Why is crypto dipping? an overview.
From macro factors, to crypto specific issues.
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This sounds great. But the volatility and huge dips we are experiencing right now are undeniable, and I’m sure many of you find it very hard to not be intimidated by what is happening and might even consider backing off from crypto.
I too have to practice a lot of mental strength to not let the emotional part of me take over. In order to maintain the big picture, and be rational despite the market volatility, what is working best so far for me is to keep educating myself on what is happening, why, and connecting the dots.
The article I’m bringing to you all today is precisely about this: the goal is to provide some context of what is happening that is causing the crypto market to be crashing so hard.
The TLDR is as follows:
The current bear market we are experiencing is a combination of many factors.
The macro economy is shaking, with the Feds raising interest rates, inflation at 40 years high, causing a negative sentiment across all assets.
In this macro environment, we are facing difficulty finding safe-haven assets, and as crypto is still being considered higher risk than other types of assets, it will inevitably get impacted more.
On top of that, we have enough damage within the crypto space with the historic collapse of LUNA: we are now starting to experience the ripple effects in the shape of Celsius, 3AC, and more to come.
When these crypto projects struggle with insolvency, they are forced to liquidate their crypto positions (mainly Bitcoin), dragging down the prices even further.
The good news is, if you are here for the long run, this is positive. Why? think of it like natural selection, where only the best will survive: those projects that are built in a way that can only thrive when the market is up, but when things go down they fall like a house of cards will be eliminated, and the kind of projects that emerge standing are those battle-tested, with true value and sustainable models.
So let me explain a little bit more by looking at the macro first, and then diving into crypto.
Global Market factors
There are a few things that we need to understand when we look at what is happening at the macro level.
First, is the Federal Reserve.
The Fed’s main job is to manage the monetary policy of the US. The goal is to keep the economy well balanced, and the main tools for them to do so are money printing, and playing with interest rates (higher or lower, depending on the market situation).
So the background to this is that, as a response to the pandemic, the Fed has been pumping in money and cutting interest rates to zero to stimulate the economy, which means artificially increasing demand.
And now, it is trying to tame the situation by increasing interest rates, and when this happens, it triggers a crash in all asset classes.
Why is the Fed doing this, you ask?
Enters, Inflation.
As a common practice, if inflation is high, then the Fed will likely rise interest rates, and vice versa.
To put things into perspective, a 2% inflation rate is the target, so anything above that is high in the Fed’s eyes. Right now, the latest CPI report by end of May indicated that the inflation rate is at 8.6%. So, considering we are closer to 10% than 2%… you get the point I’m trying to make.
Therefore, the Fed is currently raising interest rates to reduce inflation. No surprises.
Quoting WSJ, “The Federal Reserve approved the largest interest rate increase since 1994 and signaled it would continue lifting rates this year at the most rapid pace in decades as it races to slow the economy and combat inflation that is running at a 40-year high.”
![Yep, The Federal Reserve Ain't Playing⛽💸 Meme, Pic, GIF, Video ☺ [Updated] June 19, 2022](https://substackcdn.com/image/fetch/$s_!7MwW!,f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2Fdedbe58f-6b55-4cbc-8e5c-287204582f02_480x480.jpeg "Yep, The Federal Reserve Ain't Playing⛽💸 Meme, Pic, GIF, Video ☺ [Updated] June 19, 2022")
Why rising interest rates can fight inflation?
The interest rate all the media outlets and economists are referring to is the Federal Fund rate, which is essentially the benchmark all commercial banks in the US refer to when setting up the interest rate they charge for credit.
Hence, when the Fed raises the federal fund target rate, borrowing becomes more expensive because of higher interest payments: the goal is to increase the cost of credit throughout the economy.
Those who can’t or don’t want to afford the higher payments postpone projects that involve financing. It simultaneously encourages people to save money to earn higher interest payments.
This reduces the supply of money in circulation, and if it works out well, can lower inflation and moderate economic activity.
Anything else that can cause more inflation…
The Fed can only play around with interest rates because that’s their only controllable factor.
Now, let’s look at the supply side of the inflation equation, which is pretty much outside of the Fed’s control because here we are talking about current international events like the Ukraine-Russia war, the Covid lockdown in China, the labor shortage, etc that sooner or later causes significant supply chain issues.
At the end of the day, the economy is all about supply and demand.
