Crypto crisis

An urgent warning for investors

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If you’re smart, you don’t need leverage. If you’re dumb, you shouldn’t be using it.

- Warren Buffett

As someone who’s been following the crypto market since early 2017, when Bitcoin had barely hit $1000, ups and downs aren’t new to me. Back then, we saw the market shoot up by 2000% as altcoins and ICOs minted millions, and every teenager with a crypto channel considered himself an expert. And then… Everything fell in value by 90-99%.

In spite of enduring those times, I feel that the phase that the market is going through now is catastrophic on a completely different level - Poorly managed, highly leveraged firms who take irresponsible risks with your money have changed the nature of crypto investing, and the domino effect that it creates might topple one company after another. With the collapse of Celsius, Voyager, and Three Arrows Capital, more may be on the way.

Let’s look at both the business models that crypto companies operate under, why things have gotten worse now and what you can do to protect your money.

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The Middlemen

The first model is pretty straightforward - Exchanges. The main purpose of the exchanges is to let you buy and sell cryptocurrencies. They make their profits by charging a brokerage commission on trades. Exchanges like Coinbase, Binance, Bitfinex, etc. fall into this category. Though this business model is inherently safer as the exchanges don’t take on the liabilities of the consumers, things can still go wrong.

1. Bankruptcy

Mt. Gox was one of the largest cryptocurrency exchanges in the world, based out of Japan, handling around 70% of the Bitcoin in the world in 2014. But on 7 Feb 2014, Mt. Gox halted all withdrawals after nearly 850,000 BTC were reported missing or stolen from the exchange. The investors are yet to be reimbursed after the company filed for bankruptcy. Other exchanges that failed include:

• QuadrigaCX, which “lost” the keys to crypto wallets after the sudden death of its founder who held the private key - Later, it was revealed that there was gross mismanagement of user funds.

• Einstein Exchange went bankrupt in 2017.

• Bitgrail Srl went bankrupt after tokens were stolen from the exchange.

A major problem in all these cases was that these companies had customers globally, but they were based in different countries with no regulatory framework to hold them accountable.

This is a problem that still persists. Coinbase recently updated its terms of service to state that “customers’ cryptocurrency assets could be considered the property of a bankruptcy estate if such an event were to occur”, and though they say that the chances of this happening are very small, if it does happen then you are out of luck. Crypto funds are not FDIC or SIPC insured, and there is only so much the government can do.

2. Crypto Hacks

Security risks are still one of the biggest problems that plague cryptocurrency. As this Chainalysis crypto crime report says, “In 2021, criminal hackers stole approximately $3.2 billion in cryptocurrency, six times more than they made off with in 2020.” Companies like Mt. Gox, KuCoin, Binance, Bitfinex, Bitmart, and Coincheck were all victims of a hack - where the business is not responsible for making sure your funds are recovered. 

Source: Chainalysis Crime Report

And thefts are just one of the categories, as we can see. More than $14 Billion has been lost to illicit activities. There is very little that authorities can do due to the sheer scale of the crypto market. Exchange hacks have other problems as well:

• The exchanges delay announcing their losses to save face

• The exchanges could go bankrupt due to the loss of hacked funds, and this impacts the customers

• News of hacks impacts faith in the market, leading to price crashes.

3. Withdrawal freezes

Just when you think that you can take out your crypto as markets are becoming volatile, you realize that your money isn’t really yours in the first place. Binance temporarily froze its funds due to network congestion, and Celsius became the first to halt withdrawals… indefinitely. Voyager and Vauld have followed suit, leaving customers with no way to access their funds in a trying time.

Though these companies specify that they reserve the right to freeze your funds right at the moment you sign up, few people read the fine print - including me - and this led to my funds getting locked up with Celsius. But even exchange problems aren’t as destructive as the second category…

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The Lending Platforms

What is money if you don’t do anything with it? This is the idea behind the second business model - lending firms and the world of DeFi. They borrowed the funds of users, lent them out at a higher rate, and returned the profits to the users while taking a cut for themselves. At least, that’s what it looked like on paper.

The problem was that regulatory oversight in DeFi was so minimal, that crypto lenders could do anything they wanted with users’ funds claiming that there was no risk. But lenders like Celsius went on to do something very questionable:

1. Use customer funds as collateral to get crypto loans

2. Use the borrowed funds as collateral to get more loans

3. Repeat.

By using leverage in this way, they could 10x the returns on even a small profit. But what leverage gives, leverage taketh away. When the bear market hit, the losses were magnified as well! On top of this, their investments were hacked, mismanaged, and they even issued their own tokens. It was only a matter of time before they froze withdrawals, and now matters look bleak. Other funds like Crypto.com are slashing rates with no prior warning to cut their losses.

It also turned out that these funds were all connected - Voyager Digital had given a loan of $650 Million to Three Arrows Capital without collateral. Unlike protocols like MakerDAO, Compound and Curve which are truly decentralized and are at least managing to stay solvent, “CeFi” lenders like Celsius and Voyager might go down and take their customers’ money with them (Read this excellent article to know more).

So now let’s come to the real question - How do you keep your money safe in this storm? What precautions can you take?

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Well, there are some obvious things that you can do to protect your cryptocurrencies, but the most fundamental thing is to understand that crypto is a highly volatile asset, so the emphasis should be on safety and minimizing downside risk.

1. Not your keys, not your crypto. You’ve heard that a hundred times, but if you’re concerned about the safety of your assets on an exchange, the first step should be to move them to a cold-storage wallet. And don’t delay it! It might take more time than you expect.

2. Be wary of scams. There’s not much you can do if an exchange is hacked, but there are user-level hacks like this one, and being part of the Reddit Crypto community is a good way to stay aware of these risks.

3. Only invest what you can afford to lose. With high reward comes high risk. I have invested only 5-8% of my portfolio across Bitcoin and Ethereum, and it’ll sting if I lose it but it won’t ruin me. I’m prepared to see all of it go to zero.

4. Don’t put all your eggs in one basket. If I choose to experiment with crypto lending, I never invest all of my crypto in one place. I spread it across at least 3-5 different platforms. That way the risk is diversified.

5. Do your due diligence before investing in lending platforms. Research how the company is able to generate high returns and decide if the trade is worth the risk.

Personally, I think that some of the larger cryptocurrencies have potential over the long term and I can risk some money to be part of that journey. But it worries me when I hear millennials quote crypto as their retirement plan - There are much safer options out there with more predictable returns, so plan prudently and invest in crypto only if it’s part of an already diversified portfolio.

See you next week with another deep-dive!