Crypto Winter: What It Is and What it Means for the Future of Web3

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November 1, 2022 Business

The COVID-19 pandemic decimated the world’s economies in 2020 and affected cryptocurrency. Nevertheless, as the world began stabilizing, traditional financial markets flocked to cryptocurrencies, causing investments and trade volumes to soar by a staggering 689% in 2021.

As of October 2022, cryptocurrency markets have gone from bull to bear. According to a KPMG report, the first half of 2022 saw a global decline of over 50% in investments in cryptocurrency companies. At the same time, the value of cryptocurrencies has fallen by $2 trillion from the peak of a significant 2021 rally.

Things aren’t looking great for web3, but does that mean it’s the end? In this article, we dive into what a crypto winter is, take a look at the cause, and examine if this marks the end or rebirth of Web3.

What is a crypto winter?

Crypto winter is a term that describes an extended period of falling cryptocurrency prices. While the origin of the term is purely speculative, some credit “Game of Thrones,” where the House of Stark’s catchphrase was “Winter Is Coming.” It was interpreted as a sign that Westeros might be plunged into protracted strife at any moment.

Crypto winter is similar to a bear market in stocks since it denotes unfavorable sentiment and declining average asset values across a wide range of digital currencies. Moreover, it frequently coincides with other worldwide economic downturns or governmental laws, but only sometimes.

Analysts believe that earlier in 2022, the foundations for the impending crypto winter were laid. The impact of global events, particularly the Russia-Ukraine conflict that disrupted international banking, rising inflation, and interest rates, and the collapse of stablecoins TerraUSD and Luna, heralded the domino effect in the cryptocurrency industry.

The rise and fall of the NFT market, crypto, and web3 investment

In 2022, NFT sales, cryptocurrency trading, and Web3 investments have continued to fall. According to a report by DappRadar, NFT sales decreased to $3.4 billion in the third quarter of 2022 from $8.4 billion in the second quarter and $12.5 billion at the market’s peak in the first quarter.

Likewise, global investments in Web3 startups decreased from a record $32.1 billion in 2021 to $14.2 billion in the first half of 2022, and this downturn is predicted to continue. On the other hand, cryptocurrencies have had a severe decline this year, dropping $2 trillion in value since the peak of a significant surge in 2021. Since their all-time high in 2021, the value of popular tokens, including Bitcoin, Ethereum, and Binance Smart Chain, has dropped by up to 70%.

What were the causes of the current drop in values?

The recent decline in cryptocurrency prices is not unique to cryptocurrencies. Instead, it results from a global sell-off in practically all asset classes, rising inflation, and pessimism due to the Russian-Ukrainian conflict.

There are, however, a few cases of crypto-specific problems, such as the downfall of the algorithmic stablecoin, TerraUSD, and the coin that backed it, LUNA. Other incidents highlighted below have also sowed panic among investors, leading to a current drop in cryptocurrency values.

Domino effect of a stablecoin collapse

TerraUSD, or UST, was an algorithmic stablecoin, a cryptocurrency pegged to the U.S. dollar one-to-one. It operated through a convoluted system that combines economics and technology, ostensibly bringing stability to an asset class previously notorious for significant volatility. Theoretically, TerraUSD’s price would not change because LUNA and TerraUSD can be converted 1:1 and have a $1 redemption value. It would serve as a haven for cryptocurrency investors like the dollar does for conventional investors.

However, UST lost its dollar peg, which also caused the demise of its sister token, LUNA. The failure of TerraUSD and LUNA cost investors $40 billion in losses, and it has had a ripple impact on the whole cryptocurrency market.

Liquidity issue for CeFi companies

Celsius was the first CeFi company to suspend customer withdrawals on June 13. Before that, Celsius behaved like a traditional bank by promising more than 18% returns for cryptocurrency deposits. The deposited cryptocurrency would be used to make high-yield loans to other players. These other participants would utilize it for trading, and Celsius would use the yield’s earnings to reimburse investors who had deposited cryptocurrency. However, the issue arose when the debtors couldn’t meet up due to the unstable market conditions. Additionally, the company began to experience liquidity issues because of significant simultaneous customer withdrawals.

To make matters worse, Celsius managed over $475 million worth of staked Ethereum (stETH) through Lido. As stETH fell against ETH, the loan company still tried to meet its obligations in ETH. Eventually, the company filed for bankruptcy and halted withdrawals.

Bankruptcy of 3AC

The degree to which crypto firms recently relied on loans from one another came to light. One of the most prominent casualties of the market decline was the Singapore cryptocurrency hedge fund, Three Arrows Capital, or 3AC. With investments in Layer1 blockchains like Terra, DeFi protocols, centralized crypto equity companies, NFTs, and Web3 games, its asset under management (AUM) once topped $10 billion.

In February, 3AC purchased approximately 11 million LUNA for $560 million. However, because of the LUNA collapse, that purchase was less than $700 in June. To further stoke the flames, 3AC took a sizeable position in stETH like Celsius, from which 30,000 stETH were eventually sold. In June, 3AC failed to meet crypto lender, BlockFi’s margin calls and had its positions liquidated. Later, the hedge fund missed payments on a more than $660 million debt from Voyager Digital. This created a ripple effect leading to BlockFi and Voyager Digital filing for bankruptcy.

It became obvious that 3AC was heavily leveraged, particularly after Terra’s demise and the liquidation of its holdings. Then, as icing on the cake, 3AC filed a Chapter 15 bankruptcy petition to the U.S. Bankruptcy Code.

Less heat might be a good thing

Interestingly, this isn’t the first crypto winter. Reuters reports that we’re in our fifth now. If this crypto winter is anything like those that preceded it, this current dip might actually be a good thing for web3.

Traditionally in boom and bust cycles, the bust period is one of innovation, regrouping, and the culling of ideas or technologies that can’t compete. In the case of web3, it’s a reset moment that allows the fundamentals to be better developed.

For example, the bear market of 2014 gave birth to Ethereum, while 2017 saw the emergence of Polygon, Avalanche, and Algorand. The non-fungible token (NFT) revolution, decentralized finance (DeFi), stablecoins, and play-to-earn gaming were all brought into being during the last bear market in 2020.

Clearly, winter is good for building infrastructure. Freed from the heat of the market, builders and crypto market makers are able to focus on longer-term propositions and what they think the next iteration of web3 tech will be. Likewise, with less money in the space, only projects with a solid business case and strong product-market fit will emerge in the spring.

What the future holds

What tech will be at the forefront when winter passes? A safe bet is that the role of the token will change from just being something of speculation to an item that’s used for accessing and verifying identity in a more secure way. Applications include things like web3 authentication for more secure management of business documentation, and Utility NFTs which make it possible to associate real-world benefits with the online world of NFTs.

What exactly the future will hold can never be known, but there’s a good chance the next crypto spring will be as exciting as the ones before it.

About the author:

Ned Rockson is a web3 engineer with a love for scaling startups. Ned is the co-founder of SlashAuth, a web3 token-gating solution.