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Jun 21, 2022

Weekly Update: Fed policy and liquidity stress drives crypto lower

The NCI opened the week 29.3% below last week’s closing. The index’s performance was heavily influenced by Bitcoin, down 28.3%, while Ethereum fell by 27.3%.

The crypto market suffered another week of heavy losses as the Federal Reserve ramped-up its interest-rate tightening cycle and large institutional players, including funds and lending platforms, faced liquidity problems and potential insolvency.

The market's poor performance sent prices tumbling past a series of important psychological thresholds for the first time since the end of 2020/start of 2021: Bitcoin fell below $20,000, Ethereum traded under $1,000, and the aggregate crypto market cap sank past $1 trillion. 

As the week started, the debate surrounding the Federal Open Market Committee (FOMC) interest rate hike, due to be divulged on Wednesday, quickly evolved. Market participants were still discussing the previous Friday's Consumer Price Index May reading, which showed inflation had gained momentum since April and reached 8.6% on a year-over-year basis.

During the weekend, only the most pessimistic analysts predicted a 75 bp hike. Fed Chairman Jay Powell had denied the FOMC had been “actively considering” such a hike in a statement made in May. 

On Monday, CME’s FedWatch tool still reflected Powell’s previous comments, showing a 25% chance of a 75 bp hike. However, on Tuesday, the Wall Street Journal published an article titled “Fed Likely to Consider 0.75-Percentage-Point Rate Rise This Week.”

Analysts interpreted the headline as an attempt by the Fed to forewarn the market, seeking to align market expectations and avoid a surprising decision on Wednesday. On the morning that preceded the announcement, the probability of 0.75% hike had been priced in with 95% certainty, with the remaining 5% pointing to 100 bp hike.

The growing consensus around a more hawkish FED seems to have concerned investors, as the price of Bitcoin neared $20,000, briefly before US markets opened on Wednesday morning.

The Fed’s ongoing battle against inflation wasn't the only negative driver for crypto markets last week. While the FOMC confirmed the first 75 bp hike since 1994, crypto investors were consumed by a string of worrying headlines revealing an ongoing credit crunch driving institutional players towards insolvency. 

On Wednesday, Three Arrows Capital (3AC), a crypto hedge fund ($18 billion AUM), suffered at least $400 million in liquidations. The news about 3AC’s woes came on the heels of Celsius Network’s announcement that confirmed the suspension of all withdrawals and transfers between accounts due to "extreme market conditions." Both companies may now be insolvent. 

The ongoing credit crunch stoked fears that a systemic crisis may take hold in the digital assets market, in part as a delayed reaction to the collapse of the TerraLabs tokens (LUNA and UST).

According to The Block, Celsius sent at least 261,000 ETH ($535 million at current prices) to Anchor Protocol in 2022, TerraLabs' lending platform that offered high yields for deposits of Terra USD (UST), Terra’s algorithmic stable coin. Meanwhile, 3AC has informed the Wall Street Journal that it suffered heavy losses as a result of the Luna collapse. 

Celsius has also been compromised by positions in assets with low liquidity, such as stETH (Staked Ether), a synthetic representation of Ethereum tokens (ETH) locked in the Beacon Chain until the Ethereum network upgrade is implemented.

The value of this synthetic has been straying from its ETH peg since May. If Celsius is forced to sell its stETH, the platform could suffer significant losses and further accentuate the price disparity between stETH and ETH, possibly compromising other market participants, including 3AC, which also owns the synthetic.

On Friday, two other CeFi platforms, Babel Finance and Finblox, froze or capped withdrawals, both contaminated by 3AC’s possible insolvency. The increasing levels of uncertainty weighed on investors, sinking Bitcoin’s price to nearly $17,500 and ETH to $880 as US markets closed on Friday.

Investors now fear that the spread of the credit crunch could impose greater sell pressure on the market, as large institutional investors dump their assets to meet margin requirements, further spreading the contagion. 

The tumultuous week for the DeFi industry has sparked critics to question the lack of transparency of CeFi platforms, which act like banks but don't offer the same degree of transparency or the safeguards guaranteed by traditional financial institutions.

 

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