Has anything actually changed?
Breaking down recent events in crypto
👋 Welcome to the 22nd issue of The Syllabus from Invisible College — a weekly newsletter that helps you navigate the fast-moving world of web3. To get this newsletter delivered to your inbox, subscribe here:
Before we begin, a disclaimer — nothing in this piece should be construed as financial advice. With that, let’s dive in.
Upcoming Events
We’ve got a packed event calendar over the next two weeks. Here’s what’s coming up:
NFTuesday (Tues. 6/21 @ 12 pm PT)*
Building Financial Lego Blocks (Wed. 6/22 @ 12 pm PT)*
Learning about Learn-to-Earn (Thurs. 6/23 @ 12 pm PT)
Town Hall (Fri. 6/24 @ 12 pm PT)*
Building No-Code Tools for Web3 (Wed. 6/29 @ 12 pm PT)
How Crypto Venture Capital Works (Thurs. 6/30 @ 12 pm PT)*
* To access these events, you’ll need to hold at least one Decentralien NFT.
Now onto this week’s post…
The other day I was driving across town and I had a thought: If I couldn’t see crypto prices at a glance on my phone or computer, would I even know we’re in a bear market? And would my conviction about the power of crypto change at all?
For me, the answer to both questions is an emphatic, “No!”
The reality is that I can easily see prices—and I admittedly look at them far too often. Yet, it also doesn’t make sense to completely bury my head in the sand and not pay attention at all.
This week, let’s dive into what factors and narratives are driving the steep drawdown in prices lately. Trust me, I wish I were writing about stuff that’s more fun, but you’ve got to play the hand you’re dealt.
Okay, let’s get into it.
The L Word
The legendary investor Charlie Munger once said, “There are only three ways a smart person can go broke: liquor, ladies, and leverage.”
And it turns out that Charlie added the first two just because they start with the letter L.
In good times, leverage can be a siren song for aggressive investors looking to maximize returns. Leverage is when investors use assets as collateral to borrow against so they can invest even more of those assets. And sometimes they’ll even take those newly borrowed assets and borrow even more using what’s called a looping strategy.
Borrowing against assets is one of the core use cases for DeFi with many different protocols existing on every blockchain—some prominent examples being Aave and Compound.
Leverage works well when asset prices are appreciating, or even if they remain stable. But once they start dropping precipitously, the borrower runs the risk of a margin call and possible forced liquidation. A margin call is when a borrower needs to add additional funds to their collateral. If they’re unable to do so, then some of their collateral will be liquidated and sold off.
Let’s use a simple example to illustrate how it works.
Say ETH is worth $2,000 (those were the days) and a fund wishes to borrow against $1,000,000 worth of ETH as collateral. For this example, let’s say they borrow 50% in order to get their hands on $500,000 more ETH. This means their $1M worth of collateral won’t be at risk of liquidation as long as ETH stays above $1,000, which is 50% of the price it was at when they took out the loan. They usually borrow a modest percentage in order to play it safe and not get liquidated by even a tiny drop in the price of ETH.
With loan rates typically well below 10% per year and an asset that has appreciated a lot more than that in recent years, you can quickly see why this is appealing.
The problem is, if ETH dips below $1,000, as it did just this past weekend, they will need to add additional collateral, or else part of their original $1M will be liquidated.
This is exactly what’s been happening with Celcius and Three Arrows Capital (3AC), two massive crypto hedge funds, but on a way, way bigger scale. They took their customers’ funds, levered them up to the tune of billions of dollars, and now they’re getting margin called.
Is DeFi to blame at all?
Not only did those hedge funds leverage their customers’ assets, but they also invested them into DeFi protocols that have since collapsed. Most notably, Terra.
Does this mean that DeFi is broken? Well, Terra certainly is. But DeFi generally isn’t.
The vast majority of DeFi protocols 3AC and others invested in and borrowed from did exactly what they’re designed to do. Both Celsius and 3AC are considered CeFi, or centralized finance, companies. They invested funds in DeFi protocols, but they are not DeFi protocols in and of themselves.
The people and funds who adhered to sound investing principles are fine. Of course, their balances are lower now than they were before, but they haven’t completely lost their money via leverage.
The bigger problem is greed. During the bull market, some crypto hedge funds got bolder and bolder with their leverage and now their greed is getting punished.
And we’re all getting punished along with them.
Should this change how we think about crypto?
It’s times like now when people will question why they’re holding onto crypto at all—even the top assets like BTC and ETH. The price drawdown has been so significant, with BTC down ~55% and ETH down ~69% so far this year, that it’s an understandable question to ponder.
But beyond price action, nothing about those assets is fundamentally different today.
Ethereum is still programmable money with lots of developers building products on it every day and the core development team working towards the upcoming ETH merge upgrade (hopefully) soon.
Bitcoin still has by far the largest market cap and great brand recognition. Many people think Bitcoin and crypto are one and the same. Bitcoin also has the best shot at becoming a true store of value, something that requires a currency to be durable, limited in supply, and have social consensus—meaning a shared story most market participants agree upon.
As I mentioned in last week’s post, my portfolio is ETH heavy. In fact, I actually don’t own any Bitcoin at all right now. I personally believe that building useful financial tools and products with financial incentives baked into them will be a huge opportunity on the internet, so I’m betting accordingly. But I can also see a future where Bitcoin’s price stabilizes and it becomes something akin to digital gold or possibly even the default digital currency we all use online every day.
But don’t just take it from me. I encourage you to dive in and do your own research. Read the Bitcoin whitepaper, or follow along as our faculty member Rockwell reads and explains it here (token-gated). Watch our Bitcoin master class (free for token holders). Read the Ethereum whitepaper. Ask questions in the Invisible College community.
Develop your own point of view. And place your bets accordingly.
Other Recommended Reads
Where are all the crypto use cases?
Evan Conrad addresses this often asked question from crypto skeptics head-onFloaters
Arthur Hayes dives deep into what’s going on in the markets and how he’s thinking about placing bets going forwardPay students to tackle learning loss
Zaid Jilani reports on an economist’s experiment with results that flew in the face of the common wisdom about how kids learn and spend money
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Hey there! With whom can we discuss some partnership opportunities? :)