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The Fed's Liquidity Crunch

  If you've been paying any attention to the macro picture, it's been obvious the U.S. Federal Reserve controls the market. In an effort to combat inflation, leaders have basically withdrawn liquidity from the economy, depressing the price of risk assets. As bond yields climb, capital leaves the riskiest investments. With inflation proving not to be “transitory,” the Federal Reserve has only one option: reduce demand until people stop spending, even if this causes a recession.    A chart showing U.S. headline and core inflation rose more than forecasted in May. Source: U.S. Bureau of Labor Statistics   You read correctly. The objective of the all-powerful and all-knowing U.S. Federal Reserve is to make everyone so poor that they can’t afford to buy things, bringing supply and demand into equilibrium.   A spreadsheet illustrating the market downturn. Source: Charlie Bilello/Twitter   Cryptoassets have been hit the hardest, although risk-on growth stocks and venture capital portfolios have fallen almost as much. Customers can oftentimes now obtain more yields from bonds than they can via risky DeFi!   What does this amount to? In a free fall, assets become hyper-correlated and nearly all decline by at least 80%. The majority of altcoins are down 90%+, many crypto investors have been severely burned, and interest in key crypto themes are nearing all-time lows, again.   A chart showing consumer interest in crypto, NFTs and web3 over time.   Since peaking around November 2021, the total market capitalization of cryptoassets decreased from over $3 trillion to under $1 trillion.  

Luna Collapse

  We covered in detail the LUNA collapse last month, but it’s important to understand the catalyst to the crypto-pain cascade.    Ultimately, LUNA and UST were a $40-50 billion house of cards that, when it went to zero, took many projects and funds down with it. As the market conditions and macroeconomic backdrop worsened, concerns about UST redemptions and sustainability that were previously overlooked in a bull market began to rear their ugly head. This was also during a backdrop of a broader crypto market selloff in early May of 2022. Bitcoin dropped ~30% and LUNA token also experienced a major selloff leading up to the depegging event. With the value of LUNA falling so quickly, the incentive to swap UST to LUNA during the depegging disappeared. For example, if UST was trading at $0.90, you’d be incentivized to swap it for $1 worth of LUNA. However, with the price of LUNA falling amidst the market selloff, the incentive to hold LUNA was less, and this further contributed to the destabilization of the peg.   This led to the “death spiral” and the evaporation of tens of billions. While the implosion was swift, the contagion and ripple effects have taken longer to materialize. Below are some of the aftereffects beginning to rear their ugly heads:  

The Celsius Collapse

  Celsius, one of the major crypto lenders—controlling $12 billion in assets, halted all withdrawals, swaps, and account transfers in June. According to the official announcement, the team is "taking this move now to strengthen Celsius's ability to meet its withdrawal obligations over time."   Celsius likely became insolvent due to two main issues:  

• Celsius was exposed to the collapse of Luna by holding (perhaps up to $500 million) in $UST 
• The 6-8% APY interest that Celsius pledged to pay was most likely derived from staking rewards on the Ethereum Beacon Chain and were unable to liquidate their sizable  position due to the illiquidity in the market

  The company has been using Lido, a liquid staking platform, to generate returns for ETH-depositing consumers. In exchange, Celsius would use stETH as collateral to borrow stablecoins and create a higher income. This plan began to fail, however, as the stETH token began to vary from its 1:1 peg with ETH as a result of market participants preferring the safety and liquidity of ETH over stETH. If stETH continues to trade below its current exchange rate with ETH, a greater market selloff could occur due to Celsius's insolvency.    Competitor Nexo has made an offer to acquire Celsius' assets, while Goldman Sachs is reportedly attempting to finance $2 billion to acquire Celsius' distressed businesses.    In addition, BlockFi, another CeFi lending/yield platform, reportedly faced its own solvency concerns prior to FTX granting BlockFi a $400 million credit line. The funds will fund BlockFi depositors and avert the crypto exchange's bankruptcy. Nevertheless, the ‘bailout’ places prior investors in a dangerous position. According to BlockFi, the credit line agreement permits FTX to purchase BlockFi at a significant discount to the last valuation at up to $240 million.   A chart illustrating the impact these contagious events had on the crypto market cap. Source: 21Shares.   This will effectively eliminate all present BlockFi equity stockholders, including management and staff with stock options, as well as all equity investors from the company's past venture rounds. However, the FTX agreement was the sole alternative for emergency financing that didn’t subordinate customer assets to the rescuer. If BlockFi hadn’t partnered with FTX, its depositors would have been compensated after the new lender.   In late June, Voyager Digital sent Three Arrows Capital (3AC) a notice of default for failure to make payments on a $500+ million loan. According to a team statement, "Voyager plans to pursue recovery from 3AC and is in communication with the Company's legal counsel regarding available legal remedies."  

3 Arrows Capital Collapse

  Hedge fund 3 Arrows Capital (3AC) is likely familiar to crypto enthusiasts as they were regarded as one of the best and smartest funds in the space with $10 billion AUM at their peak. However, now they’re completely broke and details are emerging they were wildly reckless at best and downright criminal at worst. The stETH price fall discussed earlier with Celsius was also a major contributing factor to 3AC’s downfall.    3AC bet big on LUNA (blew up) and were highly leveraged on both stETH (depegged by 10%) and GBTC (trading at ~33% discount). These three negative events made 3AC force sellers of that $10 billion under management. They ended up dumping almost all of the funds in public wallets to pay off outstanding borrowing both on and off-chain.    The order of Luna, Celsius, and 3AC is an excellent illustration of how contagion spreads. Since then, the outbreak has grown more widespread.   A recap of major events in June. Source: Travis Kling/Twitter and Ikigai