Leverage means contagion. Just look at the crypto.

Artwork: Allie Carl/Axios

The financialization of crypto has made it vulnerable to kind of contagion we see now.

Why is this important: The big change in crypto between 2018 and today is the introduction of large-scale lending to the industry. And with lending comes a new type of risk – counterparty risk – that crypto still hasn’t found a good way to handle.

The big picture: The crypto is notoriously cyclical – the price of bitcoin fell 70% in 2011, 83% in 2013, and 84% in 2018. These declines were all relatively innocuous, however, compared to the leverage-induced carnage during the current crypto winter. .

  • This is partly because the amount of money involved was much smaller back then. But another important thing is that crypto wasn’t really financialized back then – there was almost no lending, short selling, etc.

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

  • Therefore, if I own a bitcoin, this bitcoin may lose value or even be stolen, but these losses concern only me.

State of play: Crypto lending changes the dynamic. Companies like Celsius Network and FTX – both currently bankrupt – paid interest on crypto deposits and lent crypto assets to borrowers.

  • Instead of a person owning a simple one-coin asset, a depositor is from one piece per exchange. The borrower owns the coin and the exchange owes money to the borrower while also owing money to the depositor.
  • In effect, a one-coin asset became a one-coin asset (in the hands of the borrower) plus two one-coin liabilities (in the borrower and the exchange) plus two one-coin claims (to the exchange and the depositor) .
  • There is now Three assets worth 1 bitcoin. If the actual coin is lost and the borrower defaults, the borrower and the exchange, and possibly even the depositor, can all end up losing 1 bitcoin.

What is happening: Crypto losses have trickled down to companies that have engaged in such borrowing and lending activities, from Luna and 3 Arrows Capital to Celsius, Voyager Digital, Alameda Research, FTX, Genesis and Gemini. None of them have adequately managed their counterparty risk – the risk that the trading platform you are dealing with will go bankrupt and not be able to pay you what you are owed.

  • In traditional finance, central banks can intervene to prevent such contagion. In crypto, however, there are no such macroprudential overseers.

💭 Our thought bubble, via Kate Marino of Axios: Mining crypto is the most Human thing ever. Whenever something is created for a functional financial purpose – like stocks, bonds, oil contracts, houses, etc. – there will always be people who make derivatives of these things just to make money.

The bottom line: Perhaps the leverage, and resulting contagion, was inevitable and predestined.

#Leverage #means #contagion #crypto #Crypto

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