The Cryptocurrency Industry and Its Distressed Cycles

Welcome to the 119th Pari Passu Newsletter, 

In early 2025, the market has been discussing the possibility of a strategic Bitcoin reserve that would store cryptocurrency to use during a future crisis or supply disruption [1]. In 2024 alone, the price of Bitcoin has risen by 140%, exceeding returns from stocks and gold [2]. What does this mean about the future role of cryptocurrency in our society? 

Today, we will dive into what drives the value of cryptocurrency, the business model of crypto exchanges, the relationship between different market players, and the structural problems that triggered a series of crypto bankruptcies since 2022. With a foundation of distress in crypto, the next post will dive deeper into the infamous FTX Bankruptcy that changed the digital market forever.   

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Introduction to Crypto

Since trading emerged in the 1600s, it has led to various forms of trading, such as stocks, commodities, and foreign exchanges. In 2009, the first cryptocurrency, Bitcoin, was invented. Cryptocurrency trading follows the same basic rules of trading - buy low and sell high - but with digital assets. Digital assets can be anything from a photo to cryptocurrency but must satisfy a few conditions: they must generate value for the owner, can transfer ownership and the value behind it, and can be stored and found [3].  

Fundamentally, crypto traders come in with a very different investment strategy from stock investors. Although stock investing has a wide range of strategies, a stock investor owns shares of an established company. Their focus is on the company’s earnings and growth potential. A crypto trader, on the other hand, has different expectations. While crypto prices tend to be more volatile, investors are rewarded with quick, generous returns. Over the past ten years, the average annualized return of the S&P 500 was ~13.2% compared to Bitcoin’s ~85%. Other traders treat crypto as a good hedge against inflation due to its fixed supply and long-term store of value. 

Very simply, a crypto trader generates profit from a trade in the following steps: 

1.  Choose a cryptocurrency exchange

2.  Add funds to a crypto exchange account in traditional currency or transfer cryptocurrency balance from an existing cryptocurrency wallet 

3.  Select a cryptocurrency to trade based on technical or fundamental analysis (or both)

   1. Technical analysis: make short-term trading decisions based on past price movements and market data to identify future price movements 

   2. Fundamental analysis: evaluate the cryptocurrency’s intrinsic value based on the cryptocurrency’s technology (scalability, security, innovation), economics (supply,  distribution), market size, regulatory environment, the developer’s qualifications

4. In crypto trading, exchanges happen in pairs. Investors can either choose to exchange a cryptocurrency for another cryptocurrency or a cryptocurrency for a ‘fiat currency,’ referring to a government-issued currency like the USD. 

   The concept is very similar to foreign exchange. For example, if Bitcoin is exchanged for US Dollars, it would be represented as a ticker pair BTC/USD. If BTC/USD = 30,000, it means one Bitcoin is worth $30,000 USD. By selling 0.5 BTC at a rate of $30,000 per BTC, the trade would record 0.5* $30,000 = $15,000 USD on the trader’s exchange and bank account. The Bitcoin’s exchange value to USD changes every second due to its volatility. Inherently, crypto trading is difficult because a trader has to compare the value of two different currencies. 

5. Based on the investor’s risk appetite, they might sell out their position to make profits when prices are strong. If they want to hedge against crypto’s volatility, they might reinvest these proceeds into asset classes with a negative correlation to crypto, such as gold. On the other hand, some might continuously trade crypto even if prices skyrocket, referred to as momentum investing [4].

Before getting to the bigger market events, it’s important to understand why crypto trading is a volatile asset class, the unique supply and demand dynamics, and some key metrics. 

Key Drivers of Cryptocurrency Prices: What is ‘Value’? 

Here’s where things can get a bit fuzzy with a touch of philosophy.  Just like any market, crypto prices are subject to the forces of supply and demand, macroeconomic forces, and geopolitical stability. When the COVID-19 pandemic was declared in 2020, crypto tokens recorded the largest historical drop by 40%. In late 2021, when inflation started to rise and the market became concerned about a potential rate hike, Bitcoin decreased by 19%. The sell-off continued in January 2022, with Bitcoin falling 17% and Ethereum plummeting 26%. When the market becomes unstable, investors turn towards safer assets like US Treasuries. With higher rates, bond yields would result in high returns. On the other hand, when rates are low, the yield from safe assets is low. Investors would be open to riskier assets with higher returns, like stocks and crypto. Between 2018-2022, the correlation between crypto and stock returns was under 0.3. However, this correlation can sometimes increase above 0.5 when investors expect positive macro tailwinds, such as when the Fed announced a 50 bps rate cut in 2024 [5].

