FeaturesLong Reads

The Biggest Story in Crypto in 2022: Contagion—From Terra to FTX


It’s been a chaotic year in crypto—through it all, a single and brutal narrative thread has stood out.

By Stacy Elliott

12 min read

How far will the contagion spread? Image: Shutterstock

There’s hardly a project, protocol, or institution that hasn’t felt the sting of contagion in 2022.

The lucky ones are ending the year having had to downsize their workforce to weather what seems to be an increasingly severe crypto bull market. The unlucky ones—and there have been many—are facing liquidation, lawsuits, and jail time.

The contagion—or tendency for a financial crisis to spread to other institutions, markets, or regions—has been unforgiving and widespread.

Crypto market capitalization has fallen from $3 trillion in November 2021 to $881 billion, according to CoinGecko. And somewhat unusually, at least for crypto, the story of 2022’s contagion begins with a nonprofit organization.

Terra fails

The founders of the Terra blockchain network formed the nonprofit Luna Foundation Guard (LFG) in January to safeguard the TerraUSD stablecoin and protect its dollar peg. TerraUSD, which traded as UST, was an algorithmic stablecoin that was meant to hold steady against the U.S. dollar.

Unlike collateralized stablecoins, like Tether (USDT) and USD Coin (USDC), UST was initially backed by nothing but code—a mint and burn mechanism linked to its sister token LUNA. When that mechanism began to show signs that it would likely not hold up, LFG came into the picture to build up a reserve to back UST—only it used Bitcoin and other cryptocurrencies, instead of cash.

That didn’t work.

Just days before UST lost its peg to the dollar, spiraled toward zero, and sparked fear in the markets, LFG had made its biggest Bitcoin purchase ever on May 5: $1.5 billion worth of BTC, bringing the reserve’s total balance to $3 billion. That included other holdings, like LUNA, the Terra network governance token; AVAX, the Avalanche network token; and USDT and USDC.

The purchase was made with help from Digital Currency Group-owned trading desk, Genesis, and crypto hedge fund Three Arrows Capital, LFG wrote on Twitter.

Terra co-founder Do Kwon was adored by his supporters for dunking on detractors, calling them “poor” and saying of competitor MakerDAO’s stablecoin: “By my hand $DAI will die.” In interviews with the media, he bragged about the wisdom of using Bitcoin as a reserve currency.

“For the first time, you’re starting to see a pegged currency that is attempting to observe the Bitcoin standard,” he told CNBC. “It’s making a strong directional bet that keeping a lot of those foreign reserves in the form of a digital native currency is going to be a winning recipe.”

Then the price of Bitcoin tanked. LFG, the nonprofit, wasn’t able to save UST from ruin with its reserves. The Terra network, along with UST and LUNA, was the first behemoth to fall in 2022, as UST plummeted from $1 to $0.13 in less than a week.

A lot of the firms that would eventually fall because of their exposure to Terra were in three camps, and some were in all of them: Companies that were equity investors in Terra, receiving shares in the company in exchange for checks they wrote to Terraform Labs; companies that had opened large positions on Terra’s high-yield staking protocol Anchor, where they were earning returns of up to 20% on their deposits; or companies and individuals that granted undercollateralized, or just plain uncollateralized, loans to firms that had invested in Terra or had large, leveraged UST or LUNA positions.

Among them: Galaxy Digital CEO Mike Novogratz, who famously tweeted a picture of his new tattoo in January: A wolf howling at the moon along with a “Luna” label. He proclaimed himself a “lunatic” and personally thanked Kwon. 

Terra triggers 3AC collapse

After Terra collapsed, Galaxy Digital projected a $300 million loss for Q2 and a 12% drop in its partner capital to $2.2 billion. When the results were released, the loss was even worse than it predicted: The firm saw a net comprehensive loss of $554.7 million, and partner capital was down 27% to $1.8 billion, according to a company press release.

But the next important domino to fall after Terra was the now-infamous Three Arrows Capital, also known as 3AC, for which Terra’s Anchor protocol had become a steady source of profits. 

Co-founders Kyle Davies and Su Zhu started 3AC in 2012, making them old-timers by crypto standards. At its height, the hedge fund was managing upwards of $10 billion. It was the firm that every startup wanted on its cap table and every institution was happy to lend to, often asking for very little or no collateral. Its reputation was that good.

In many ways, Terra was just big enough to force an even bigger player to topple.

“The data suggests that FTX’s demise hasn’t been investors’ biggest issue this year,” the team at Chainalysis, a crypto compliance company, wrote in a recent blog. “Both the depegging of Terra’s UST token and the collapse a few weeks later of Celsius and Three Arrows Capital (3AC) drove much bigger realized losses for investors: $20.5 billion in the case of UST and a whopping $33.0 billion in the case of Celsius and 3AC, versus just $9.0 billion for FTX.”

Three Arrows had been so successful that, over time, it began placing riskier and riskier bets, including a nine-figure position in Anchor, created by Terraform Labs head of research Nicholas Platt.

At the time, Platt envisioned the Terra protocol would become the gold standard for passive income in DeFi. 

“To generate yield, Anchor lends out deposits to borrowers who put down liquid-staked [proof-of-stake] assets from major blockchains as collateral,” he wrote in 2020. “Anchor’s yield is thus powered by block rewards of major proof-of-stake blockchains. Ultimately, we envision Anchor to become the gold standard for passive income on the blockchain.”

