Crypto Contagion, the Great Deleveraging, and the Macro Landscape (Part 1)

21 min readJul 4, 2022

Crypto has been hit hard with one thing after another in the last few months. Almost no one has avoided the pain. Taking a break from checking prices and Twitter can be a good idea. However, we must face the music at some point, reflect on what went wrong, and re-affirm our investment thesis for this space. In this article, we’ll rip the bandaid off and face the facts.

Bitcoin crashed from its all-time-high around $69,000 in Nov. of 2021 to the recent bottom of around $17,600 on June 18th (depending on the exchange.) That’s a 75% decline, which wasn’t supposed to happen, right? Many believed in some form of a “super-cycle” where Bitcoin would not repeat the massive drawdowns of its past cycles. Whether that’s due to widespread adoption, becoming a bigger and more mature asset, or finally earning some respect as an asset class from the deep pockets of institutions. It turns out these things can come and go, and institutions are humans too.

First, it’s important to understand how we got here and the driving forces behind this crypto crash. We will also cover everything you need to know about the current macro-environment driving all markets and how to identify the signal from the noise to better prepare. None of this is financial advice, of course.

The Great Deleveraging

Leverage, you’ve probably heard that word more in the last six months than the past five years. It really does feel like a dirty word at this point and seemingly leaves a trail of destruction in its path. Leverage, however, is not inherently good or bad. It is a tool that can foster innovation when used effectively and in moderation. The problem is when we don’t know when to stop.

Take the game Jenga as an example. You start with a sturdy structure. As you remove pieces from that structure and place them on top, you make a taller, less stable tower.

The game continues until, eventually, the foundation becomes too weak to hold up, and the whole thing comes crashing down. The only way to play the game is to keep going until something breaks. This is the game all major countries and economic powers are playing and have been playing for quite some time. It’s been played many times throughout history, and its name is the long-term debt cycle, popularized by Ray Dalio. (The video linked above is a much watch for anyone wanting to understand economics. The part about the long-term debt cycle starts at 14:30.)

The crypto markets have not evaded such practices as it stems from basic human emotions of greed and impatience. It might start with good intentions, but the incentives and game theory in a competitive environment lead to more and more leverage.

We like to think we are inventing and discovering new economic and financial systems in the crypto industry. In reality, true innovation is much more scarce than it appears. Most projects within crypto turn out to be new forms of the same old system, and, of course, there are plenty of bad actors and outright scams as well.

We don’t need to reinvent the wheel here. The traditional financial system has many aspects solved. In other words, fundamental economic truths have been proven throughout history that don’t need to be thrown out. The crypto industry should build on these basic principles and established economic laws. Innovation is often required at the base layer, especially due to the implementation of decentralization. However, approaching the development of a new financial ecosystem, like anything, is best done with humility.

The crypto ecosystem has undergone a bank panic of sorts. Due to insufficient transparency and overly risky practices, particularly around leverage, CeFi counterparties offering borrowing and lending services are dealing with the contagion effects of a few big players being liquidated.

Unlike the big banks, crypto companies aren’t too big to fail. The central bank won’t be bailing us out, and our separate financial ecosystem doesn’t have its version of a central bank either. This is what genuinely free markets look like, and it might just be one of the last places you’ll see that now rare phenomenon. The only bailouts in a capitalistic system come from the private sector. When a crypto company becomes insolvent, it either dies off, gets bailed out, or is acquired in some form by a bigger player. We must learn what a centralized crypto project looks like that is of the old system in all of its good and bad attributes yet disguised as something new.

Credit to @JackNieworld on this fantastic thread tracking the crypto contagion.

Here is a broad overview of what went down. Risk assets, in general, have become out of favour in 2022 due to tightening liquidity conditions that the Fed has orchestrated. Bitcoin and the NASDAQ both made their all-time highs in November of 2021, which was the beginning of the Fed’s pivot. The last week of November is when Fed Chairman Jerome Powell said it was time to retire the term “transitory” when discussing the U.S. inflation trends. Since then, the markets have been trying to figure out and price-in future expectations and what it will mean for the economy.

While the macro backdrop looks as ugly as ever, crypto has its own solvency issues. Leverage in the space has been washed out in dramatic fashion yet again, but the scale is much larger this time.

