The traditional finance market is a global web of interconnected organisations which are mostly interdependent on each other. Therefore, the collapse of one organisation could trigger a fallout of its associated firms, and the domino ensues. The crypto industry is no different, and it is currently experiencing its own contagion effect which started with the collapse of Terra.
The digital asset industry is going through one of its worst years in history. The crypto winter, which began in the initial months of 2022, still rages on and has gotten uglier over the past few months. Experts believe that this is the direct effect of a “crypto contagion” which has caused the market to nosedive and inflicted further pain on investors. But what is the crypto contagion effect and how long will it last? Tag along to find out.
What is the crypto contagion effect?
As you may know, contagion refers to the spread of an illness through close contact. In the financial world, contagion refers to a domino effect, where one financial crisis can spread through the entire ecosystem, causing severe market drawbacks. This could then cascade to other markets, and regions as well.
The 2008 financial crisis is a perfect example of such a contagion — it sparked a global monetary crisis, probably the worst since the Great Depression.
The traditional finance market is a global web of interconnected organisations which are mostly interdependent on each other. Therefore, the collapse of one organisation could trigger a fallout of its associated firms, and the domino ensues. The crypto industry is no different, and it is currently experiencing its own contagion effect which started with the collapse of Terra.
Terra (LUNA) collapse
The crypto industry’s contagion effect began in May this year, with the collapse of Terra (LUNA) and its algorithmic stablecoin, TerraUSD (UST). On May 7, a series of large UST dumps on the Anchor protocol caused the stablecoin to lose its peg with the US Dollar. This caused massive FUD among investors who scurried to exit their positions in UST. The sell-off caused the price of UST to plummet to almost $0.35 in a matter of days. This immediately impacted the price of LUNA (now rebranded as Terra Classic), which dropped 96 percent within a week.
In the end, the $48 billion combined market cap of LUNA and UST disappeared in the span of a few days. As such, any firms that invested in LUNA and UST now had a gaping hole in their books. This caused a massive contagion effect, resulting in several firms pausing withdrawals, laying off employees, and even declaring bankruptcy. Some of the major firms that became insolvent after the Terra meltdown include crypto hedge fund, 3 Arrows Capital (3AC) and brokerage firm Voyager Digital, along with crypto lenders Vauld and Celsius.
The FTX meltdown
The collapse of Terra caused crypto prices to plummet and put pressure on the entire digital asset ecosystem. And just as the market began to cover, it was dealt another major blow — the FTX fiasco. On November 11, FTX, the world’s second-largest crypto exchange, filed for Chapter 11 bankruptcy after facing a severe liquidity crisis. However, the meltdown of FTX was not something the crypto market was prepared for, and it took the industry by surprise.
The FTX collapse led to a contagion effect that left a burning hole in the bearish market. Hundreds of firms that were exposed to the exchange suffered liquidity crises as most of their assets were deposited on FTX. Top crypto firms like BlockFi, Genesis Capital, Gemini and others halted withdrawals. BlockFi even had to file for bankruptcy after which they filed a lawsuit against FTX.
Overall, these two incidents have shaken up the industry and caused investors to lose confidence in the market. Bitcoin has been struggling to break out of the $17,000 mark since the FTX meltdown and has lost almost 65 percent of its valuation YTD. It’s a similar story with Ethereum and most of the other cryptocurrencies on the top 100 list. Thanks to the contagion effect, the global cryptocurrency market cap is also stuttering around the $800 billion mark, a far cry from its all-time high of nearly $2.9 trillion in November 2021.
The crypto contagion that began in May could spill over into 2023
According to blockchain analytics firm Nansen, the FTX collapse was likely triggered by the Terra meltdown. And experts believe that what began in May 2022 could extend deep into 2023. While the market seems to have steadied itself after all chaos in November, the shockwaves from the downfall of FTX continue to resonate throughout the crypto ecosystem.
For instance, crypto miner Core Scientific filed for bankruptcy on December 21. Unsurprisingly, the collapse of the mining giant can also be attributed, to some degree, to the fall of Celsius. Core Scientific provided Celsius with hosting services, and claims that it is owed upwards of $5 million. However, with Celsius declaring bankruptcy in July, these funds are effectively stuck in limbo.
Another entity that’s struggling to shake off the contagion effect is the Grayscale Bitcoin Trust, a digital currency investment product. It recorded a 41 percent discount amid the FTX meltdown and this discount has only widened in the last few weeks. If things get worse, Grayscale Investments, the company that operates GBTC, could be forced to buy up to 20 percent of Grayscale Bitcoin Trust (GBTC) shares.
As such, the more companies that are affected, the longer the crypto contagion will last. However, many experts believe the crypto market is not big enough to impact the global financial market. But if institutional investors start selling off their holdings and exit the market, the broader crypto market could be looking at a further downturn of events and a prolonged crypto winter.
Conclusion
A lot needs to happen for the digital assets industry to return to its former glory, starting with widespread regulatory policies and improved security and transparency in the industry. As we head into the New Year, only time will tell whether the market will survive, thrive or wither away.