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Losses are blowing holes in balance sheets and pushing firms in the industry to near bankruptcy

Turmoil in the digital-assets ecosystem has grown in recent weeks, with losses in cryptocurrencies blowing holes in balance sheets and pushing firms near bankruptcy.

After a pair of cryptocurrencies crashed, wiping out billions of dollars in value in May, a British Virgin Islands court this past week ordered a hedge fund that had survived several crypto downturns to liquidate. Another platform that counts the hedge fund as an investor capped withdrawals while evaluating how the hedge fund’s woes would affect its liquidity.

A handful of crypto players have established financial ties throughout the market and added to risk by borrowing and lending digital assets among themselves, with at least one lender, Celsius Network LLC, drawing on collateral to do its own borrowing.

“Everything is deeply, deeply intertwined; we didn’t have this in 2018,” said Chris Bendiksen, head of research at the London-based asset-management firm CoinShares, CS 1.32%▲ referring to a past crypto market downturn.

While new to crypto, such problems are well-known in the traditional financial realm. During the 2007-08 global financial crisis, bank-lending practices including rehypothecation of assets—using collateral to borrow more money—left banks short on liquidity. In the aftermath, regulators tightened oversight.

Digital asset prices have been falling dramatically along with other speculative bets in response to the Federal Reserve’s move to raise interest rates. Crypto’s headache intensified in May, when the stablecoin TerraUSD broke from its dollar peg and dragged the value of its sister cryptocurrency Luna down with it, eradicating $40 billion.

Investors got a taste of how the commingling of crypto investments would hit the market when a fire sale of assets backing the TerraUSD stablecoin pushed the price of bitcoin almost $10,000 lower to trade around $30,000.

Problems facing Three Arrows Capital Ltd., the hedge fund ordered to liquidate after being heavily invested in Luna, spilled over to the crypto brokerage Voyager Digital Ltd. this past week. On Friday, Voyager said it was temporarily suspending trading, deposits, withdrawals and loyalty rewards. It earlier issued a notice of default to Three Arrows for allegedly failing to make a loan repayment of 15,250 bitcoin and $350 million in USD Coin, a stablecoin. The loan is worth about $646 million based on bitcoin’s current price of around $19,400. Shares of Voyager, which are traded on the Toronto Stock Exchange, are down more than 96% this year. On Friday, Three Arrows’ liquidators asked a New York bankruptcy court to recognize the British Virgin Islands case and to allow them to handle any assets in the U.S.

Three Arrows’ financial troubles have affected the smaller firms in its orbit. The Hong Kong-based trading firm 8 Blocks Capital said Three Arrows has cut off communications after allegedly misappropriating $1 million of its capital. Kyber Network, a decentralized-finance project, said the firm has “a small portion of its Treasury” with the hedge fund, which it said hasn’t responded to any of its attempts to communicate.

Three Arrows didn’t respond to a request for comment.

Crypto still exists largely outside of regulation, with few federal laws specific to crypto and the Securities and Exchange Commission taking up cases against individual firms on an ad hoc basis. The growth of the industry—worth more than $3 trillion at its peak last year—has surpassed the ability of regulators to keep up, according to analysts. The blowup of TerraUSD prompted renewed calls for Congress to pass legislation covering crypto.

Without a central bank to swallow illiquid assets and curtail contagion, crypto has taken a page from the traditional financial playbook. The crypto exchange FTX, headed by Sam Bankman-Fried, has struck a deal with the crypto lender BlockFi Inc. including a $400 million credit facility and the option for FTX to buy the company for as much as $240 million. BlockFi Chief Executive Zac Prince said by Twitter on Friday that market events related to Celsius and Three Arrows had a negative impact on the company.

BlockFi said it experienced about $80 million in losses from its loan exposure to the hedge fund.

In June, Mr. Bankman-Fried’s other crypto company, the trading firm Alameda Research, extended two credit lines, one worth $200 million and another for 15,000 bitcoins, to Voyager. Alameda acquired a $35 million stake in Voyager in May.

The travails of the crypto market call to mind the actions of a pair of financiers during prior times of turmoil. J.P. Morgan twice stepped in to prevent economic collapse before the Federal Reserve system was created in 1913. More recently, in 2008, Warren Buffett helped to revive Goldman Sachs Group Inc. and General Electric Co.

The crypto market’s problems could be the tip of the iceberg. Three Arrows, a big borrower in the system, has seen its levered positions liquidated by exchanges including BitMEX and Deribit after failing to meet margin calls. Margin calls, which are demands from lenders for more collateral from borrowers to back their loans, have swept across the crypto trading industry as the value of major cryptocurrencies fell in the midst of a broad market selloff.

The crypto investor Mike Novogratz, who bet heavily on Luna before its spiral, drew parallels between the current leverage-fueled carnage in crypto and the 1998 blowup of Long-Term Capital Management, a heavily leveraged hedge fund whose collapse sparked concern of contagion in the financial system.

The ascent of leverage in crypto has been growing for years, bursting with the downfall of TerraUSD and a pseudo crypto bank tied to it that offered holders of the stablecoin nearly 20% for putting their deposits in, said Caitlin Long, chief executive of Custodia Bank, which aims to provide custody and other digital asset banking services for institutional investors.

Crypto firms began taking on more leverage after the approval of Grayscale Bitcoin Trust in 2013. The trust for years was one of the few bitcoin investments that average investors could access in brokerage or retirement accounts. Because of that, its value often traded many times higher than that of spot bitcoin, letting investors profit from the difference. Three Arrows held 6.1% of the trust’s shares at the end of 2020, according to a filing with the SEC.

