Understanding What Caused the Recent Crypto Crash, And How Crypto Exchanges Can Protect Users

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The post Understanding What Caused the Recent Crypto Crash, And How Crypto Exchanges Can Protect Users appeared first on Coinpedia – Fintech & Cryptocurreny News Media| Crypto Guide

Nearly two months have passed since the Terra-Luna crash on May 7. Be it stopping time or going back to the past, it is futile and next to impossible for investors to recover their losses. However, the ‘cockroach theory’ tells us that when you see one cockroach, there may be many more you can’t see right away. After all, one cockroach usually means there are more lying around in the dark.

Not long after the Terra-Luna crash, cryptocurrency lending platforms Celsius and Babel Finance experienced a liquidity crisis which even spread to hedge funds in the industry. So what were the causes of the recent incidents? What should major exchanges do to best protect their users? This article will provide a step-by-step analysis.

Terra-Luna Crash

UST is the stablecoin with the largest market value on the Terra chain, pegged to the US dollar on a 1:1 basis. Luna is the governance token of the Terra protocol, which is mainly used to pay public chain gas fees, pledge mining and protocol governance. Common stablecoins such as USDC or USDT are issued by collateralizing fiat currency.

UST is an algorithmic stablecoin, meaning it does not rely on collateral. How does it achieve algorithmic stability? The algorithm designed by Terra is to make 1 UST equivalent to US$1 worth of Luna. That is, for every UST minted, US$1 worth of Luna must be burned, and US$1 worth of Luna can also be exchanged for 1 UST.

Let’s take a closer look at the exchange process in the figure below. When the price of UST exceeds US$1, arbitrageurs earn the difference by burning Luna to mint UST, and the price gradually returns to US$1 as the supply of UST increases. When the price of UST falls below US$1, arbitrageurs can also speculate by exchanging Luna, and the price will rise to US$1 as the UST supply shrinks.

The logic of this algorithmic stablecoin cannot be faulted. However, a whale (an entity or individual with large holdings) sold the equivalent of US$285 million in UST on May 7, which resulted in a huge spread that caused the token price to nosedive, setting off market panic.

As mentioned, minting UST requires the burning of Luna, so selling UST is equivalent to minting and selling the same amount of LUNA! This created strong selling pressure on the token. Due to significantcapital outflow, Luna plummeted from US$86 to US$61 within 12 hours, and several UST sell-offs took place in transactions amounting to millions. This unprecedented nature of the sell-offs sparked market panic. Although Terra announced it would build reserves of Bitcoin to stabilize the system by buying more Luna and UST, this failed to work.

Collapse of Celsius/Babel Finance

On June 13, Crypto lender Celsius announced the suspension of all withdrawals, transactions and transfers between accounts. This indicated that Celsius might be in financial trouble due to the lack of liquidity caused by a massive run on deposits amidst the market panic.

Celsius had enjoyed one-time success, raising US$750 million in November last year. As a crypto company, its assets under management stood at more than US$30 billion. In spite of this, Celsius appeared to have collapsed overnight and the reason is nothing but alarming.

Market data shows that Celsius managed about 1 million Ethereum, of which only 27% were spot assets, while 44% were pledged under an Ethereum 2.0 contract through Lido and held in the form of stETH. The remaining 29% was directly pledged for a period of at least one year. This indicates that Celsius’ actual capital liquidity was less than 30% of its assets, far below the level needed to deal with massive runs.

The fundamental reason for the collapse of Celsius lies in poor risk management. In addition, there were many problems in the management and operations of the company itself.

After Celsius announced the suspension of withdrawals, transactions and transfers, more “mines” in the crypto market were detonated one after another throughout the week. Hong Kong-based cryptocurrency lending firm Babel Finance told clients that it would suspend redemptions and withdrawals for all products, citing “unusual liquidity pressures.”

Babel Finance was a crypto lending and trading business founded in 2018,  with an outstanding loan portfolio of more than US$3 billion at the end of 2021. The firm has around 500 clients, many of which are institutional clients, including traditional banks, investment funds, accredited investors and family offices.

Three Arrows Capital’s insolvency

It’s not just lending platforms in the crypto space that have created a crisis similar to the one experienced by traditional financial industry during the Global Financial Crisis. The storm has even spread to hedge funds in the industry. Three Arrows Capital Ltd. also raised concerns among investors after it failed to meet margin calls from lenders. The crypto-focused hedge fund hired legal and financial advisors after suffering heavy losses from a broad market sell-off.

The nearly 10-year-old hedge fund’s assets under management once topped US$10 billion, but had shrunk to about US$3 billion in April. Its portfolio includes tokens such as Avalanche, Solana, Polkadot, and Terra. With the recent steady decline in the cryptocurrency market, almost all the projects Three Arrows Capital invested in are underwater. According to media reports, the total liquidation amount of Three Arrows Capital on the lending platform is as high as US$400 million, and it may face bankruptcy.

How do exchanges protect the rights and interests of users? (Taking Huobi Global as an example)

Huobi Global has a comprehensive process for risk management, and also has leading capabilities in this area which are unique in the industry. This has enabled the platform to achieve a stellar track record of zero safety incidents in the nine years since its inception. When the Terra-Luna collapse took place, Huobi Global did well in the following three aspects, which can provide learnings for other exchanges:

  • Judging the situation efficiently and appropriately
  • Informing users of risks promptly
  • Operating the platform on a user-centric basis

Let’s have a look at the process which Huobi Global used to deal with the Terra-Luna collapse:

  1. When Luna started its death spiral, Huobi Global closed the deposit channel to protect users. The price of Luna on Huobi Global was the highest among all platforms during that period, which protected the interests of Luna holders on the platform and gave them sufficient time to make adjustments.
  2. As soon as it was confirmed that Luna was no longer being issued, Huobi Global informed holders of Luna and UST of the risks in advance, so that they could make an informed decision.
  3. After providing extensive and detailed updates, Huobi Global reopened the recharge channel to meet the trading needs of its users.

Following the recent market turmoil, Huobi Global immediately stepped up measures to protect users’ assets from serious security incidents. Its daily operations including deposits and withdrawals remained normal.

Whenever a market crisis takes place, Huobi Global believes in meeting its responsibility as an industry leader to protect users’ interests. In a bear market, it is difficult for investors to avoid risks, but choosing high-quality projects and platforms can at least help them to limit unnecessary losses.

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