Crypto Contagion

The layer-1 blockchain Luna and its stablecoin UST. was the first significant player to fall. Luna reached an all-time high of $116 in April this year and had a market cap of $37 Billion. On May 6th, it began the major crash from $77 to basically zero in just six days. Such an implosion has been seen in small-cap altcoins many times, but never for something the size of luna. On top of that, the stablecoin attached at the hip to luna (UST) had a peak market cap of well over $18 billion, which is now just $600 million.

Terraform Labs raised $47 million across three ICOs in 2018 and has since raised tens of millions more from prominent crypto V.C.s. Namely Galaxy Digital, which invested 25 million dollars in Terra in early 2021.

The Terra Death Spiral Explained

The whole Luna saga is well described in this Medium article. A brief excerpt from the article:

“On Terra, 1 Dollar worth of LUNA can always be burned to mint 1 UST, and 1 UST can always be burned to mint 1 Dollar worth of LUNA. Suppose UST is trading at $1.50 or 50% above its 1 Dollar peg. If you hold LUNA, you could burn 1 Dollar worth of LUNA to mint 1.5 UST and then sell that newly minted UST for another stablecoin. The result is an instant 50% profit. The increase in UST supply, combined with the selling pressure from you and other LUNA holders, who are minting and selling UST, eventually brings UST back down to its 1 Dollar peg. The prospect of these instant profits creates buying pressure for LUNA as well.

Logically the same process applies in the other direction. For example, if UST is trading at just 50 cents or 50% below its peg, as a UST holder, you could burn 1 UST and essentially mint twice the dollar amount in LUNA and make a 2x profit assuming you immediately sell that LUNA for something else. This reduction in UST’s supply, combined with the buying pressure for UST from traders who want to make a quick profit, eventually brings UST’s peg back up to 1 Dollar. This is why UST is referred to as an algorithmic stablecoin.

Though this process of maintaining a peg sounds robust on paper, in practice, a de-pegging of UST to the downside runs the risk of something called a death spiral. As I just mentioned, when UST drops below its peg, there’s a huge incentive for traders to come in and buy that UST, burn it to mint LUNA, and sell that LUNA for an instant profit. I’ll repeat that to realize this profit, that newly minted LUNA must be immediately sold.

When the crypto market is on the rise, this process isn’t necessarily a problem because there’s a lot of speculative demand for LUNA. Any selling by UST arbitrage traders is unlikely to affect its price. However, when the crypto market is on the decline, this process becomes a problem. Because there’s not much speculative demand for LUNA, its price is decreasing. At the same time, it’s being aggressively sold by UST holders. This makes its price fall even further and causes panic among UST holders.”

Another piece of the Luna death spiral is how Terraform Labs seemed to know that UST would fail. They developed a plan in the months leading up to the crash to accumulate $10 billion worth of bitcoin to back the UST/LUNA peg. The idea is that eventually, you would have the option to redeem Bitcoin from their treasury instead of minting more LUNA. Therefore, when you wanted to exit UST, in theory, bitcoin would relieve some of the selling pressure on Luna. This would also make it a partially-backed algorithmic stablecoin.

Well, they didn’t get very far before the sharks smelled blood. They had accumulated over $3 billion worth of bitcoin when unknown large entities began to sell out of UST in mass — causing UST to lose its peg and causing further panic. TerraForm Labs tried to defend the peg by selling bitcoin into the open market, but it wasn’t enough. The bitcoin selling made the whole market even more fearful and caused more liquidations of traders.

The collapse of Terra/Luna crippled several huge entities in the crypto ecosystem. Although there was some delay before that was revealed.

Some people began calling out Celsius (a CeFi platform, not DeFi as often wrongly stated by the media), a particularly vulnerable crypto yield platform. Celsius is a company that takes depositor funds and facilitates borrowing and lending to earn a high yield that they pay out to customers. They also allocate large amounts of their customer’s assets to various DeFi protocols, many of which are risky.

This included the Anchor protocol, which paid out a 20% yield for UST depositors. This was a subsidized yield, meaning most of those returns were from the dilution of the ANC token (Anchor’s native token.) Therefore, not at all sustainable.

Celsius’ strategies were not very transparent, so many were caught off guard by how much risk they were taking and how poor the risk management seemed to have been. Although, more information will come out in time and help illuminate the truth.

After some time, the following source causing lenders trouble was the stEth-to-Eth de-pegging. It’s a derivative token backed 1:1 by ETH. Users who stake their ETH on the Lido Finance platform receive the staked derivative in return. Click here to read more on stEth.