That trade was so successful that investors viewed it as risk-free, Ms. Long said. When it became less profitable as more products became available, investors began trading in bitcoin-futures markets, speculating that the price would go higher yet. And when that dried up, they turned to yield-generating platforms.

“All this leverage flocked from the sure thing to the less sure thing,” Ms. Long said. “With each one of these big trends it got riskier for traders to play them.”

Crypto investors are bracing for more pain yet. Celsius froze client accounts in June, and the crypto lender Babel Finance and the futures exchange CoinFLEX halted customer withdrawals. Babel Finance said it has reached preliminary agreements on the repayment period of some debts, but it hasn’t resumed withdrawals. CoinFLEX is issuing $47 million of another token in the hope of resuming customer withdrawals after a major customer went into “negative equity.”

Faced with uncertainty, some crypto lenders have begun recalling loans to large borrowers to check for their financial health, while others have tightened access to their loan products.

“There is a shortage of supply as companies like Celsius have now turned off withdrawals and have a smaller amount of assets to lend out,” said Adam Reeds, chief executive of the crypto lender Ledn. “Many market makers who used to borrow from platforms like that are now looking at alternatives.”

For now, executives in the industry are hoping the current crisis is a repeat of the “crypto winter” in 2018, during which the bad actors who orchestrated the boom and bust of initial coin offerings were flushed out, making the system stronger as a result.

“Just like we the industry flushed out all the ICO froth in the previous bull market, in this one it’s all the leverage being flushed out,” Ms. Long said.

A string of record quarterly deliveries came to an end in the second quarter, when Tesla handed over 254,695 vehicles to customers

Tesla Inc. TSLA 1.24%▲ vehicle deliveries fell quarter-over-quarter for the first time in more than two years, reflecting an extended shutdown in China, supply-chain disruptions and challenges associated with opening two new factories.

Elon Musk’s electric-vehicle maker said Saturday that it had delivered 254,695 vehicles to customers in the three months ended in June, down from 310,048 in the prior quarter. Deliveries were up roughly 27% from last year’s second quarter, when Tesla handed over 201,304 vehicles.

Analysts surveyed by FactSet forecast that Tesla would deliver around 264,000 vehicles in the second quarter. Many analysts in recent weeks had lowered their expectations after the company had to temporarily shut down its largest factory, in Shanghai, because of local Covid-19 restrictions. Tesla also has had trouble getting its new factories in Germany and Texas up to speed, Mr. Musk has said, calling the plants “gigantic money furnaces.”

The company produced 258,580 vehicles in the second quarter, down from 305,407 in the first quarter and up from 206,421 in last year’s second quarter. “June 2022 was the highest vehicle-production month in Tesla’s history,” the company said.

As recently as April, Mr. Musk had been sanguine about Tesla’s outlook, saying the company likely would produce more than 1.5 million vehicles in 2022, up some 60% over last year. Wall Street now believes Tesla could struggle to hit 1.4 million.

The decline in deliveries, which include cars that Tesla has sold or leased out, is poised to weigh on the company’s second-quarter earnings, scheduled for July 20. Analysts expect Tesla in a few weeks to report roughly $2 billion in quarterly profit, up from around $1.1 billion during the year-earlier period but down from its $3.3 billion record in the first quarter.

The auto maker’s bottom line is likely to be dented by a roughly $475 million bitcoin-related impairment, according to Credit Suisse. Tesla bought $1.5 billion worth of bitcoin in early 2021, when the cryptocurrency was trading above $28,000. The price of bitcoin fell below $17,700 in mid-June, according to CoinDesk. The company’s disclosed accounting methodology factors in the lowest market price of bitcoin since the asset was acquired.

Tesla shares lost more than a third of their value in the first six months of 2022. On April 26, the stock dropped more than 12%, its biggest one-day retreat in more than a year after Twitter Inc. TWTR 2.25%▲ accepted Mr. Musk’s $44 billion bid to take over the social-media company. Mr. Musk initially said he would rely on a bank loan backed by some of his Tesla shares to finance the deal. The following month, he adjusted his financing plan to include more equity instead.

Mr. Musk himself recently took a notedly multiday pause from posting on Twitter, where he often opines on Tesla and other matters. He returned to posting on the platform Friday.

Tesla delivered roughly 238,533 Model 3 sedans and Model Y compact sport-utility vehicles combined during the second quarter, up from 199,409 of those models a year earlier. It delivered 16,162 of its higher-end models—Model S sedans and Model X sport-utility vehicles—up from 1,895 during last year’s second quarter.

The company, like many rivals, has been increasing prices for its cars as it faces higher supply costs. U.S. customers who ordered the long-range version of Tesla’s Model Y compact sport-utility vehicle in late June could expect to pay roughly $68,000, or around $14,000 more than they would have if they ordered the model a year earlier, according to Bernstein Research.

Though consumer demand has held strong—buyers often face monthslong waits for new Teslas—Mr. Musk has expressed growing concern about the global economy. Tesla has let go hundreds of employees in recent weeks, part of cuts that Mr. Musk has indicated could touch 10% of the company’s salaried workforce.

The company, he said in an email to employees last month, had “become overstaffed in many areas.” He has since delivered mixed messages about how those cuts would affect Tesla’s overall staffing level. Tesla is also dealing with other labor issues, including a new lawsuit filed Thursday in California state court by current and former employees alleging racial harassment and discrimination. The company didn’t respond to a request for comment about the case.

