How Bitcoin and Cryptocurrency Work


New York –

Over the past few years, several companies have attempted to act as the cryptocurrency equivalent of a bank, promising lucrative returns to customers who deposit bitcoin or other digital assets.

In less than 12 months, almost all of the biggest companies have failed spectacularly. Last week, Genesis filed for Chapter 11, joining Voyager Digital, Celsius and BlockFi on the list of companies that have filed for bankruptcy protection or gone out of business.

This subset of the industry has grown as cryptocurrency enthusiasts have sought to build their own parallel worlds in finance that are not tied to traditional banking and government-issued currencies. But with no guarantees and no government support, these companies fell like dominoes. What started with the collapse of one cryptocurrency company in May has moved to one crypto lending firm, and then another.

In addition, government regulators have begun cracking down on cryptocurrency companies’ ability to advertise their services, saying their products must be regulated by securities regulators.

The collapse is reminiscent of the 2008 financial crisis, but on a smaller scale. There is no concern that the collapse of these crypto firms will affect the broader economy.

Cryptocurrency companies like Voyager, Genesis, and BlockFi were trying to do what banks do in traditional finance: take crypto deposits, pay depositors a dividend on their crypto holdings, and then make loans for profit. This is what the banking industry has been doing for hundreds of years, but with government sanctioned currencies.

The biggest drawback of cryptocurrency is the lack of security measures. There is no deposit insurance, government shutdown, or special agency to protect depositors if a crypto bank fails. This was good when cryptocurrency prices rose because the collateral was accepted by banks in exchange for loans.

Demand for cryptocurrency deposits was so high that firms were willing to pay 10% or more on depositors’ crypto holdings.

But then cryptocurrency prices began to fall and continued to fall. For example, bitcoin fell from more than $65,000 in November 2021 to below $17,000 in November last year. As a result, many of the underlying collateral held by these firms became worth less than the loans they issued, leaving several “crypto banks” virtually bankrupt.

The first two crypto lending firms to collapse were Celsius and Voyager Digital. The companies were exposed to both falling cryptocurrency prices and risky loans to crypto hedge funds such as Three Arrows Capital, which was forced to liquidate and go out of business in June.

Another crypto lender, BlockFi, turned to then-crypto giant FTX and its founder Sam Bankman-Fried for a bailout. Bankman-Fried has given a financial lifeline to BlockFi, one of several moves that have earned Bankman-Fried praise as a savior or financial supporter for the crypto industry.

But the collapse of FTX in November over a high-risk loan to its affiliated hedge fund Alameda Research ended BlockFi’s financial lifeline. BlockFi’s own bankruptcy was inevitable. In a demonstration of how intertwined these crypto lenders are, Genesis loaned billions to Alameda.

Many of these high-tech firms faced bad loans and experienced a very old phenomenon: depositors demanded their money back and a bank run began.

WHAT’S NEXT?

Tens of thousands of customers of these crypto-lending firms are now waiting to see if their assets can be recovered or found in bankruptcy court, which could take months or even years. Genesis has more than $900 million in client funds in bankruptcy.

It is unclear whether cryptocurrency lending will see a comeback anytime soon. After the failure of FTX, cryptocurrency giant Binance announced that it will set up its own fund to provide rescue financing for a crypto firm in trouble, an idea that originated from government-sponsored central banking or deposit insurance.

In addition, the cryptocurrency industry is coming up with the idea of ​​some sort of regulation that would provide minimum security to depositors or investors that currently does not exist. There were several pending bills in Congress last year, but with the shift in control of the House to Republicans, it’s unclear whether the broader GOP is interested in regulating the cryptocurrency industry.



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