So if the Fed can’t control the supply side of things, it will try to influence the demand side as much as possible: by increasing interest rates it’s essentially attempting to destroy demand to a point that supply pressures are irrelevant because nobody can afford to buy.
Of course, by doing this, there will be a profound impact on all asset classes, particularly crypto as it’s still considered high risk by most institutions.
Ultimately, the asset markets will boil down to investors’ expectations based on different macro metrics.
Now all of these factors are only macro. Let’s look at crypto now.
Crypto specific events
The historic LUNA collapse
The first domino to fall here is LUNA.
The LUNA/UST crash in May was a historic one, which represented the death of 2 top 10 cryptocurrencies by market cap, and the collapse of one of the major Layer 1 blockchain platforms, destroying over $50B of capital.
Here is the full article where I covered this crash extensively.
The biggest concern across the crypto world are related to the second and third order consequences, aka the ripple effect a collapse of this order of magnitude would mean for crypto.
Well, wonder no more, it has started.
First to follow: Celsius.
Celsius is a centralized lending and borrowing platform: you can deposit crypto in Celsius and receive interest rates in exchange.
So seems like Celsius has been attracting deposits by offering high interest rates, and they use these deposits to leverage on DeFi yield farming in order to fulfill the rates commitment.
Now, the issue is that around last week, Celsius announced the pause of all withdrawals, which basically means it has insolvency issues, and that they can’t actually honor all the depositors’ commitments.
This doesn’t necessarily mean that they don’t have the assets. It means they can’t access them, and therefore the insolvency issue.
How does this happen?
Let me give you an example: it is known that Celsius locked a lot of ETH to stake, which currently is known to be a one way deposit, so exact withdrawal possibility will only be confirmed post The Merge.
This kind of investment works well when the market is up, but doesn’t work so well otherwise, as they cant unlock their positions to give funds back to their users.
And the worst is, they’ve been speculating with clients’ money.
What made the crypto community so annoyed with Celsius, is the decentralized vocabulary they have been using so far to market their centralized product, which is misleading and maliciuos. If it was indeed decentralized, they would not have been able to pause withdrawals to begin with.
For those who like a good drama, here is Peter Schiff confronting Celsius CEO last year.
Now, in order to honor the commitment to its depositors, it needs to raise its liquidity.
Which options does it have? Well, it could either come from debt, or worse, sales of crypto assets.
And voilà, here again we see why there is so much sell-off of Bitcoin that can drag down prices even more.
We don’t know what’s the end of the story yet - things are still unfolding at the time of this article, so stay tune.
Next up, Three Arrows Capital
3AC is one of the bluechip hedge funds in this space, with over 3 billion worth of crypto under management as of April 2022.
It is well known that they suffered heavy losses from LUNA’s collapse, and now thanks to them being over-leveraged (which essentially means using some crypto to borrow even more to invest), when facing price drops of this magnitude they were getting margin called from everywhere to top up more assets to hold their positions.
When they fail to do so, the platforms had no choice but to liquidate their positions, causing the markets to further dump.
And this is another story that is still unfolding, so let’s see how it ends…
Final Thoughts
First.
The crypto market is experiencing the ripple effect, and there will be other companies affected in the future.
Based on what we are seeing though, the commonality of these projects is that they are all “trust-based” companies, aka centralized. And when the decision makers get too greedy, they try to speculate more than they can afford. It tends to work out fine when market is doing good, but when the sentiment goes negative, they fall majestically.
And this is where I jump in again to highlight two important facts:
Not your keys, not your coins (read more here).
Decentralization matters (read more here).
If you don’t have these 2 things, then it defeats the purpose of crypto altogether. Without these, we are just talking about a fancier version of the traditional financial games as we know it.
So be mindful when you decide where to put your hard earned money.
Second.
Nobody knows how much worse or not the macro environment will get. And nobody can really time the market either.
But hopefully by understanding how the few macro factors interact and affect each other, you can make sense of what is happening.
Third.
Coming back to crypto.
This isn’t the end.
This is survival of the fittest: bear markets help us cut off the fat in this space, so crypto can get healthier, and have a return to strong foundation and sustainable growth, which is really great for those of us who are in for the long run.
Thanks for making it this far! If you enjoyed it, make sure to like, subscribe and share, so more people can find us!
Thanks for the article.
Very well written and something that I personally was looking for in order to understand the current plays in crypto space.