Supply-chain disruptions and their ripple effects have caused many auto makers to operate less efficiently, according to consulting firm AlixPartners LLP. As of the fourth quarter, auto makers in the U.S. employed 29 people for every thousand vehicles they produced in 2021, up around 31% from a year earlier, the firm said.

For all of its recent disruptions, Tesla is likely to be the only major auto maker to increase U.S. sales in the first half of the year, from a year earlier, according to research firm Cox Automotive. Overall, sales of new vehicles in the U.S. during the first six months of 2022 were expected to have fallen about 17% from a year earlier, the firm said.

General Motors Co. GM 1.35%▲ said Friday that it built about 95,000 vehicles without certain parts and had to set the cars aside instead of shipping them to dealers. Its U.S. sales for the first half of the year were down nearly 18%.

Tesla’s in-house software engineering expertise made it more adept than many rivals at adjusting to a global shortfall of semiconductors. That know-how, paired with battery expertise, is likely to benefit the company as a global shift toward electric vehicles strains supply chains, UBS analysts said in a recent note.

“Tesla’s supply chain is structurally superior vs. peers in the mission-critical areas of semiconductors, battery cells and battery raw materials,” the analysts wrote last month. “Tesla is likely to keep all competitors at a stable or even growing distance in terms of absolute growth and profitability.”

Collapsed investment firm expected to face claims from ‘significant number of creditors’, court documents show

Three Arrows Capital has filed for bankruptcy in the US, highlighting the scale and reach of the prominent crypto investment firm’s borrowings across the industry before it collapsed into liquidation this week.

The Chapter 15 bankruptcy filing in Manhattan federal court late on Friday came just days after Three Arrows was pushed into liquidation in the British Virgin Islands, following claims that it failed to pay $80mn it owed to digital asset exchange Deribit. The US bankruptcy petition was made to empower attorneys appointed to lead the unwinding of Three Arrows in the British Virgin Islands, the Singapore-based fund’s legal domicile, to shield its US assets.

The failure of Three Arrows, which used borrowing to turbocharge its bets on cryptocurrencies, is the latest sign of how this year’s turmoil in digital asset markets has severely wrongfooted some of the industry’s biggest players. It also highlights how trouble at one firm can ricochet across the sector due to opaque links between investors, crypto exchanges and lending firms.

Insolvency specialists at Teneo, the advisory firm appointed in the British Virgin Islands to liquidate Three Arrows, told the US court that a “significant number of creditors” are expected to make claims against the hedge fund.

Deribit, a derivatives focused crypto trading platform, had kicked off the liquidation proceedings in the British Virgin Islands last week, with Three Arrows later agreeing to place itself into liquidation. However, Three Arrows is also in arbitration in New York with one of its biggest creditors, Russell Crumpler, one of the firm’s liquidators, said in a US court filing.

“With many creditors seeking to enforce their rights to collect on the debtor’s outstanding debt obligations, the risk increased that the debtor would dissipate it assets without consideration of each individual lender’s ability to recoup its losses,” Crumpler said.

In a sign of the scale of Three Arrows’s borrowings, Toronto-listed crypto lender Voyager Digital said in late June that it could lose more than $650mn in loans it made to the crypto investment firm co-founded by Su Zhu and Kyle Davies. Voyager late on Friday said it was suspending withdrawals and trading on its platform as it explores “strategic alternatives”. It added that it is “actively pursuing all available remedies for recovery from Three Arrows”.

BlockFi, another big crypto lender, said on Friday it had sustained around $80mn in losses due to the Three Arrows collapse even after it unwound some of its positions. BlockFi on Friday also announced a deal in which FTX will provide it fresh financing in return for an option that allows the crypto exchange to buy the group for up to $240mn.

Three Arrows is also facing regulatory scrutiny in Singapore. The Monetary Authority of Singapore reprimanded the group this week for providing false information and breaching an asset under management threshold. Authorities in the city-state said they had been investigating Three Arrows for a year. The fund was first managed in Singapore before shifting its domicile to the British Virgin Islands in September.

Three Arrows rose to prominence during the height of the crypto bull market that peaked in November 2021. Zhu pitched a “supercycle” thesis in which increasing mainstream adoption meant prices would continue to rise without falling back into a near-term bear market. However, as investors have raced away from speculative assets this year, the crypto market has come under intense pressure. The market value of the leading 500 crypto tokens has collapsed from a high last November of $3.2tn to under $1tn.

Three Arrows did not respond to a request for comment on its liquidation. Zhu said on Twitter last month, “We are in the process of communicating with relevant parties and fully committed to working this out.”

The first six months were full of surprises, from surging inflation to a crypto implosion. Get ready for more shocks in the second half.

We’re halfway through the year, but markets are beginning to fear we’re not even halfway through the bad news 2022 has in store.

The first six months were full of surprises: Inflation. The biggest selloff in bonds in four decades. A plunge in tech stocks rarely matched in history. And the implosion of crypto.

The looming risk that investors ignored for months is recession. But whether the economy will slump or be just fine remains unknown. Attempts to put a probability on it range from 90% in a Deutsche Bank survey of clients to the spurious precision of 4.11% in the New York Federal Reserve’s recession forecasting model.

While investors are at last focused on recession uncertainty, risks elsewhere in the world could hit U.S. investors, too. Japan might finally be forced to relent and allow bond yields to rise, which would suck back cash the country’s investors had poured overseas. In Europe, the central bank has promised a new plan to support Italy—but we’ve seen this show before. If it follows the pattern of too little, too late, we could see a return of the eurozone debt crisis, something markets are not prepared for.