In summary, crypto and stocks are driven by fundamentally different factors. Crypto valuation is driven more by market confidence in the future adoption of crypto, liquidity, supply and demand, and regulations. On the other hand, stock valuation is determined more by increased earnings, interest rates, and monetary policies.   

What’s interesting about Bitcoin specifically is that Bitcoin’s supply was designed to be capped at 21mm BTC. From the year 2140, no new Bitcoins will be issued.  When Bitcoin’s creator Satoshi Nakamoto invented Bitcoin in 2009, he established a process called “reserve halving”: every four years, the rate of issuing new Bitcoin decreases by half. In Bitcoin, new coins are created only from a special mechanism called mining. Bitcoin miners are specialized computers or individuals that collect transactions from the Bitcoin network and bundle them in a ‘block.’ A block is just a unit of data that stores transaction details. As a reward, they earn a certain number of bitcoins per block, but this ratio has been halving every four years. In 2009, it was 50 BTC per block. In 2012 it was 25 BTC per block, and will decrease to 0 BTC per block by 2140. This means that Bitcoin is a very scarce asset with a fixed schedule to reduce supply. Theoretically, halving would increase the investment value of Bitcoin because lower supply would increase scarcity and demand. After the halving, demand would increase as more investors would be drawn to participate in the price appreciation. Historically, every halving cycle has driven up prices, but the rate has flattened out recently. It is unclear whether the market has priced in the value from future halvings, so other factors, such as liquidity, would be more crucial to understanding future price movements [6]. 

Let’s turn from external to internal forces. Swinging between fear and greed is a natural emotional rollercoaster for a crypto investor. The graph below shows a typical Bitcoin market cycle where the accumulation phase attracts investors with an optimistic view and buys up Bitcoin at a low price. Then, in the growth phase, the price steadily rises as more investors want to capture rising prices until it peaks (halving cycles have occurred here). In the ‘bubble’ phase, the Fear and Greed Index shows the highest greed as the price exceeds the historical highs. Selling volume builds up slowly as more buyers push up prices. At last, the bubble crashes. Repeating the previous cycles where Bitcoin prices came down by 80%, the latest cycle has also seen an all-time high of $69k in November 2021 to $15k in November 2022.

Unsurprisingly, there is no consensus on the value of crypto. It has also been evolving constantly. 

Everyone can have a view of the ‘true’ value of crypto. For some, it can be worth less than a penny. In fact, Bitcoin is not backed by any cash flows like an actual business. A value investor might echo Buffett’s comment that “Cryptocurrencies basically have no value and they don't produce anything. In terms of value: zero.” But for others, it might hold infinite value. For example, initially, many expected Bitcoin to be a widely adopted currency, but this is unclear, given how volatile and deflationary it is. Now, many appreciate crypto as a ‘store of value’ that is not meant to be used now but stored for long-term purposes. The statement “valuation is more of an art rather than science” could not be more fitting for crypto as an asset class. 

So what gets investors confident in the value of crypto? 

When a user sees the price of crypto rise, they increase their trading activity, expecting that there will be another buyer at a higher price. When they see the price of crypto fall, they will decrease their trading activity. However, this is only the first layer that drives investor psychology. Improved security, regulations, and the increased adoption of crypto is also what moves the market. Currently, Bitcoin is accepted as a payment for 15 thousand companies around the world, including blue-chip companies such as PayPal and Microsoft. Increased endorsements from major institutions could boost the confidence of mainstream investors, increasing market liquidity and credibility [9].  

One of the most interesting aspects of distress in the crypto world is how closely interconnected all the players are. Let’s say a company’s supplier goes into distress. Depending on how much exposure and role the supplier plays in the value chain, the company itself may or may not be severely affected. In crypto, the ripple effect of distress is much more prominent. Compared to the stock market, there are fewer market participants, so any sell-off would lead to a greater drop in prices. Crypto traders also take on higher risk by taking on higher leverage than stock market participants, as further elaborated below. Furthermore, crypto market participants are structurally designed to be dependent on each other. How does each player depend on one another? Which party has the upper hand in the relationship? A look into the center of the value chain would be a good starting point.  

The Business Model of Crypto Exchanges [10]

A crypto exchange, just like a stock exchange, is the market infrastructure where buyers and sellers trade cryptocurrency. The main streams of revenue come from the following: 

1. Transaction Fees: a crypto exchange generates revenue by taking a percentage of every trade as transaction fees. In a simple example, there are two parties in a trade, and the exchange charges 0.10% of the dollar amount for each trade. If a trade is worth $10k, the exchange will make  $10k*0.001*2= $20 (multiplied by two because both parties pay a transaction fee). 

