Crypto trading firm Cumberland weighed into the ongoing trend of centralized digital asset firms falling apart amid a deepened liquidity crisis clouding the industry. It suggests that the overall market’s immediate recovery partially hinges upon whether the distressed assets could be transferred from insolvent firms to solvent ones.
Crisis Not Over Yet
When a prolonged bear market hits the crypto industry, over-leveraged firms tend to be in deep trouble as their collateral plunges in value, soon leading to liquidation. As a result, a ripple effect spreads across the industry, toppling down one firm after another. When users all rush to withdraw funds, heightening the liquidity issue, some firms may have to conduct extreme measures like suspending withdrawals and transactions.
Given the context of a series of firms already halting withdrawalsreducing headcountand looking for restructuring, Cumberland argued that the deteriorated market condition is in a state of uncertainty as more troubled companies may soon collapse due to their colossal sizes of liabilities. More badly managed firms need to have their assets liquidated to “partially offset their outstanding liabilities,” the report said.
As more crypto assets get liquidated, prices will continue plummeting, meaning more pain ahead for the industry. cumberland viewed the ongoing crisis as quite similar to what had happened in the traditional markets since “the underlying economics are no different than the examples in textbooks.”
Additionally, the firm believes the recovery of the badly beaten crypto market depends on how those insolvent firms manage their “distressed assets.”
This is hardly a novel phenomenon; excessively leveraged finance companies have been punished in bear markets for hundreds of years. While this current cycle raises eyebrows because the assets are digital, the underlying economics are no different than the examples in textbooks.
— Cumberland (@CumberlandSays) July 5, 2022
For instance, FTX sent a $250M revolving credit line to BlockFi weeks ago for funding its operations and repaying existing loans. Later, the exchange giant increased the amount to $400M, with the privilege of acquiring the failing lending firm at a discount of $240M in the future.
DeFi vs. CeFi
When investors are hesitant to pour capital into the crypto space, as shown by the decline of off-chain inflows, volatility tends to increase as asset liquidity decreases. Unlike CeFi, which entails complicated human-controlled processes for capital deployment, DeFi has demonstrated relative strength when it comes to transparency regarding liquidation levels as well as its distance from the spot market, Cumberland noted.
Known for its algorithmic-driven mechanism that forcefully executes smart contracts despite market conditions, DeFi protocols would automatically liquidate collaterals whenever the thresholds are touched. It partially explains why they have outperformed centralized firms that offer similar services off-chain during the massive market crash.