Almost any economic outcome is likely to prove a fresh surprise. If there’s a soft landing, stocks should do well as the recent recession panic reverses. If there’s a recession, there could easily be a big loss still to come, since only the drop of recent weeks appears to be related to recession risk.

There’s one sliver of good news: Prices are already down a lot, which brings them closer to wherever they will eventually bottom out. The S&P 500 has fallen by the most in the first half of a year since the 21% loss in 1970, when the economy was in recession. Long-dated Treasurys lost 10% even including coupon payments, the biggest six-month loss since Paul Volcker’s Fed forced the economy into recession in 1980.

There’s no sure way to work out what probability the market is putting on the Fed driving the economy into recession this time.

J.P. Morgan strategist Nikolaos Panigirtzoglou says the simplest way to extract probabilities from the price moves is to compare price falls with the average peak-to-trough fall of past recessions. Since the S&P 500 is down a bit over 20% and the average fall in the last 11 recessions was 26%, that suggests an almost 80% chance of recession is priced.

Yet, much of this year’s selloff wasn’t about recession risk. To see this we need to distinguish the direct and indirect effects the Fed has on prices of stocks and bonds.

The direct effect is to push up bond yields and push down valuations of stocks with profits far in the future, which means those with high valuations such as Big Tech. This is what dominated until June, with bond yields soaring and growth stocks crashing, while cheap “value” stocks were basically fine. Exclude the technology sector to strip out the bulk of this effect and economically-sensitive cyclical sectors of the stock market had only slightly underperformed defensives by June 7.

Then it all changed. Investors woke up to the indirect effect of the Fed, which is to weaken the economy. This has almost the opposite effect on asset prices. A weaker economy means less inflation than otherwise, justifying lower bond yields. It also hits earnings, particularly for cyclical companies, which tends to hurt stocks with relatively low valuations more than growth stocks.

Since June 7 cheap stocks have been hammered and cyclical sectors—especially oil stocks and miners—have plummeted. In the past two weeks recession fears showed up in Treasurys too, as investors bet that the Fed will have to cut rates aggressively next year. The drop of almost half a percentage point in the 10-year Treasury is the most over such a period since the first pandemic lockdown. Wall Street analysts have also been racing to cut their earnings forecasts, after ignoring recession risks and actually upgrading earnings predictions in the first five months of the year.

The markets now understand the outlook is clouded, so will be less bothered by a sudden shower. But investors will still get drenched if the storm of a deep recession washes away earnings.

There are clear risks that could be imported from abroad. Hedge funds are betting big that the Bank of Japan will abandon its bond yield controls, which have shielded it from tightening global monetary policy and crushed the yen. If the hedge funds are right—and there’s nothing forcing the BoJ to act, let alone soon—Japanese bond yields would leap and the yen’s extreme weakness go into sudden reverse, roiling markets globally.

Better yields at home, as well as the prospect of losses on the currency, would push Japan’s army of small investors to repatriate their money, pushing the yen up and prices everywhere else down – and adding more upward pressure to Treasury yields.

The risk from Europe is familiar: politics. The European Central Bank acted early to head off a crisis in Italy’s government financing. It now has the difficult job of persuading the frugal north to accept a deal underwriting the country’s bonds, without imposing unacceptable conditions on Italy. If it fails to come up with enough money, Italy and the eurozone could be in serious trouble again by the autumn.

I remain hopeful that recession will be mild, not hit until next year, and perhaps be avoided altogether. But the economic data are going the wrong way, and higher interest rates haven’t even begun to bite on ordinary households yet. The dangers are big, and the markets are still not fully prepared.

Ms. Hall, a model and actress, and Mr. Murdoch wed in March 2016

Jerry Hall filed for divorce from Rupert Murdoch on Friday, citing “irreconcilable differences” and seeking spousal support.

Ms. Hall, a model and actress, and Mr. Murdoch wed in March 2016. Mr. Murdoch, 91 years old, is executive chairman of News Corp, NWSA 1.09%▲ which owns The Wall Street Journal, and is also chairman of Fox Corp. FOX 3.00%▲ The filing was made in Los Angeles Superior Court.

Ms. Hall turns 66 on July 2.

A trust had been created to hold the Murdoch family’s substantial voting stakes in News Corp and Fox Corp. Mr. Murdoch controls the trust, while four children from his first two marriages—sons Lachlan and James and daughters Elisabeth and Prudence—also have votes. Two younger daughters from his third marriage, to Wendi Deng—Grace and Chloe—are beneficiaries of the trust but don’t have votes.

People familiar with the ownership structure of the trust said that the pending divorce won’t affect control of the trust.

In addition, one of the people said there is a prenuptial agreement in place. The terms of that agreement couldn’t be immediately learned.

The marriage to Ms. Hall is Mr. Murdoch’s fourth.

The New York Times in June reported that the couple was seeking a divorce.

The famous psychoanalyst’s granddaughter spent much of her life publicly opposing his theories

The things that might have emerged if only Sophie Freud had just once hauled herself on to a couch for a session of psychoanalysis. There was the wartime escape from Europe, the estrangement from an uncaring father and the conflicted feelings for her mother. Looming over it all was the shadow of her famous family name, both elevating and tormenting her.

But Freud spent much of her life in opposition to her famous grandfather, Sigmund, and his theories, and so took pride in a life-long refusal to submit to psychoanalysis. “I’m very sceptical about much of psychoanalysis,” she told the Boston Globe in 2002. “I think it’s such a narcissistic indulgence that I cannot believe in it.”

