Liquidity crisis of the 'cryptos': DeFi, CeFi and why there will be more sales in bitcoin
The problems of crypto-asset companies, especially lending platforms that use cryptocurrencies as collateral, have been making headlines for months in a crypto winter tougher than any of the previous ones. The market correction is not yet equal to that of other bear market periods, although bitcoin already accumulates a 70% drop from its all-time highs, however, the liquidity and confidence crisis in digital tokens threatens to cloud the advantages of blockchain and decentralized finance (DeFi Development Services).
As much as many experts defend that the fundamentals of the market remain strong, with promising developments and a future full of applications for the blockchain and web3, many others warn that there is still suffering ahead for crypto currencies.
The failure of Terra Luna and its UST stablecoin marked the beginning of the current bear market. That action reduced the cryptocurrency market capitalization by 70% from its peak in November 2021”, comments Teeka Tiwari, director of Palm Beach Research. But the expert hopes that other pieces will fall soon, prey to the domino effect. "I don't know if the sell-off will be as violent as the first round," he explains, but he warns investors to "prepare mentally."
The current volatility is unrelated to a decline in confidence or belief in the fundamentals of these top-tier assets. It is a liquidity issue, the expert emphasises. Many investors use bitcoin (BTC) and ethereum (ETH) as collateral for loans throughout the crypto ecosystem. “In cryptocurrencies, BTC and ETH are blue chip assets in the same way that US Treasuries are the blue chips of the traditional financial system,” Tiwari clarifies.
In traditional finance, US Treasury bonds are held and borrowed against by Wall Street firms because they are considered the safest financial assets. In the world of cryptocurrencies, bitcoin and ethereum play the same role. This is crucial because the recent bitcoin sell-off makes me think of the 2008 global financial catastrophe. Back then, subprime loans were the first to fall during the real estate crisis, with companies having to sell their main assets to cover their guarantee margins”, explains the Palm Beach Research analyst.
The same is happening with cryptocurrencies, and bitcoin and ethereum are paying the price, the analyst continues. That is primarily the cause of their declines from all-time highs of 70% and 78%, respectively.
The analyst maintains the analogy to the "subprime" crisis in the US and emphasises that "we have seen multiple crypto enterprises go bankrupt during this market bass guitarist," just as they did at that period when the corporations with the most questionable assets fell one after another. Three Arrows Capital, BlockFi, Celsius, Voyager Digital, or Vauld are a few of the most well-known companies.
"More cryptocurrency businesses will fail. The expert claims that it is all related to centralised finance (CeFi).
Centralized Finance (CeFi) companies use Decentralized Finance (DeFi) protocols built on blockchain technology to make banking, lending, credit, and investing more accessible and cheaper for millions of people. That is, they allow users to trade billions of dollars in assets without human intervention.
Many of these DeFi protocols have continued to run smoothly, as “the problem is not with the protocols, but with the amount of speculative and leveraged bets that CeFi companies, like BlockFi, Celsius, and others, pile into these protocols,” he explains. Tiwari. The DeFi space works by taking collateral and issuing loans against those collaterals to borrowers. CeFi companies, like Celsius, took deposits from the public and then used that money to generate returns from DeFi Development projects.
“The problem is that the CeFi companies got greedy and used leverage to increase their profits,” laments the Palm Beach Research expert. “This approach worked until it stopped. The first domino to fall was when TerraLuna and its UST stablecoin crashed,” he argues.
Many CeFi companies had large positions in UST and Luna. They had used those holdings as collateral to back billions of dollars in other loans. Cascading margin calls were triggered when Luna and UST prices crashed. This situation put pressure on other assets that had nothing to do with Luna and UST. That sale then triggered more margin calls and the chain of defaults was set in motion, which brings us to where we are today.
DEFI PROJECTS WILL BE OK, CEFI PROJECTS NOT SO MUCH
Decentralized financial protocols like Uniswap and Aave are open and transparent. At any time, you can see exactly what's going on. Instead, centralized platforms like BlockFi and Celsius use DeFi Development Company protocols to generate returns, but are owned by private companies. They are opaque. How much leverage they are utilising is unknown to us.
When it comes to private companies, it is not known how many times they have lent the same asset. Lending the same asset more than once is called 'remortgaging', and without rigorous risk management controls, remortgaging assets can sink a company in a day.
This is the same problem many Wall Street firms faced in 2008. Just like then, CeFi firms and cryptocurrency hedge funds have found themselves with highly leveraged positions crashing in price. Due to margin calls, they are compelled to liquidate their bitcoin and ether.
“This cascading effect is not over. It is almost certain that there will be more pain before we can say that this has come to an end”, adds Tiwari.