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How The Financialization of Crypto Caused Contagion

Derek Wolfe

Updated: November 29, 2022

A bitcoin shattering down
Editor’s Note:

EDITOR'S NOTE: We learned a lesson from the 2008 financial crisis (though we can’t speak for most banks): financial leverage can be deadly if not used properly. When you assume more risk than you can afford, such as in the case of trading futures contracts, you risk losing more capital than you own. But when you rely on an institution—be it an exchange, a fund, or any large financial enterprise that takes on over-leveraged positions—you assume a segment of the institution's risk burden. As FTX and BlockFi have shown us, such institutions can collapse. This is counterparty risk. And if it takes place in an unregulated market, there’s no government agency that can help you get your money back should the collapse be a direct consequence of the firm’s bad decisions and not yours alone. Read more to learn about the risks of financialization. And as a side note, be aware that one of the main reasons why central banks and other financial institutions hold physical gold and silver is that there’s no counterparty risk and no excessive leverage beyond the weight of the gold being stored in a depository. These are reasons why gold is considered a safe haven. And it would be risky not to own even a small allocation to protect your capital.

The financialization of crypto made it vulnerable to the kind of contagion we're now seeing, Axios' Felix Salmon writes.

Why it matters: The big change in crypto between 2018 and today is the introduction of large-scale lending to the sector. And with lending comes a new kind of risk — counterparty risk — that crypto still hasn't found a good way of dealing with.

The big picture: Crypto is notoriously cyclical — the price of bitcoin plunged 70% in 2011, 83% in 2013, and 84% in 2018. Those drawdowns were all relatively harmless, however, in comparison to the leverage-induced carnage being wrought during the current crypto winter.

  • Part of that is just because the amount of money at stake was much smaller back then. But another big part of it is that crypto wasn't really financialized then — there was almost zero lending, shorting, and the like.

How it works: At the heart of the crypto project is a technological feat: The ability to create digital objects that exist only in one place and can't be copied. If I send you a bitcoin, I can't send that same bitcoin to someone else.

  • As a result, if I own a bitcoin, that bitcoin can go down in value, or even be stolen, but those losses are mine alone.

State of play: Crypto lending changes the dynamic. Companies like Celsius Network and FTX — both now in bankruptcy — paid interest on crypto deposits, and lent out crypto assets to borrowers.

  • Instead of one person owning a simple asset of one coin, a depositor is owed a coin by the exchange. The borrower owns the coin, and the exchange is owed money from the borrower while also owing money to the depositor.
  • Effectively, an asset of one coin has become an asset of one coin (in the hands of the borrower) plus two liabilities of one coin (at the borrower and the exchange) plus two receivables of one coin (at the exchange and the depositor).
  • There are now three assets worth 1 bitcoin. If the actual coin is lost and the borrower defaults, then the borrower and the exchange and possibly even the depositor can all lend up losing 1 bitcoin.

What's happening: Crypto losses have rippled across companies that engaged in such borrowing and lending activity, from Luna to 3 Arrows Capital to Celsius to Voyager Digital to Alameda Research to FTX to Genesis to Gemini.

  • None of them adequately managed their counterparty risk — the risk that the trading venue you're dealing with will go bust and not be able to pay you what you're owed.
  • In traditional finance, central banks can step in to prevent such contagion. In crypto, however, there are no such macroprudential overseers.

💭 Our thought bubble, via Axios' Kate Marino: Levering crypto is the most human thing ever. Any time something’s created for a functional financial purpose — like stock, bonds, oil contracts, houses, you name it — there will always be people who engineer derivations of those things purely to make money.

The bottom line: Perhaps the leverage, and the subsequent contagion, was inevitable and foreordained.

Originally published by Axios.

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