Freud died earlier this month, aged 97, after a long life shaped by the great tumult of the 20th century and the enduring tension between a weighty family legacy and an independent spirit.

Miriam Sophie Freud was born to a wealthy Jewish family in Vienna in 1924. Her father was Sigmund’s eldest son, Martin, a lawyer who would take charge of his father’s publishing house. Her mother, Ernestine, was a speech therapist. Growing up, every Sunday featured a visit to her grandfather’s apartment on 19 Berggasse.

A governess would lead Sophie to the study for a 15-minute audience with the great professor, whom she loved and understood from a young age was God-like — even if she could not quite say why. Sigmund was stern, and by then suffering from cancer, but would give his granddaughter money to go to the theatre. “He would say: ‘Are you a good girl?’” Sophie recalled. “I was taught to be very much in awe of him.”

Her own family life was miserable. Her parents were ill-matched, and Sophie later wrote that “quarrels, tears and violent hysterical scenes were the background music of my childhood.”

In 1938, after a Nazi-ruled Germany annexed Austria, Sophie and her mother relocated to Paris. They were forced to flee again when the Nazis invaded two years later. Mother and daughter made a close escape by bicycling some 400 miles to Nice. From there they journeyed to New York.

Though they were poor, the patronage of an uncle, the pioneering publicist Edward Bernays, meant Sophie attended Radcliffe College and studied psychology. She would go on to earn a masters in social work, and then a doctoral degree, working at clinics, mental hospitals and as an adoption specialist. She placed a special emphasis on helping single mothers.

Sophie also taught for decades at Simmons College in Boston, where she chaired the human behaviour programme. Until she reluctantly gave it up aged 77, she could be seen riding around campus on a red motor scooter.

If Sigmund Freud believed in probing the unconscious to understand the adult, his granddaughter leaned on fate. She once said she believed people only held 5 per cent control over the course of their lives — the rest was chance.

She dismissed Freud’s concept of penis envy as silly and called the Oedipus Complex “outdated”. An early feminist, she seemed to take particular umbrage at Sigmund’s claim that only men could experience true passion. In 1998, she published a book, My Three Mothers And Other Passions, that served as a rebuttal.

“In my eyes, both Adolf Hitler and my grandfather were false prophets of the 20th century,” she said in 2003. So wedded was Sigmund Freud to what he viewed as a singular truth, she said, that “never could he be wrong”. To some observers, the intensity of her disagreement with her grandfather was, itself, Freudian.

Her own marriage, to Paul Loewenstein, a fellow Jewish émigré who had escaped from a French concentration camp, fared better than that of her parents. They raised three children — Dania, Andrea and George. Still, she asked for a divorce after 40 years, coolly deciding the union was no longer satisfying.

Later on, Sophie made a determined effort to reconnect with her aunt Anna, Sigmund’s daughter and appointed successor, even taking a sabbatical in England to do so. “I needed Tante Anna’s blessing before I could rightfully reclaim the family legacy that I had betrayed, and yet remained faithful to, in its core,” she explained in her memoir.

Even after her retirement, Sophie continued to teach at Simmons. She travelled widely, often on her own. For exercise, she walked regularly around the nearby Walden Pond and swam in its waters — the same ones where another eccentric, Henry David Thoreau, famously pondered independence and self-reliance. Joshua Chaffin

Cory Klippsten is a big fan of Bitcoin. But his affinity for cryptocurrencies ends there. Klippsten, head of a company called Swan Bitcoin, sees a growing minefield of scams, fraud, and risky products throughout the industry. As the market retreats, he sounds embarrassed to be associated with it.

“I’m a Bitcoiner who believes Bitcoin is transforming the world,” says Klippsten, 44. “I’m so sick of having my name and business associated with the crypto industry. It’s exhausting.”

There’s no small irony in a Bitcoin purist taking shots at the rest of crypto. Bitcoin is no paragon of virtue; mining the stuff is energy-intensive and environmentally costly. And it’s failing miserably as a store of value or an inflation hedge—two heavily promoted uses. Down 70% in seven months with $900 billion in lost market value, the king of crypto looks more naked than ever.

But Bitcoin isn’t crypto’s biggest problem these days. It’s the token’s progeny and the industry’s freewheeling financial practices. Rather than revolutionizing Wall Street, the crypto industry has adopted many of its products and reinvented them, largely with rules of its own making. Now, thanks to a cocktail of unbridled leverage, automated liquidations, and collapsing prices, it’s also reinventing a financial crisis.

“The industry and these companies are shrouded in mystery. In that situation, history tells us that there will be all sorts of risky behavior, fraud, and deceit,” says John Reed Stark, a former chief of the Securities and Exchange Commission’s Office of Internet Enforcement. “It’s not the Wild West. It’s a Walking Dead-like anarchy with no law and order.”

Beyond Bitcoin are legions of other tokens, trading platforms, and quasi-banks offering stupendously high yields on deposits. This parallel world of shadow banking and trading is straining to stay above water amid a series of crises, including the failure of a major “stablecoin,” a hedge fund collapse, and a liquidity crunch at some large crypto lenders.

A tougher macro climate has put the industry on its heels. Rising interest rates and tighter financial conditions have triggered a stampede out of anything related to crypto, amid a broader selloff in tech overall.

