mining activity, has fallen slightly, but is still at a very high level, very close to the highest level ever. Ultimately, Bitcoin continues to produce a block every 10 minutes, and that is what it is being asked to do.

After the global financial crisis, the financial system was regulated and the banks rebuilt, stronger. The S&P 500 has stabilized below 700 points to reach 3800 points at the time of writing this article despite a negative performance of more than 20% since the beginning of the year! If history repeats itself, digital currencies will be regulated and decentralized finance rebuilt, stronger. As for the price of bitcoin and other currencies, I will let you figure it out.

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