   However, this fee is not fixed. It’s similar to how a business discounts customers who have purchased more than the regular customer. To reward traders who bring in more volume with lower transaction fees, many exchanges have a volume-based pricing system. The lower fees will incentivize these large traders to trade more often, creating a positive loop that benefits both the traders and the exchange to increase revenue. This is why crypto exchanges prioritize boosting liquidity, as it directly contributes to their profits. 

   Transaction fees look different across crypto exchanges, attracting different types of traders. 

   Higher transaction fees mean an exchange has stronger pricing power. For example, Coinbase has the highest transaction fees, between 0.4 and 0.6%, while competitors mostly sit in the 0.1-0.2% range. However, Coinbase has been able to use these fees to invest in higher-quality customer service, security, and compliance as a publicly traded company. 

2. Deposit and Withdrawal Fees: when the user funds the crypto exchange account with fiat currency, deposit fees can occur, and when the user removes cryptocurrency from their account, withdrawal fees occur. Many exchanges set deposit fees near zero while withdrawal fees are charged as a fraction of each coin. For example, withdrawing Bitcoin costs an average  0.05% fee, which equates to $5 for every $10,000 of deposit. 

3. Subscription Services: While most exchanges don’t, Coinbase is a unique model that has a monthly subscription service catered towards more experienced traders at $29.99/month for zero trading fees and priority access to customer support. By growing its subscription revenue, Coinbase has been trying to hedge against the large exposure from volatile Bitcoin volumes.

It may seem like crypto exchanges are just like stock market exchanges that simply act as a platform. This is not entirely true. Some crypto exchanges have built a brand by developing digital tokens and giving fee discounts to traders who use their native tokens. On top of this, exchanges can retain customers by offering better customer services, an easier user experience, and a wide variety of currencies. 

However, the risk associated with this business model is that revenue is concentrated around the most liquid tokens even if the exchange offers a variety of currencies. For example, Coinbase drives more than 50% of the trading volume of Bitcoin and Ethereum, which have shown positive correlation across market cycles, so it is hard to hedge against broader market movements. 

Different Types of Crypto Exchanges [11]

Among the five hundred available crypto exchanges, each exchange has unique features. Some focus on simple transactions, while others provide more advanced services such as derivatives trading, NFTs, and pool mining where miners work together and share mining rewards. More broadly, users have the option to choose between a centralized exchange (CEX) or a decentralized exchange (DEX), each creating their own ecosystem called centralized finance (CeFi) and decentralized finance (DeFi). 

Some popular CEXs include Binance, OKX, Bybit, and Coinbase. While these names would be relatively unfamiliar to most people given DEXs’ smaller historical market share at 5% of total crypto trading volume, the most popular DEXs are Orca for Solana, Pancakeswap for BSC, Uniswap for Ethereum.

CEXs are run by a single entity that manages buy and sell orders in a single location. Due to faster trading speeds, higher-quality customer service, and a stronger user authentication process, many crypto traders have historically preferred CEX over DTX. Most importantly, CEXs have higher trading volumes because they service a wider range of clients and offer lower costs. This liquidity has allowed traders to quickly buy and sell assets at stable prices even during volatile market conditions. 

A company is considered distressed if they have insufficient assets to meet its liabilities. Similarly, a crypto exchange that halts customer withdrawals (liabilities) because they do not have enough cash or cryptocurrency (assets) would be treated as a default. Default rates for CEXs exchanges have started to rise up to 20% in 2022 for different reasons than historically. In the 2010s, the main reason was primarily exposure to security breaches and hacking [11]. More recently, the main reasons have been commercial misjudgement and poor risk management. For example, Celsius has failed because they were over-exposed to currencies, Brittex due to regulatory uncertainty, and Voyager because of defaulting counterparties. The FTX bankruptcy, which we will cover next week, is a clear example of this. 

On DEXs, however, traders can directly trade with each other without a middle-man. This allows them to have direct ownership and better security protection over their money.  To facilitate trades without a bank, broker, or centralized exchanges, DEXs rely on “smart contracts.” Smart contracts are digital contracts stored on a blockchain that match buyers and sellers, hold funds securely during a trade, and automatically complete transactions when predetermined conditions are met. If you are a trader, you can trust the information on the exchange because the transaction records are shared across all parties. On top of this, you can save transaction fees as there is no middleman charging you. While the platform still lags behind CEX’s level of trading volume, which is still in the early stages, DeFi is a rapidly growing area within crypto. 

