Robert Steinadler, 9 months ago

Contagion in the crypto market – How did it happen and what are the consequences? 

During the last week, there was only one big topic that was discussed and brought up the worst fears: contagion. The term describes the possibility that one major incident can lead to a chain reaction that affects the whole market and eventually result in a crash. Since the beginning of April Bitcoin and the crypto market, in general, have only seen one direction and that was going down south. It seems that the most recent events had a dramatic impact on an already difficult situation.

In this article, we are going to explore the effects and like to provide our readers with the perspective of LiteBit as a crypto platform.

Celsius shut down

The fact that Celsius shut down came with a lot of foreshadowing but still caught many investors by surprise. Even days before the company decided to halt all withdrawals it published a blog post reassuring that there is enough liquidity available. Even the CEO commented on Twitter that there was no reason to worry.

It remains unclear why they kept making these statements. At some point, management might have thought that the market would turn around and business could indeed continue as usual. Sooner or later the truth will be brought to light. Even though it may take some time it is obvious that Celsius will have to answer how this happened and why they came to the conclusion to communicate with their customers in such an unsatisfying manner.

But why did Celsius get affected in the first place?

Lending is a complex business

The problem with lending platforms like Celsius is that they not only lend money to retail customers. They are also active in using customer funds to lend out to bigger players or invest in staking derivatives like staked Ether (stETH) which is provided by Lido.

Interest or yield cannot be generated without taking risks. The risk for companies like Celsius is that the crypto assets that they are investing in are dropping so much in value that they cannot sustain the dollar value that is needed. The first big drop that was responsible for driving the price down was the crash of Terra. The consequence of that crash alongside the Fed raising the interest rates was the reason that Celsius had to ask for its money back when the price of its assets fell down below a certain level.

What happens if you have to ask for money back that belongs to your customers but has been lent to third parties or is stuck in complex DeFi products?

That’s when contagion effects come into play. They immediately affect other businesses. First of all other lenders, then hedge funds, and last but not least the whole market. Before you can say “magic internet money” everybody has to sell assets to put up for their debt.

What Celsius also did is to protect their remaining funds by freezing them, effectively preventing customers to worsen the situation by withdrawing their funds in a bank run.

Sell-offs are shaking the market

The result of contagion is that all players in the market who are working with leverage - which is in the end money that they don’t own - have to liquidate positions or even worse get liquidated by a margin call. Only those with enough liquidity or the ability to protect the liquidity that they have will survive.

These sell-offs are brutal and are going to continue until everybody who cannot back their own positions with money is liquidated by the market or by their own risk management. In the light of the recent events, Three Arrows Capital is a prime example of a hedge fund that got liquidated by the prices dropping further and in effect became itself another cause for contagion. At the time of writing the story still unravels which companies got affected by 3ACs downfall. It is worth mentioning that 3AC was heavily invested in Terra and its failed stablecoin ecosystem which weakened its position before things got out of control.

It will take months to get a complete overview of how many players in the crypto industry got affected and which other contagion effects came into play.

In the meantime, it is mostly retail customers who are caught by surprise and in many cases face devastating losses. Especially all those who were invested in Terra or held funds with Celsius (although it remains to be seen if they will get their funds back in the end). It is important to understand that these losses are the result of a chain of events that are not only extremely unlikely to happen but also not inherent to crypto. In fact, most of the chaos that was created has been the result of an opaque money market that was not run completely on the blockchain.

How is LiteBit affected by this contagion?

Many retail customers wonder – could this also happen to LiteBit? First of all, LiteBit is a financially healthy organization. We do not offer crypto lending and do not have any loans with client funds as collateral so there are little similarities to parties like Celsius or 3AC.

At LiteBit, we understand that crypto can be unpredictable and comes with high volatility. This is why we have ensured that we have sufficient assets and liquidity. And this shows: we receive yearly financial audits and passed each one. We have received no external funding and do not take any positions in other companies or projects to ensure the safety of the client funds that have been entrusted to us. Protecting these funds (both fiat and crypto) has our highest priority.

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