But the industry has hardly steeled itself to pass a market stress test. Crypto start-ups and exchanges expanded in a regulatory vacuum, establishing their own governance rules or dispersing them through open-source software “protocols.” Crypto advocates have long pitched these homegrown practices as an improvement over Wall Street—breaking finance from the shackles of banks and brokerages. But in some ways, the industry adapted a Wall Street playbook to a new technology. And its supervision has been almost entirely by those with a financial interest in the outcome.

Two of the biggest worries now are a crypto bank and a hedge fund. Celsius Network, a major crypto lender that had taken in $11 billion of deposits, has frozen withdrawals as it tries to prevent a run on the bank that would likely put it out of business. On June 30, Celsius said it’s taking steps to preserve assets and is exploring options that “include pursuing strategic transactions as well as a restructuring of our liabilities, among other avenues.” Celsius did not respond to requests for comment.

Hedge fund Three Arrows Capital, known as 3AC, meanwhile, has been ordered to liquidate by a court in the British Virgin Islands after being sued by creditors. The fund had borrowed heavily to build a portfolio that it said was worth $18 billion. And it had built a large position in Grayscale Bitcoin Trust GBTC +1.58% (ticker: GBTC), a closed-end trust that trades publicly and was a popular vehicle for crypto arbitrage.

For years, GBTC traded at a significant premium to its underlying Bitcoin holdings—sporting a value 35% higher than its tokens holdings at one point in 2020. That meant hedge funds could make easy money by borrowing Bitcoin, giving them to the trust in exchange for shares, and then selling the shares for a profit once a waiting period expired.

But in 2021, that premium flipped to a discount, and it has widened as the price of Bitcoin declined—GBTC recently traded at a discount of 29% to its net asset value. That trapped investors like 3AC, listed as one of the trust’s largest owners in June.

Yet even as the discount widened, 3AC kept buying, in a “classic case of a bettor at the table that keeps losing and doubling down,” said Sean Farrell, head of digital asset strategy at Fundstrat Global Advisors. Ultimately, “3AC could no longer hold its daisy chain of leverage together, causing illiquidity issues across the crypto lending space,” said Farrell, who compares 3AC to Long-Term Capital Management, a massively leveraged hedge fund that required a government-arranged bailout in 1998.

3AC didn’t respond to a request for comment. Grayscale CEO Michael Sonnenshein says the trust’s main holders are long-term investors.

Lenders and brokers with exposure to 3AC included Voyager Digital VOYG –17.14% (VOYG.Canada), which said in a news release that 3AC defaulted on a $675 million loan consisting of Bitcoin and USDC, a stablecoin pegged to the dollar. Voyager has since curtailed withdrawals from its platform. The company had no comment.

Without government backstops, crypto’s white knights have been other crypto people. The billionaire founder of the exchange FTX US, Sam Bankman-Fried, agreed to extend a $400 million revolving line of credit to BlockFi, with an option to buy the company. BlockFi suffered around $80 million in losses due to exposure to 3AC. Bankman-Fried, through his trading firm, Alameda Research, has also bailed out Voyager with lines of credit worth around $500 million.

“We spent decades evolving rules that were designed to prevent abuses on Wall Street,” says Eric Kaplan, senior advisor to the center for financial markets at the Milken Institute. “Some in the crypto markets are turning their backs on that.”

How much longer that free-for-all lasts is the subject of much debate in Washington. The Biden administration, Congress, and agencies like the SEC are working on rules. Yet regulators and lawmakers are at odds over whether to apply established rules to crypto or to write new ones.

Regulators see systemic risks if crypto isn’t reined in. The European Central Bank recently warned that the crypto market was similar in size to securitized subprime mortgages before the 2008 financial crisis. Crypto assets “will pose a risk to financial stability,” the ECB said in a report, if they keep growing and banks increasingly get involved.

“The market at this point isn’t big enough to trigger a systemic risk event, but these are not static markets. They are continuously evolving and growing,” says Lee Reiners, who heads the Global Financial Markets Center at Duke University. “It’s time to sound the alarm bells.”

For much of the past decade, crypto evolved in a regulatory gray zone. Products and marketing that would never be allowed on today’s Wall Street—thanks to a century of financial regulations—found homes in crypto. The industry is now packed with Wall Street alumni, traders, and others from the financial industry.

The heads of major companies such as Galaxy Digital Holdings GLXY –10.39% (GLXY.Canada), Grayscale Investments, and Genesis Trading all worked on Wall Street before coming to crypto. At Coinbase Global COIN +4.30% (COIN), the head of global financial operations came from Goldman Sachs. Celsius was founded by Alex Mashinsky, a serial tech entrepreneur, but its senior team includes alumni of Royal Bank of Canada, Citigroup, and Morgan Stanley.

One of the largest equity market makers, Jane Street Capital, is part of the crypto plumbing, providing liquidity to exchanges like Robinhood Markets (HOOD) and trading crypto for itself. “What’s going on in crypto is a pretty wonderful sandbox for a lot of different experiments,” said Thomas Uhm, a member of Jane Street’s crypto sales and trading team, on a podcast in February.

Without a regulator like the SEC in charge, crypto companies set many of their own rules. Industrywide listing requirements for tokens don’t exist. Binance.US lists more than 100 tokens, from ApeCoin to Zilliqa. Coinbase offers around 170 tokens, including some issued by entities that the company’s own venture-capital arm has funded. Coinbase says its token investments don’t influence listings.

Crypto traders aren’t just going up against sophisticated investors like hedge funds or high-frequency trading firms. They may be trading against companies that act as their broker, custodian, market maker, and exchange—all rolled into one entity.