Further Breaking Down the Ecosystem 

In a market where counterparties rely on each other to generate profits, it is crucial to understand what their role and value propositions are. Broadly speaking, the players can be categorized either into action takers or infrastructures that serve the market participants that rely on each other: 

• Miners: individuals or large businesses that use highly specialized computers to validate and add new ‘blocks’ to the blockchain. They get paid through block rewards from their blockchain network, which incentivizes them to maintain the integrity and security of a cryptocurrency network. For example, preventing users from attempting to spend the same coins twice. The block they receive decreases after each halving event, but the existing block stays the same. 

• Investors: retail investors have traditionally dominated the crypto market, attracted by high, speedy returns that can exceed 100% in bull cycles. Some investors in foreign countries also use crypto to hedge against inflation and the falling value of their currency.

However, institutional investors have increasingly been drawn to crypto, seeing progress in scalability and regulations. In January 2024, the SEC approved Bitcoin-funded ETFs, lowering the cost of crypto exposure. Hedge funds tend to use crypto for higher returns, opportunities to capture price inefficiencies, and portfolio diversification, while pension funds have been allocating a small portion of their portfolios to crypto. Fortune 500 companies such as MicroStrategy have been buying Bitcoin to store it on their balance sheet as a hedge against inflation, betting on its long-term value. 

Some crypto traders use margin trading, a risky yet lucrative strategy by borrowing leveraged funds. This allows the margin trader to trade with more capital than they own. Depending on the exchange, a trader can borrow up to 100x their balance. For example, if a trader wants to invest $10k in Bitcoin with 10x, they would need to have 10,000/10 = $1000 stored as collateral in their account. Assuming the price increases by 20% to $12k, the trader’s profit will be $12,000-10,000 = $2000 vs. the original $1200-1000= $200 they would have made without the use of leverage. However, leverage works the other way around when prices drop. If the price is down 20%, the trader’s position is down by $2000, and the balance turns negative to $1000-2000= -$1000. If the trader cannot increase their funds with more collateral, they are forced to liquidate because the fund's lender will not pay for the trader’s loss. A crypto exchange automatically triggers a liquidation when the user’s balance dips below a threshold called maintenance margin, which ranges between 2.5%-10% of the balance. 

However, margin trading is not only used by retail investors but also hedge funds. Usually, crypto hedge funds diversify exposure across different tokens and adjust risk in their portfolios to prevent margin calls. However, in 2022, many hedge funds faced a series of margin calls after the collapse of a specific token, as further explained below. As crypto prices plummeted, the value of the borrower’s collateral was also wiped out so that hedge funds could not pay back their investors[13]. 

• Lending Platform: can be centralized like traditional banks, where the platform serves as a middleman to facilitate lending and borrowing. The major centralized platforms are BlockFi, Celsius, and Voyager. It could be decentralized, operating on blockchain technology, where lenders and borrowers directly interact with each other. For decentralized platforms, automatic processes called ‘smart contracts’ determine loan issuance, repayment, and interest rate automatically based on market supply and demand. They generate revenue from deposits, withdrawals, and service fees from managing loans. They also absorb the spread between the interest rate the borrower pays and the rate lenders earn interest on.

• Lenders [14] [15]: some investors don’t have the risk tolerance to do margin trading themselves, so some platforms offer a feature called ‘spot margin trading.’ Instead of directly trading crypto, users can lend money in cryptocurrency or fiat currency to other users on the platform and earn interest income and principal.  Unlike traditional loans, loan agreements do not need any or only a few intermediaries like banks, so borrowers can pay lower fees and lenders can boost their returns. Most loans are backed by collateral in the form of a specific cryptocurrency deposited by the borrower. Exchanges usually require the collateral to cover at least 100% of the loan. Compared to traditional loans, crypto loans have higher interest rates, around 5%-13%. These rates compensate lenders for volatile crypto prices that determine the collateral value and the lack of credit checks required by borrowers.

  They can be structured as either fixed or floating rates. However, there is no maturity date for crypto loans. In a way, these open term loans are similar to a revolving credit facility since the borrower can repay the loan anytime. However, this also means lenders can demand repayment anytime. Given the volatility of crypto asset prices, most platforms control the risk of default by allowing borrowers to access only up to a certain percentage of the collateral, called loan-to-value (LTV). Usually, an LTV of 70% (for example a $7k loan is backed by $10k of Bitcoin) would be considered high, demanding a higher interest rate to account for higher risk. If the value of the collateral drops below the LTV, the exchanges will automatically liquidate the loans. 

• Traditional Banks: traditional banks can allow crypto investors to hold their fiat currencies in accounts linked to their crypto-related activities. They can also issue collateralized crypto loans back by fiat currencies. Some banks offer products such as crypto ETFs. 

Until now, we’ve covered what determines crypto valuation, the business model of crypto exchanges, and structural elements driving distress in the market. Now, we will break down specific events leading up to the series of crypto restructurings since 2022. 

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