Some systems connect lenders with borrowers, and depending how much demand there is on either side, calculate an ‘interest rate’ for investors who tip money in.
These are called “automated lending protocols”, and the biggest ones are Aave, Maker and Compound, which have fallen 65 per cent, 59 per cent and 72 per cent respectively.
DeFi also boasts “automated market makers” or decentralised exchanges, which automatically connect buyers and sellers and also provide liquidity to marketplaces.
The biggest ones are Uniswap, Curve and PancakeSwap which are down 60 per cent, 78 per cent and 67 per cent respectively since January 1. Australian DeFi projects include Synthetix, which is down 38 per cent, Maple Finance, which is down 14 per cent.
Although the token prices are the most obvious way to track the performance of a DeFi project, the yields show how much demand there is for the system.
For example, if many people want to lend their money out, yields are high. When people don’t want to lend it out, yields are low. Yields in January were between 10 and 20 per cent, whereas yields are between 0.5 per cent and 5 per cent now, showing just how much money has pulled out of crypto markets.
NFTs, or non-fungible-tokens, have been hit the hardest in this latest crypto selloff. NFTs are any digital asset fixed to a token, and saw an explosion of popularity in the digital art market.
The popularity of digital artworks fixed to NFT technology meant many people who previously had never been interested in crypto markets poured their money in.
Australian businesses exposed to the NFT market are NFT marketplace builder ImmutableX, which is down 73 per cent, and video game Illuvium, which is down 86 per cent since the start of the year.
The only types of digital assets that have seen inflows are stablecoins. These are cryptocurrencies that trade in line with another asset like the US dollar or Australian dollar.
Although the market capitalisation of Bitcoin has fallen 70 per cent this year, the market capitalisation of all stablecoins has only decreased by 11 per cent. Most analysts say this is an indication that money has rushed out of many digital assets, but hasn’t entirely left the ecosystem.
What is causing the sell-off (and is it just crypto)?
There are two main reasons why cryptocurrencies of all stripes have sold off.
The first is a macroeconomic one. For a long time, low-interest rates meant bonds and other “safe” investments yielded very little, so investors were pushed out to equities and sometimes crypto to try and find some returns.
Digital assets are notoriously volatile and subject to market sentiment and momentum, rather than fundamental analysis, so there were many excited traders trying to make money on the movements.
Combined with the rise of lucrative DeFi yields, and a rush of speculation on NFTs, and crypto markets soared over the past few years.
But rising interest rates around the world means investors want to avoid holding risky assets right now.
Since the US Federal Reserve started increasing interest rates in March – the first time in three years – and signalled there would be many more rises, investors have yanked their money out of riskier markets. The US central bank acted again on July 27, lifting rates another 0.75 of a percentage point.
This “risk-off attitude” is visible in the indiscriminate crunch in high-growth technology stocks which have fallen as much as 70 per cent.
What is causing so many crypto ‘banks’ to collapse?
The second reason cryptocurrencies are being sold off is the widespread collapse of several large crypto “banks” and hedge funds. Most notably, Three Arrows Capital and crypto lender Celsius, both of which have filed for bankruptcy.
Just like in the global financial crisis, these collapses come down to huge amounts of leverage and borrowing in this latest crypto cycle.
In May, an algorithmic stablecoin called Terra/Luna collapsed. It was meant to remain firmly pegged to the US dollar through a trading mechanism. But the team behind the coin was paying traders 18 per cent interest to keep the coin stable.
Terra/Luna was very widely held as a stablecoin and when it suddenly fell to $0, many businesses were in trouble.
One was Singapore-based Three Arrows Capital. Not only was it heavily exposed to Terra/Luna, but it had also taken out loans it was unable to pay back once the crypto collapse took place.
Another collapsed crypto business was Celsius, which offered customers returns over 18 per cent for depositing their digital assets. Celsius had taken those deposits and traded them in high-risk markets behind the scenes to earn the interest to pay back to customers.
One investment was actually in Three Arrows Capital; an illustration of the market contagion that has crypto investors nervous. Just how many large players are exposed to each other?
It turns out a lot. Greyscale Trust, BlockFi, Voyager are just some of the names that had huge holes blown in their balance sheets when Three Arrows Collapsed.
Another crypto bank, Babel Finance, is also struggling to stay solvent. Turns out Babel was also taking depositor money and trading it without any risk controls behind the scenes.
Australian-founded cryptocurrency exchange Zipmex has been caught up in the turmoil, last month announcing it was trying to claw back $69 million it had lent to the rocky “bank”.
It’s worth noting these businesses are all centralised organisations. They are run by teams of people who made decisions about how much they wanted to borrow against their deposits.
Unlike traditional stock exchanges, which have automated “circuit breakers” that halt trading if the market starts selling off drastically, crypto businesses couldn’t stop the flow of money out the door in time.
They were also borrowing more and more crypto to turbocharge their returns. They took huge risks and it blew up.
The contagion within crypto markets hasn’t spilled over into other markets, but looking under the hood reveals just how interlinked many of these crypto projects are.
How does this compare to previous crashes?
This is not the first crypto crash. In fact, in the 10-ish year history of bitcoin there have been several 70 per cent falls, as well as an eye-watering 90 per cent fall.
Ethereum, which emerged in 2015 with its cryptographic smart contract blockchain, has also suffered at least two 70 per cent collapses.
During those crashes, it was fairly clear what had caused the sell-offs. It was either a hack, an exchange shut down, regulators were banning crypto-use or the macro picture had investors of all stripes cashing out their investments.
This time round though, there are more complex reasons as to why cryptocurrencies – and there are 19,000 of them – are being sold off.
But sophisticated crypto investors don’t seem particularly worried about the pull-back.
If you have done your homework on the types of projects being developed, and are examining the unit economics on-chain, many investors see a buying opportunity. Just like tech investors in the stock market.
Can crypto bounce back from this?
Like many venture capital-backed or speculative businesses, crypto start-ups have laid off waves of workers to conserve cash.
But at the heart of much of the crypto industry’s “wash-out” is an internal debate, or a re-examination, of decentralised businesses versus centralised ones.
To market observers, the crypto organisations built on-chain using decentralised systems have withstood the widespread carnage.
They say the blockchain-based technology that connects buyers and sellers, or lenders and borrowers, may be experiencing less activity than usual, and their automated yield calculations might be lower, but the technology itself hasn’t broken.
In fact, many investors are pleased the selloff has swept some of the over-hyped, frenzied and unsophisticated investors obsessed with speculation out of the market.