Market makers, stock exchanges, and brokerages have long been separated on Wall Street due to conflicts of interest that would arise if they handled it all—such as making it possible to trade against their own customers or front-run orders. In crypto, that separation often doesn’t exist, leaving investors vulnerable, according to regulators such as SEC Chairman Gary Gensler.

“There’s no prohibition against wash-trading on crypto exchanges, no prohibition against proprietary trading, no best-execution rules, and no standardized reporting,” says Timothy Massad, a former chairman of the Commodity Futures Trading Commission. “It’s this whole lack of a framework where you can’t compare it to securities that concerns me.”

Crypto trading platforms say some of the concerns are overblown or stem from a lack of clarity around the rules. A Coinbase representative said the company doesn’t trade against customers or act as a market maker. “We will continue to call for a regulatory framework for the crypto-economy that ensures consumer protections and expands access for all,” the representative said in a statement.

“Many exchanges serve multiple functions out of necessity as the industry is still in its infancy,” Binance said in a statement to Barron’s. “As a leading exchange, Binance takes user protection and responsible trading seriously.” FTX declined to comment.

Yet centralized exchanges account for only some of the trading. Billions of dollars worth of crypto also sits on decentralized finance, or DeFi, platforms. Traders, borrowers, and lenders set their own terms in DeFi, matched by algorithms or software protocols that automate all aspects of a transaction. Positions may be automatically liquidated if collateral levels fall below preset thresholds.

Investors often plow money into DeFi to capture advertised double-digit or even triple-digit yields. Nothing like that exists in traditional finance—bank savings rates now hit 1.6% at best. Junk bond yields average 8%. But in DeFi, since there aren’t companies standing behind the trading and borrowing protocols, there’s scant recourse if deposits vanish due to a hack or software glitch.

Theft on DeFi isn’t trivial. Protocols accounted for 97% of the $1.7 billion of crypto stolen in 2022 as of May 1, according to blockchain analytics firm Chainalysis. “It’s a major consumer protection issue that you don’t have recourse if you have funds stolen on DeFi,” says Chainalysis Director of Research Kim Grauer, adding that she’s optimistic protocols will get more secure over time.

With stablecoins, crypto is reinventing financial wallpaper that started in the 1970s: the money-market fund. Stablecoins, like money-market funds, aim to maintain a fixed $1 price. But unlike regulated funds, stablecoins can own whatever assets they want as reserves, including other tokens like Bitcoin.

The perils of this approach became apparent with the recent crash of an “algorithmic” stablecoin called TerraUSD, wiping out $60 billion in a few weeks. The episode highlighted the system’s fragility and contagion risks as Tether, the largest stablecoin, briefly “broke the buck,” raising concerns that the industry wasn’t prepared for a classic run on the bank.

The term stablecoin is “an effective marketing strategy but could really hurt if the stablecoin were to fail,” says Hilary Allen, a law professor at American University who has written critically about crypto. Money-market funds have broken the buck in stressful markets, such as the 2008 financial crisis, requiring bailouts and market stabilization measures, she adds. In stablecoins, owners of the tokens don’t even have ironclad redemption rights, let alone a federal backstop.

Crypto companies are elbowing into another Wall Street club: home loans. Start-ups like Milo are offering zero-down mortgages, backed by crypto as collateral. The company, along with others, aims to chip off even a tiny slice of the multitrillion-dollar home loan market. Some traditional mortgages have already been traded on a blockchain. Securitizing crypto mortgages may be next. “We talk to a number of regulators and are trying to get them to understand what we’re doing,” says Milo CEO Josip Rupena.

To understand why Bitcoin purists object to all this, it’s helpful to know some history.

Bitcoin, launched in 2009, was developed as a peer-to-peer system for transferring a currency without using intermediaries like banks. The technology, dubbed “permissionless,” was designed as if corporations and governments were the enemy of individual economic rights.

Yet the Bitcoin blockchain—a network of computers whirring endlessly to solve math problems that validate transactions—wasn’t built to scale up. Transaction processing is glacial compared with card networks like Visa (V). Nor was the blockchain designed for uses beyond payments. That opened the floodgates to other blockchains. Today, hundreds of them form the backbones for trading platforms, tokens, financial products, videogames, and online worlds.

Crypto also took advantage of a lack of regulation to raise capital and set up corporate structures on its own terms. Rather than issuing equity, blockchain companies would raise money from venture capital and then airdrop tokens—distributing them free to build support—or engage in an “initial coin offering.” Exchanges and brokerage firms received state licenses to operate as money-transfer businesses, partly because there was no clear path to register the business or tokens with the SEC.

Early inefficiencies in the market lured Wall Street veterans. Take Dave Weisberger, who worked on quantitative trading and market structure at firms like Salomon Brothers and Two Sigma Securities. Weisberger went on to co-found a firm called CoinRoutes that imports crypto market data from dozens of exchanges.

In a presentation at a crypto event in October, Weisberger said the crypto markets had “plenty of dumb traders for you to see on the tape and take advantage of.” Crypto, he added, offers “so much more inefficiency than other markets that it’s very exciting. It’s one of the reasons that so many traders are flocking to it.”

With more sophisticated firms now in the space, market efficiency is improving, Weisberger said in an interview. But retail traders aren’t getting anything close to the national “best execution” standard for equity trades, according to Massad. A small investor on Coinbase is trading only against other investors or market makers on the platform. Institutional investors use firms like CoinRoutes to send orders to whatever exchange offers the best price.

