How the crypto market came crashing down

It's been another bad week for the cryptocurrency market.

On Sunday, crypto lending and trading platform Celsius Network announced that it would be pausing all withdrawals and transfers. Coinbase, another crypto trading platform, also laid off 18 per cent of its workforce on Tuesday and warned of an extended "crypto winter." And on Saturday, the price of Bitcoin fell below US$20,000 for the first time since 2020.

This crash kicked off last month, as the U.S. Federal Reserve signalled its intention to hike interest rates to combat inflation, prompting investors to sell off risky assets like crypto holdings. But it's not the only factor that explains the recent collapse in the crypto market.

Many crypto-trading platforms had been offering decentralized financial products, also known as DeFi. DeFi enables users to borrow, trade and earn interest off of cryptocurrency holdings, similar to a bank.

"The DeFi ecosystem purports to provide a parallel financial system to the traditional financial system. It's effectively an effort to replicate traditional functions of the financial system by using open source global decentralized blockchains," Ryan Clements, an associate professor at the University of Calgary's Faculty of Law, told CTVNews.ca over a video interview on Saturday.

But the DeFi ecosystem often relies on algorithmic stablecoins, which are cryptocurrencies that attempt to fix their value at a consistent rate through the use of computer calculations that control their supply, offering investors a purportedly stable alternative to volatile cryptocurrencies like Bitcoin.

But in May, the value of TerraUSD, a popular stablecoin, dropped from around US$1 to less than 10 cents. As of June 18, that cryptocurrency is worth less than a penny.

"That failed in a catastrophic fashion and that had a cascade effect on the larger crypto market, which accelerated the selling pressure," Clements said.

Some of these crypto exchanges, such as Celsius, operated on a fractional reserve system just like a bank, where it would lend out crypto assets that it receives as deposits. But as selling pressure intensified, Celsius halted withdrawals and transfers.

"There was a run on Celsius as a crypto bank and Celsius had to freeze all withdraws because it couldn't meet the depositor demands," Clements explained.

While crypto exchange platforms may offer services similar to what a bank offers, Clements notes that there are far fewer protections. Unlike bank deposits, which are insured by the Canadian Deposit Insurance Corporation, crypto deposits have no insurance, meaning that all of your assets could be gone if your crypto platform shuts down.

That's what happened in 2019, when the B.C.-based crypto exchange Quadriga shut down. Its clients collectively lost at least $169 million.

CALLS FOR BETTER CRYPTO REGULATION

Experts say the crashing crypto market is underscoring the need for stronger consumer protection in the sector in order to protect Canadians.

"This is an area that is still small, but it's growing really rapidly. And it is largely unregulated," Carolyn Rogers, senior deputy governor of the Bank of Canada, told Reuters on Thursday. "We don't want to wait until it gets a lot larger before we bring regulatory controls in place."

Back in February, Conservative MP Michelle Rempel Garner introduced a private member's bill to the House of Commons calling on the minister of finance to develop a national regulatory framework for cryptocurrency.

"The market instability we are seeing today further emphasizes the need to talk about how to both protect people, and provide regulatory stability for growth in the cryptoasset sector," Rempel Garner said in a statement last month, as crypto assets began tumbling down.

But Clements says the current regulations on paper are actually "quite robust."

"We have rules with respect to virtual currency dealers being money service businesses and having to register with FINTRAC and be subject to reporting requirements relating to anti-money laundering and anti-terrorism financing," he said.

Several crypto exchange platforms are already registered and regulated by securities administrators. These platforms are subject to risk disclosures, requiring them to be transparent about who their borrowers are, how the deposits are being held, how much in capital reserves they have as well as what kinds of safeguards are being implemented.

However, because of the global reach of the internet, many platforms that are used by Canadians are based outside of Canada and don't comply with these regulations.

"The biggest challenge in this area … is actually enforcement, because there's a whole bunch of lending intermediaries that have popped up over the last several years that are accessible by Canadian platforms," said Clements. "These lending intermediaries aren't complying."

Celsius is not registered with any provincial securities regulator in Canada, despite the fact that it received a US$400 million investment from the Quebec pension fund. It had also promised its customers huge returns on their deposits, as much as 18.6 per cent annually. At the same time, it also offered loans for as little as 0.1 per cent interest annually.

Clements says charging deposits a high interest rate while offering low-interest loans is "the opposite of what a bank does"

And so there's a lot of people including myself, who have long been skeptical of how these returns are generated, what risks do these lenders take on," he said.

Reuters reported on Thursday that in the U.S., regulators in five states have announced that they're opening investigations into Celsius. Celsius told its clients on Wednesday that it is "attempting to stabilize our liquidity and operations."

WHAT CRYPTO INVESTORS NEED TO KNOW

Experts agree that anyone choosing to jump into the cryptocurrency market need to understand the high-risk nature of these investments.

"Like any asset that's jumping around in price, people see an opportunity for quick gains," said Rogers. "Our concern is they may not understand the risks. They may not even understand that it's not a regulated area."

This risk factor also applies to algorithmic stablecoins, as the TerraUSD crash demonstrates.

"You need to be prepared for the volatility, like all risk assets, and you need to be very cautious when promoters of certain acid crypto assets are making claims about their stability or making claims about their guaranteed yields," Clements.

With files from Reuters.