It’s important to differentiate between an algorithmic stablecoin de-pegging like UST and a 1:1-backed derivative that can be redeemed later. This means stEth doesn’t have the same death spiral risk. Through smart contracts, owners of stEth will be able to redeem their Eth once the merge to Ethereum proof of stake (Eth 2.0) is complete. What a product like Lido is doing is pooling together users’ Eth to stake (you need 32 Eth to be able to stake currently.) They are providing liquidity to customers through the stEth token as a derivative.

Similar to how GBTC can trade at a premium or discount to the underlying BTC in custody, stEth can relative to Eth. As you can see below, it currently trades at around a 4% discount.

You can track this here.

Here is an explanation from Lyn Alden on how excessive leverage is causing problems in this scenario.

“One of the problems with DeFi is that people use it for recursive leverage. For example, they deposit ETH into a liquidity pool and get stablecoins collateralized by that ETH. Then they take those stablecoins, deposit them into a liquidity pool, get some other token collateralized by the stablecoins, deposit that other token, and so on. There are various arbitrage opportunities to get high yields from layers of rehypothecation. So there’s a lot of rehypothecation in the ecosystem in general. The same recursive thing is happening with stETH arbitrage; some big players could blow up if the stETH/ETH spread gets too wide for a continuous period. -Lyn Alden, June 12th, 2022 report.

Celsius froze customer withdrawals just later that night due to liquidity issues as the rumours of their exposure to stETH caused customers to essentially induce a bank run. Celsius held a significant amount of STETH, which they used as collateral to borrow stablecoins, similar to Lyn’s description above. This is an ongoing problem for Celsius and over a million of their depositors still have their funds locked.

The risk of further de-pegging is not that it can go to zero as Luna/UST did, but it can cause more liquidations. Forced selling will drive down the price of Eth and likely crypto as a whole in the short term, which could also lead to more dominoes falling.

The crypto contagion story doesn’t stop there. Three Arrows Capital or “3AC”, a famous crypto hedge fund with a peak of over $18 billion in assets under management, went insolvent on June 14th. They were one of the largest investors in Terra/Luna. They got caught up with the stETH-to-ETH problem. They were the second-largest holder of GBTC bitcoin trust, which has gone down even more than Bitcoin (around a 30% discount to AUM) throughout this crash.

3AC has been around since 2012. They survived a decade of volatile crypto trading. The firm had borrowed billions of dollars from multiple counterparties to invest in many altcoin/DeFi projects. They became forced sellers on several of their DeFi and CeFi loans which quickly snowballed into more cascading liquidations. Their collapse spread across the whole ecosystem, with multiple lenders facing various levels of solvency risk.

Hundreds of millions of uncovered losses hit the exchange and yield platform Voyager Digital due to its large uncollateralized loans to 3AC. Some firms, however, had collateralized loans to 3AC and ended up liquidating them.

Is the crypto contagion done?

The extent to which crypto firms survive and restrict customer withdrawals depends mainly on their risk management practices. Higher-grade ones are holding up better than lower-grade ones so far, but there is potential broad contagion risk still.

The shock and peak fear part of the crash due to leveraged liquidations, AKA forced sellers, and the sudden withdrawal of liquidity has halted for now. Whether or not we get more follow-through is yet to be seen. It would be a much easier call if the macro environment, equities, and real estate all didn’t look so bad.

It’s hard to imagine Bitcoin and digital assets not making new lows if all other markets continue further down in the weeks and months ahead. Bitcoin is a risk asset for the players affecting the market. That’s the simplest way to explain the 90% correlation with the NASDAQ since the beginning of 2017.

Current Macro Environment

The macro landscape has many headwinds. Here are some key drivers for all markets.

Business cycle/liquidity cycle, the Fed, and money printing
Macroeconomic factors including the economic distortions of lockdowns two years ago, supply chain disruptions, declining GDP, malinvestment, and too much debt
China, the factory of the world, their zero-covid policy and lockdowns
Geopolitical decisions regarding sanctions relating to commodity and food trade partners
Policymaker’s decisions on energy supply sources and crypto regulations

If you feel overwhelmed, join the club. This is one of the most challenging periods to navigate. Many professional traders and asset managers have said so themselves. So let me try to pull out the signal from the noise. Here are the most important things to look for as a sign that risk assets like crypto will be in favour again.

