“It’s only when the tide goes out that you learn who has been swimming naked” - this famous quote from Warren Buffett (his views on crypto aside) is especially relevant in light of the recent events in crypto. With gigantic players - the likes of which were thought to be infallible by many in the space - starting to straight-up go insolvent, the tide has definitely gone out. This might sound grim, but the truth is that it brings immense opportunity for everyone that managed to make it through the downturn. So, what happened exactly, how do the recent events impact the crypto space, and what are the longer-term effects going to be?
What happened: Assets, liabilities and insolvency
In our previous post, we covered the basics on how to avoid losing your funds in market conditions such as these, but now, we’ll go deeper and look at the root causes and mechanisms which lead to former giants losing their footing. Even if you’re not that interested in the specific events that happened (and are still taking place), this should still concern you: when a giant as big as Celsius, BlockFi, or Three Arrows Capital threatens to fall head over heels, the resulting shockwave can have drastic effects throughout the markets. If you think you’re safe because you store your crypto safely on a hardware wallet, the price of your assets - especially if it’s the biggest assets in crypto - can be severely affected by the massive liquidations which can take place in such conditions.
The root cause of almost all threats of insolvency with any entity that engages in lending and borrowing is an asset-liability mismatch. If this term has you scratching your head, the good news is that it’s very simple, and it just requires a basic understanding of the balance sheet. A balance sheet is simply a document that shows what a company owns and owes, as well as how much shareholders have invested, with assets (what it owns) and liabilities (what it owes) + shareholder equity shown on opposite sides. These two sides need to be balanced, that is, assets should equal liabilities plus shareholder equity. In this case, however, we’re interested in the assets and liabilities specifically, and an asset-liability mismatch occurs when a company can’t afford to pay off its debts due to an unexpected change in the structure of its assets and/or liabilities.
How does a change like that happen? To understand this, we need to keep in mind that both assets and liabilities can be either short-term or long-term. Short-term assets include cash and cash equivalents, as well as liquid assets (such as BTC), while long-term assets primarily include investments which cannot be liquidated (i.e. sold) quickly or efficiently (this also includes fixed assets such as machinery and buildings, but this isn’t relevant for the situation we’re looking at). On the side of liabilities, short-term liabilities are customer funds which are eligible for withdrawal and short-term loans, as well as interest that is already owed to customers, whereas long-term liabilities include interest and debt that is to be paid out later.
Normally, a company should have enough short-term assets to cover short-term liabilities, since short-term liabilities cannot be covered by long-term assets. In simple terms: if customers want to withdraw their funds immediately, this needs to be covered with liquid assets rather than illiquid investments that can only be sold at a much later date. What happened with Celsius - and what’s potentially happening with other entities - is simply that some of their short-term assets suddenly became long-term, whereas long-term liabilities became short-term debt. The first part of this change - the one on the asset side - can be caused e.g. by stETH (staked Ether) losing its 1:1 peg with liquid ETH, so that the company can’t liquidate it without incurring significant losses until after the Ethereum 2.0 merge. As for liabilities, these can become short-term when an unexpectedly large proportion of users decide to withdraw their deposits, triggering what’s known as a bank run.
If that happens, the company often has to attempt to liquidate some of its long-term assets at significant losses, but this is often either completely impossible or would lead to the company going underwater due to excessive discounts on these relatively illiquid assets. This is why the first thing that an entity in this situation does is typically to sell off its most liquid assets, primarily BTC and ETH. This can lead to market conditions that we’ve seen recently: BTC and ETH drop, while most alts hold up relatively well, as companies scramble to sell what they can rather than what they want to.
What does this mean for you?
When forced selling of this magnitude occurs, it tends to drive prices down to levels that would otherwise be instantly defended as support. It’s not that companies in danger of bankruptcy want to sell BTC below $20k, but rather that they have no choice in the matter. Selling altcoins isn’t an option because of insufficient liquidity, so the only thing they can do is to hit that red button and hope that they manage to stay afloat (unless, that is, the red button is hit automatically by liquidation engines on their exchange accounts).
This creates what’s known as a deleveraging event, and this can be very positive for the health of the broader crypto ecosystem. Firstly, it flushes out excessively leveraged players from the market - meaning that there won’t be any more entities that are forced to sell massive amounts - and secondly, it drives prices back down to value areas for long-term investors. Don’t take this to mean that the bottom is definitely in, as it’s still unclear how many big players are affected (if company A goes has huge loans from companies B and C, then these latter two can be hit very hard if A goes under), but there is one crucial takeaway: when the lion’s share of sell pressure comes from those that are forced to sell, and when this sell pressure is suddenly exhausted, prices will reflect the new lack of supply very quickly.