After a violent few weeks, an excessively leveraged part of the crypto market has collapsed: the Terra Celsius 3AC Nexus. But given its importance, the reaction of the entire market was almost too violent. Why? And what follows from this?
Actually everything seems quite logical. Bitcoin and other cryptocurrency prices plummet, stablecoins like Terra collapse, startups like Celsius and hedge funds like 3AC go bankrupt. All very typical of a bear market like the one crypto is currently going through.
But something doesn't fit. Prices have fallen too far for what was happening on the surface.
There was a series of collapses of projects that were of significant size: first UST and Terra , then Celsius , shortly after 3AC . As far as we can see, these collapses have remained so far.
These are not small coins and companies. But they are not pillars of the market either, but the top dogs of a part of the market that one could call excessive. You could think of them as a kind of knot that takes leverage to the extreme.
The sacred cow of modern finance
Leverage is the basis of modern finance. It may have started with the Templars accepting gold and silver coins from the Crusaders in exchange for promissory notes to redeem in the Holy Land. Over the centuries, this grew into the practice of Italian money changers, taking deposits from their bank and issuing paper money in return, which merchants could freely book in a network of changers: Leverage stores one value and issues another, virtual value on its basis.
Over time, it became normal to increase leverage: original value becomes more on a virtual level. Money (or another security) is created. This happens every day in finance. In the Bretton Woods system, gold was leveraged to create dollars and dollars to create other currencies. The current system dispenses with the gold, but leverages the money supply of the central banks: banks create money by granting loans that are only covered by a partial reserve.
In and of themselves, levers are an enormously fertile financial mechanism. Without him we would probably still be in the monetary Middle Ages. But leverage can reach excessive levels where it creates bubbles and instability. This probably happened in every construct that we call the "UST-Terra-Celsius-3AC-Nexus", or in short: the "Nexus".
Numerous mechanisms worked together in the knot. They allowed new layers of leverage to be formed and the lever to be further increased. Some of the mechanisms are these:
UST was an algorithmic stablecoin backed by Terra token (LUNA), later also Bitcoin, and replicated the value of the dollar.
On a DeFi platform on the Terra blockchain, UST could be staked with up to 20 percent interest. This cannot be sustainable unless real USD – or other dollar tokens such as USDC or USDT – have the same interest rates.
However, the system remained stable as long as the UST held parity with USD (or other dollar tokens).
UST's smart contract incentivized traders to smooth out deviations from parity — as long as the Terra tokens used as collateral represented enough value.
Traders and investors can deposit tokens and cryptocurrencies such as UST, Terra, Ether, Avalanche or Bitcoin on lending platforms such as Celsius as collateral to borrow other coins or currencies such as USDC or USDT.
These loans are overcollateralised, for example by being 150 percent covered with other tokens. For example, a trader can deposit 150,000 UST to receive 100,000 USDT.
The borrowed dollar tokens can be used to buy UST to stabilize the rate.
Since platforms like Celsius also stake the UST tokens with 20 percent, the trader still receives interest on his deposited UST.
Hedge funds like 3AC borrow money on such platforms to make profits with stablecoins and other tokens and/or trade other coins up
Or so. There are a multitude of variations on how this actually works, and given that there are quite a few brilliant (though not necessarily wise) people in the industry, the actual process may have been far more sophisticated, elegant, and also complex. But the details are not important here.
The point is that the Terra Celsius 3AC node created a kind of Munchausen machine: the system supports itself; it pulls up on its own braid. It produces tokens, uses them as collateral to create stablecoins, which become collateral, to lend other stablecoins with which to support the price of the tokens and stablecoins, and so on. Somewhere at the bottom there is value – bitcoin, ether, tether, USDC – but they have so many layers of leverage over them that the bottom can hardly be seen.
The Terra Celius 3AC node (TC3 Nexus) has been pushing this system to the limit. He created a $10 billion stablecoin (UST) out of thin air and gave tokens like Terra (LUNA) a market cap of $20 billion or even $30 billion, maybe 50 or 60. And all without there being a tangible one there was economic activity in this system that was not self-sustaining.
At the same time, hedge funds like 3AC can leverage this knot themselves in order to use it to drive up the prices of other tokens such as Avalanche (AVAX) or Fantom (FTM). I mention these two because they are known to have been traded with by 3AC. The two Ethereum competitors temporarily had market caps of $28 and $8 billion respectively, of which only around 8-15 percent remain today.
What might be bubbling beneath the surface
These collapses may spill over to other platforms and coins. But in fact, they only touch tiny parts of the entire ecosystem. You can't be responsible for the fact that it loses so massively.
The total market cap of all cryptocurrencies has fallen from $1.25 trillion to $900 billion over the last 7 days. That's a $350 billion loss. 180 of them are based on Bitcoin alone, and a good 80 on Ethereum. This significantly exceeds even the maximum speculative value of UST, Terra and Celsius, even if we add other tokens like Cardano, Avalanche and Fantom.
The circumstances are wrong. Given what has happened, prices have fallen too far and this gives us a peek below the surface. There, however, we find several options to explain the mismatch:
1.) It is a panic sale. The course was already unfavorable and the incident caused the already shaky hands of speculators and investors to sell excessively.
2.) The market was going down anyway and was just waiting for an opportunity. Price was overvalued and the collapse of the Nexus gave it the energy to ride out the long overdue but painful correction.
3.) The Nexus - or similar constructs - had a bigger impact on the price of ALL cryptocurrencies than most realized.
4.) There's something we don't know yet, and more failures are to come. Will Crypto.com and Nexo also follow Celsius, despite all assurances that they are not affected? Will the stablecoin crisis spread to Dai or Tether?
Depending on what you choose, cryptocurrencies are currently grossly undervalued and should be grabbed while the summer sale lasts. Or the market has demonstrated how weak and shaky it is set up, and that even small pricks are enough to let out a lot of hot air. In that case, the real catastrophes may be yet to come – what happens if Tether collapses, if MicroStrategy or El Salvador goes bust, if one of the major exchanges crashes? Was the Terra Celsius 3AC Nexus just the first batch in a cascade? Will bankruptcy itself become leverage?
We can't give any answers. But everyone should ask themselves these questions, whether it is about how best to manage the portfolio that has already been built up, or whether to use the favorable prices to get in or to buy more.
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