The Fed Pivot

Like it or not, what the Fed does and says is currently the most critical factor for all markets. That includes other countries as most of them, especially the likes of Europe and the rest of the G7 countries, will follow along with what direction the Fed goes in. This isn’t because everyone just admires the U.S. It’s because the U.S. dollar is the global reserve currency, and the total amount of dollar-denominated debt globally is massive. This limits many countries’ options economically.

The Fed pivot refers to a reversal from tightening to loose monetary policy. This comes mainly from cutting interest rates and buying government debt assets via treasury bonds. Also, possibly more of the same stimulus packages we saw as a response to Covid lockdowns, which the Fed plays a role in along with the Government.

Below are the Fed’s mandates from the source.

“The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

“Stable prices” is basically referring to inflation and deflation. Since the beginning of 2022, inflation has become an enormous problem. Their long-standing target is a CPI (consumer price index) of around 2%. Last month’s year-over-year CPI print reached a 40-year high of 8.6%.

The problem is that the Fed has limited tools to fight inflation, especially when supply-side deficits are significant contributors. They have admitted that they have no control over the supply side of goods and services. Their primary tool is raising and cutting interest rates. Due to the extremely high debt levels, they cannot raise rates higher than inflation as we did in the 80s. If they did, we would see a global deleveraging event that would look like the great depression, if not worse, assuming they follow through with it. The Central bank is stuck between a rock and a hard place.

The Fed knows they must bring inflation down fast, so they are intentionally causing demand destruction. That means they are trying to decrease credit in the economy (fewer loans being taken out and more loans being paid down due to the higher cost of servicing the loans.) This will decrease consumer spending and thus decrease business earnings. One of the last shoes to drop is when even the fortified/strong companies have to lay off employees and/or reduce wages.

Does this scenario sound familiar? Anyone who lived through 2008 probably thinks so. This is what a proper recession looks like; I know it’s been a while. The Fed essentially has to force us into a recession in order to kill inflation before it spirals out of control.

It’s an impossible situation. The Fed is trying to navigate a plane crash for a “soft landing.” However, just as they had to capitulate on the idea of inflation being “transitory,” they are now aiming for a, “softish” landing, in their own words. In reality, it looks like we are heading for a crash.

That doesn’t mean this is the crash that ends the long-term debt cycle. There’s an extensive range of possible outcomes between the great depression and a mild recession that we are likely experiencing the beginnings of. Regardless of what happens in the current business cycle, a reset in some form will come eventually. A system that requires ever-increasing debt creation to fund its current liabilities is unsustainable.

The timeline of when this reset happens, no one can know. Many have been calling for it ever since 2008. If you had listened to them and held gold, for example, you would have missed out on one of the longest bull markets with incredible gains. Gold has basically been flat since then. This isn’t to say that gold won’t hedge the next macro collapse. However, the ability of central planners to kick the can down the road this time seems to be on another level.

These concepts go beyond the scope of this article which instead focuses on this bear market. We, along with many economists, are assuming we see another liquidity cycle similar to what happened coming out of the Covid crash of 2020. Typically when you near the end of the long-term debt cycle, the speed of corrections increases, and the time between them decreases. Here’s a great read if you want to learn more about how this all ends. Endgame: The Long-Term Debt Cycle

It’s important to know that all markets are forward-looking. Meaning they will price in expected value. Market participants have different time horizons for their positions. The accumulative time frame usually results in a 3 to 6-month view. That is why liquid asset classes like stocks and crypto will bottom before all the problems and headwinds are gone.

The Signal for a Fed Pivot

The first signal is the 90-degree turn. In other words, they are going from raising rates in each month’s meeting to holding rates in a wait-and-see mode. Similarly, they pause the current offloading of their balance sheet via selling bonds in the market. The full 180-degree pivot comes when they actually cut rates and/or go back to buying U.S. government bonds.

Either the 90 or the 180-degree pivot will come when something in the system breaks that can cause contagion effects and take down the whole thing. The pivot will also come if inflation gets under control around their targeted rates of 2 to 3%. Whichever comes first, but it’s more likely to be something breaking.

This also means the Fed is not concerned with how far stocks go down. As long as the plumbing of the system is functioning and inflation is still too high, they will continue tightening.

The Fed is like the crew of an old and antiquated ship sailing in sea conditions it wasn’t built for. Eventually, something will break that, if not attended to quickly, will sink the whole ship. They are waiting, ducktape in hand, to patch the hole.

Many economists and investors with this view believe the Fed will be forced to pivot after another two to four months of raising rates. But by then, we will likely be in a recession. The official conditions might be met once the 2nd quarter GDP numbers are announced in a couple of weeks.

