The 2022 Crypto Credit Crisis Explained
A sordid tale of how a few greedy players screwed millions of retail investors
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The global crypto market has lost $1.2 trillion dollars since April 2022 and multiple crypto companies are facing bankruptcy.
Just WTF happened?
Yes, inflation is at a 40-year high and the stock market has also declined. But this isn’t a post about macroeconomics. No, I want to write about how a few greedy players screwed millions of retail investors.
Let’s explain like I’m five:
Terra UST and LUNA’s $59 billion collapse
Three Arrows Capital’s downfall from $10B to bankruptcy
Celsius’ decline from $20B to freezing customer withdrawals
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Terra UST and LUNA’s $59 billion collapse
Terra is a blockchain protocol led by Do Kwon, a South Korean entrepreneur. The chain had two main tokens:
UST was a stablecoin pegged to the US dollar (1 UST = $1).
LUNA was a token meant to stabilize UST’s peg.
How UST and LUNA work
There are many types of stablecoins. USDC, for example, is a stablecoin that’s backed by actual US dollars in its treasury. But UST was different.
You see, UST was an “algorithmic” stablecoin that would magically maintain its $1 peg using its sister token, LUNA:
You can always redeem 1 UST for $1 in LUNA.
As a result, if UST falls below $1, you can make a profit by exchanging 1 UST for $1 in LUNA. This would eventually bring UST’s price back up to $1.
To get people to invest in UST and LUNA, Terra heavily promoted Anchor, a “savings” protocol that offered 20% APY.
Of course, all of this falls apart if you just ask a few questions:
Where does UST and LUNA’s value come from?
Who would borrow money at 20% APY?
Some people did ask these questions only to get mocked by Do Kwon for being poor:
Behind the scenes, Do knew that UST could depeg if demand dried up. That’s why he raised $1B Bitcoin in early 2022 to back the price of UST. Many institutional investors participated in this fundraise, exchanging real money for large amounts of LUNA.
UST and LUNA’s collapse
The chickens came home to roost in May 2022:
UST depegged and its price dropped 95% from $1 to less than 5 cents in a few days. Terra tried to maintain the peg by printing more LUNA and using its bitcoin reserve. But the death spiral continued until both UST and LUNA became worthless. $59B evaporated into thin air over a few weeks, including $18B from UST "stablecoin."
This was just the beginning, however:
How Three Arrows Capital went from $10B to bankruptcy
Three Arrows Capital (3AC) is a crypto fund led by Zhu Su and Kyle Davies. At its peak, 3AC had $10B+ in assets under management. Its investments include a “who’s who” list of leading blockchains and DeFi protocols:
All this success made 3AC cocky. The fund started borrowing money from lenders and investors based on its reputation alone instead of putting up any collateral. Like Do Kwon, Zhu Su had incredible confidence that crypto was going to the moon:
From 2021 onwards, 3AC made three terrible bets:
3AC bought $200M+ in LUNA to fund Terra’s bitcoin reserve. This investment went to $0 after UST / LUNA’s collapse.
3AC invested heavily in stETH, which we’ll cover in the Celsius section below.
3AC was the largest shareholder of GBTC which suffered a massive loss.
Let’s dive into #3 in more detail.
What is GBTC?
Grayscale Bitcoin Trust (GBTC) is a publicly-traded security that’s meant to track the price of Bitcoin. Basically, GBTC bought a lot of Bitcoin and issued shares that reflected the net asset value of its treasury. Here’s some more history:
For years, GBTC shares traded at a premium to Bitcoin’s price due to demand from institutional investors who couldn’t hold Bitcoin directly.
In 2021, Canadian regulators approved several Bitcoin ETFs that more closely tracked the price of Bitcoin vs. GBTC. Institutional investors sold their GBTC shares to buy these ETFs.
GBTC’s started trading at a discount to its net asset value instead of at a premium. To reverse this, GBTC asked the SEC to list it as a Bitcoin ETF too.