Moreover, there’s also more arbitrage opportunity in crypto. A hedge fund could buy Bitcoin on one platform and sell it at a higher price on another, or use publicly traded equities and spot crypto markets to make that bet. That type of trade is much tougher to pull off in stocks, where bid/ask spreads are generally tight and prices don’t deviate much across national exchanges.

“In equity markets, retail gets the best deal,” says Weisberger. “In crypto, generally retail traders pay higher fees or trade outside of where the actual spread is.”

The crypto crash has been a wake-up call, even for people in the industry who thought they weren’t taking big risks by taking out a loan.

Shahar Abrams is one such investor. A 30-year-old industry consultant, he had taken out a $140,000 loan last December with Celsius. As collateral, he had posted $560,000 worth of a token called CEL, a proprietary coin originally issued by the company. He used the proceeds to help buy a condo and grand piano. “My dream piano and a place to put it,” said Abrams, who lives in Atlanta.

What he didn’t expect was a collapse of his collateral. As Terra plunged, prices sank for other tokens. CEL’s price halved in one day and fell another 50% the next. That prompted a margin call from Celsius to post more collateral within 24 hours. Abrams decided not to throw more money into it, but it wouldn’t have mattered. Celsius liquidated his collateral to repay the loan before its own deadline. In the end, borrowing against his collateral instead of selling it cost him about $420,000.

“Clearly there’s a lot more risk to the platform than people realized,” says Abrams, who consulted for Celsius and recommended it to friends. “I always thought Celsius was the absolute safest one, and that’s why I steered people there.”

Celsius and other lenders now face a regulatory storm. Even before the company seized up, it had been accused by state regulators of violating securities laws and had stopped offering its interest accounts to new U.S. retail investors. Regulators in at least five states are probing its deposit freeze. Celsius in legal proceedings has disputed that it violated securities laws and has said it is “working closely with U.S. states to provide clarity about our business operations.”

Other crypto lenders sound undeterred, arguing that they’re safeguarding depositors while meeting demand for loans that banks won’t provide.

Ledn, a lender based in Toronto, says its typical borrower doesn’t want to sell his or her Bitcoin, and can’t find a traditional lender. “With Bitcoin, we can offer people in Mexico a loan at the same interest rate that a client in Canada or the U.S. can get,” says Ledn co-founder Mauricio Di Bartolomeo. The typical loan is for $15,000, he says, used for things like buying a home or school tuition.

Ledn also advertises high-yield savings accounts, including 7.5% on the stablecoin USD Coin and 5.25% on Bitcoin. Di Bartolomeo says that liquidations and withdrawals have increased recently, but he’s confident the platform can weather the crisis.

Companies like Milo, the mortgage lender, say they’re issuing home loans to the “crypto-rich,” providing credit they couldn’t get through a traditional lender. Milo doesn’t check credit scores or require much income and asset documentation, other than requirements for anti-money-laundering purposes. And while few banks take crypto as collateral, Milo bases its loans on a borrower’s Bitcoin or other crypto holdings.

Rupena, who founded Milo after working on Wall Street, says a home buyer can put zero down for a loan. A borrower could get a $1 million mortgage for a house priced at $1 million, backed by $1 million worth of Bitcoin and the house itself. If the crypto collateral drops below a preset threshold, the company could require the borrower to add more; if prices continue to drop and the borrower doesn’t add more crypto, Milo may liquidate the collateral or foreclose on the property.

For now, traditional lenders like Wells Fargo (WFC) and Rocket Cos.’ (RKT) Rocket Mortgage don’t have much to fear. The crypto-rich market is small. Milo issued its first mortgage in April, funding a set of rental properties in Coral Gables, Fla., secured with Ether and Bitcoin, then worth around $600,000. Since then, Milo says it has closed about $10 million in loans.

If zero-down mortgages take off, they would revive a product that evaporated for most buyers after the 2008 financial crisis. Rupena was in his early 20s back then, following a stint as an intern on Lehman Brothers’ mortgage desk. That experience taught him to “think about the world a little differently and the downside in a different lens,” he said, adding that the company hasn’t had to issue any margin calls as the crypto market crashed.

Crypto industry executives say many of their innovations will make finance faster, cheaper, and more accessible. When an investor buys or sells a stock, for example, it typically takes two business days for the transaction to settle. Crypto transactions are often completed within minutes, once they’re recorded on a blockchain.

Traditional cross-border payments can be even more burdensome, requiring multiple banks to coordinate transfers over several days or wire transfer services that charge steep transaction and currency-exchange fees. International crypto payments happen almost immediately, wallet-to-wallet, and may be less costly.

“Use of the blockchain and distributed ledgers definitely brings efficiency to many financial products and processes. There’s no doubt that that’s the case,” says former SEC Chairman Jay Clayton, now an advisor at crypto firm Fireblocks and senior policy advisor at law firm Sullivan & Cromwell. The issue, Clayton says, is that some in the industry don’t so much want clearer rules of the road as they don’t want to obey what’s on the books: “The calls for so-called clarity in many ways are just calls to change the applicable law.”

Some software engineers say it’s high time for governments to take charge.

Bitcoin “was this financial populist movement as a reaction to the speculative excesses of Wall Street,” says Stephen Diehl, one such critic now urging Congress to crack down. “Imagine if Occupy Wall Street was an equivalent movement,” he said, referring to the populist protest against income inequality. “Now, imagine if everyone on Occupy Wall Street was replaced with a hedge fund manager. That’s what we have with crypto.” b