Watch what the Fed is Watching

As we discussed earlier, they are still very focused on inflation as the priority over their other mandates. The market will probably not react positively in the short term if inflation doesn’t make a decent step down each subsequent month — the rate of change matters. However, the markets move as soon as the CPI print is announced.

To keep up with the smart money, you will want to look out for other indicators to have an idea of where inflation is heading. If you had to pick one contributing input for the current high inflation, then energy would be the one to watch. If energy prices come down, that will likely bring inflation down too.

Some form of resolution to the Ukraine/Russia war that boosts global trade for energy and food staples can bring down inflation. Sanctions would have to be lifted. Admittedly, this is probably a long way off. It would alleviate pressure on inflation as it is another significant contributor.

Policymakers’ decisions on energy supply sources can also help bring inflation down in the long run. The markets would also price ahead of time this new information when it comes out but not too far ahead of the actual energy supply increase. Two examples are deregulating fracking or investing in nuclear power plants. The same goes for several countries, especially those most affected by no longer importing oil and gas from Russia. (Europe)

Crypto Specific Catalysts

Positive regulation that allows big money to come in. Be aware that this could also cause a divergence between digital assets like Bitcoin and maybe Ethereum getting labelled as commodities and most other altcoins as securities.

Related to positive regulation would be the accounting rules changing in favour of corporations holding BTC on their balance sheet. This has deterred corporations from following Michael Saylor’s and his company MicroStrategy’s lead. It should be a no-brainer, simple fix.

We can’t forget the long-awaited Bitcoin ETF in the U.S. The political and public pressure on the Fed to approve a BTC ETF has been growing for many months. While it’s speculation, the Fed might be more obliged to approve one now that prices are so low, at least more so than when euphoria was in the market at its highs. The Grayscale Bitcoin Trust was recently rejected by the SEC to turn its product into an ETF once more. Grayscale has now said they will be taking the fight to the courts to pursue legal action against the SEC.

More countries adopting bitcoin as legal tender, like El Salvador, might not immediately impact the price in a bear market. Still, it’s a positive for the fundamentals nonetheless. The game theory will look like it’s beginning to pick up steam. When the U.S. essentially defaulted on its debts to Russia, it sent an alarm to countries across the globe that if you get on America’s bad side, your dollar-denominated assets could become worthless overnight. While the dollar has extremely sticky network effects, it is becoming less and less tolerated as the global reserve currency. Bitcoin is a potential alternative, especially for smaller countries that don’t have their own currency or are dealing with hyperinflation.

While I’m sure I’m missing a catalyst or two that can pull the digital asset space out of the bear market, I believe this list gives us enough indicators to keep an eye out for. One of them alone might not be enough to overcome the many headwinds we face in today’s environment. However, the more we see, the better the odds are that the bottom is in.

Conclusion

When the markets turn to risk-on, it will likely be fast and provide great opportunities to go long again. By the nature of being at the end of a long-term debt cycle, volatility increases, and the time between business cycles and recessions is shorter. This is not an environment for leverage, as nasty wicks will wash out greedy speculators on both sides.

The crypto entities that have had the most issues since prices trended downwards have been from CeFi companies. It is encouraging to see how well the more decentralized projects have held up throughout the contagion and mass deleveraging as of late. DeFi needs to continue to become more and more anti-fragile. Whatever doesn’t kill it makes it stronger.

Suppose your fundamental thesis for an investment remains intact. A bear market should be viewed as an opportunity for accumulation. Especially if you invest responsibly with money you can spare, the longer prices stay low, the better. The key here is doing your homework and building conviction based on facts and a vision about where value will be in the future.

Remember, fiat systems are a failed economic system for most people and only serve a small elite group of people. The reset will happen eventually, and we believe crypto will play a role in the new system coming out the other side. Crypto ideals such as decentralization, access for all, transparency, immutable data, and much more are real solutions to the current systemic issues we see today. Crypto is a once-in-a-lifetime opportunity. We are still early, and we need to fight for that opportunity.

It’s principles like these that Clip Finance is proud to promote. We believe that everyone should have access to a more fair and transparent financial system.

Did this bear market catch you by surprise? Are you left wondering if it’s too late to sell or too early to buy? Well, it’s never too late to create an informed and level-headed plan to make the most of the bear market. In part two of our bear market series, we will go in-depth on creating that plan.