Zhu thought this was a massive arbitrage opportunity. 3AC could buy GBTC shares at a discount and make a profit when the price went up after the ETF got approved:
But the SEC still hasn’t approved GBTC as an ETF as of this writing. Meanwhile, GBTC’s price vs. its net asset value kept declining (now at -30% as of July 2022). 3AC was eventually forced to close their GBTC position at a massive loss.
When the overall crypto market soured, lenders started asking 3AC for their money back. For example, 3AC borrowed 15,250 in Bitcoin and $350M in USDC from Voyager, a leading crypto lender. However, due to its terrible investments in LUNA, GBTC, and God knows what else, 3AC no longer had money to repay its loans.
The firm had no choice but to declare bankruptcy. Su Zhu and Kyle Davies’ whereabouts are currently unknown.
How Celsius and other crypto lending firms froze $20B in customer assets
Celsius is a crypto lending company led by Alex Mashinsky. At its peak, the company had $20B in assets under management from 1.7M customers. Many of these customers were retail investors attracted to the 10%+ APYs that Celsius offered on stablecoins. After all, why wouldn’t you want to earn 10x the yield of your local bank from a platform that has “ military-grade security and next-level transparency”?
Of course, the real question is:
Just wtf was Celsius doing with people’s deposits to return 10%+ APY?
Let’s look at one of Celsius’ biggest plays - a $400M investment in stETH.
What is stETH?
stETH, or “staked ETH,” represents a unit of ether that’s been deposited on Ethereum’s new proof of stake beacon chain. Let me explain:
Ethereum is in the process of upgrading from proof of work (the main blockchain) to proof of stake (the beacon chain).
You can stake your ETH through Lido Finance and get stETH in return. In the process, you can earn 4% APY.
The catch is: You cannot officially redeem your stETH for ETH until 6-12 months after Ethereum upgrades to proof of stake (2023+).
There is one out: You can swap your stETH for ETH using a liquidity pool. A liquidity pool is a basket of ETH and stETH tokens that help facilitate token swaps (see this article on How to provide liquidity?).
So here’s what happened:
Celsius put $400M+ into stETH expecting the crypto bull market to continue.
The bear market arrived and stETH investors became antsy. Many of them started swapping their stETH for ETH, including 3AC and Celsius. Eventually, the liquidity pool didn’t have any ETH left, so swaps were no longer possible.
stETH price started falling relative to ETH. Celsius’ remaining stETH was dropping rapidly in value and it couldn’t swap to ETH fast enough.
At the same time, Celsius’ depositors started asking for their money back - money that Celsius didn’t have. People shared concerns, but Alex Mashinsky was defiant:
Just one day after the above tweet, Celsius announced that it was pausing withdrawals for all 1.7M customers:
A company that built its reputation on “banks are not your friends” turned out to be much riskier than a bank.
The fallout of the 2022 crypto credit crisis
So this is wtf happened:
As a retail investor, you deposited money into Celsius and other CeFi lending platforms to earn 10%+ APY.
These platforms then loaned out your money to 3AC and put it in risky assets such as UST, GBTC, and stETH to chase even higher yields.
After UST and 3AC’s collapse, CeFi platforms can no longer return your money.
This sordid series of events is due to greed and recklessness from a few key crypto players - figureheads in a space that’s supposed to be decentralized.
The silver lining is that actual decentralized finance platforms (e.g., Aave) were largely shielded from this collapse.
Unfortunately, that’s little solace for the millions of retail investors that got screwed:
Let’s conclude this rant by listing a few takeaways:
Don’t put in more than you can afford to lose - crypto is very volatile.
Do your own research and don’t invest in things you don’t understand.
Ask questions like “Where does this yield come from?”
Don’t FOMO into rapidly rising prices or crazy APYs.
For the love of God, don’t leverage.
I hope more people learn these lessons because losing your money is the worst way to onboard to this space.
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I think the moral of this story is if the founder tweets out defensive, gaslighty comments, it’s best to steer clear of their currency.
Fantastic thread Peter, great write-up on the recent events that led us here!