At its height, and right before Terra collapsed, Anchor had $14 billion in UST deposited. But that passive-income goldmine was, of course, unsustainable. And when the music stopped, investors rushed for the exit. Anchor’s implosion then precipitated the collapse of the entire Terra ecosystem.

For what it’s worth, as of this writing, Anchor still exists. It has $560 million worth of UST left and promises 16.26% interest on deposits.

The 3AC co-founders, Kyle Davies and Su Zhu, would later confirm that they took a $200 million loss from their UST and LUNA positions. When Terra’s market turmoil sent Bitcoin crashing from $30,000 to $20,000 in May, it put 3AC under pressure to add collateral on all its loans or face liquidation.

“What we failed to realize was that Luna was capable of falling to effective zero in a matter of days and that this would catalyze a credit squeeze across the industry that would put significant pressure on all of our illiquid positions,” co-founder Su Zhu told Bloomberg in July.

Among its illiquid positions was a large stake in the Grayscale Bitcoin Trust, which used to be the preferred way for investors to gain Bitcoin exposure without directly holding BTC—so much so that it sold at a premium to the underlying Bitcoin. When 3AC started buying up GBTC shares, it looked likely that the firm would be able to resell them and make a profit once the lockup period expired.

In fact, by January 2021, 3AC was the largest shareholder of Grayscale Bitcoin Trust (GBTC), having increased its holding to $1.3 billion. But the mandatory lockup period meant that by the time 3AC could have started selling its shares, the premium had disappeared. The firm was left holding a bag of GBTC that it couldn’t sell without booking a loss.

To compound that problem, 3AC used borrowed money—$3.5 billion was still outstanding when it was ordered to liquidate—to fund many of its positions. That included $75 million worth of USDC from Celsius, an undisclosed “large” loan from BlockFi, $2.3 billion from Genesis, and $640 million from Voyager Digital. The firm also borrowed from exchanges: BitMEX, FTX, Blockchain.com, and Deribit.

When 3AC failed to meet margin calls, or requests to add more collateral to secure its loans, lenders began threatening to liquidate the hedge fund’s assets. Court documents from 3AC’s bankruptcy proceedings show that Derebit leadership tried repeatedly to get in touch with the hedge fund’s co-founders.

“You really need to start communicating,” one of the Derebit executives said to Davies. “Deribit legal team is preparing for the worst now, including [a] plan of seizure of your assets and stocks. … Don’t do anything stupid and please communicate.”

The company later said on Twitter that even if none of the loans were repaid, it would “remain financially healthy and operations will not be impacted.”

Another of the company’s lenders, Blockchain.com, got what’s now become a famous quip on Crypto Twitter from 3AC executive, Edward Zhao—“yo uhh hmm”—when he told Zhao the company would need to call back portions of a loan made to the beleaguered hedge fund.

In a matter of weeks, companies that had secured 3AC’s loans with collateral liquidated the firm’s positions. But that left the ones that hadn’t asked 3AC to provide any collateral—after all, it was one of the biggest and most successful firms in the industry—to serve default notices. 

Ultimately, it was the default notice from Voyager Digital for $640 million that preceded 3AC seeking Chapter 15 bankruptcy protection on July 1.

Through all of it, FTX founder and then-CEO Sam Bankman-Fried maintained a white knight veneer. He famously said in June that he felt that his company had a responsibility to help all the struggling companies (a sentiment he’d repeat on Decrypt’s gm podcast in August).

“I do feel like we have a responsibility to seriously consider stepping in, even if it is at a loss to ourselves, to stem contagion," he told NPR. "Even if we weren't the ones who caused it, or weren't involved in it. I think that's what's healthy for the ecosystem, and I want to do what can help it grow and thrive."

After realizing big losses from 3AC’s collapse, BlockFi, Voyager Digital, and Celsius were circling the drain. All three companies sought help from Bankman-Fried.

BlockFi accepted a $400 million revolving line of credit from FTX US, which included terms for BlockFi to be acquired for $240 million pending certain “performance triggers,” CEO Zac Prince said on Twitter. Voyager Digital accepted two lines of credit from Bankman-Fried’s trading desk, Alameda Research: $200 million cash and 15,000 BTC.

Word got out that Bankman-Fried considered doing a deal with Celsius, but passed because of a $1.2 billion hole in its balance sheet.

FTX joins the bankruptcy parade

In the end, it didn’t matter who did or didn’t get a bailout. All three companies have since filed for Chapter 11 bankruptcy protection. 

That’s because FTX—the company whose CEO was shaming others for not joining him in helping struggling firms in the industry—was itself insolvent. What’s more, it was insolvent partly for the same reason as 3AC, Celsius, BlockFi, and Voyager Digital: Terra.

Analysis of on-chain data has shown that Alameda Research experienced a huge loss when Terra collapsed in the spring. To cover up the loss, client funds were moved from FTX to Alameda. The going theory, according to allegations from the Commodity Futures Trading Commission, is that a fake client account was created to hide Alameda’s liabilities.

“At least in part to remediate the risk that Alameda’s large liability would be discovered, at Bankman-Fried’s direction, FTX executives reallocated Alameda’s approximately $8 billion in liabilities to a customer account on FTX’s systems that Bankman-Fried would later refer to as ‘our Korean friend’s account” and/or ‘the weird Korean account,’” the CFTC wrote in its complaint

The company seemed set on not disclosing its losses from Terra until things started to come apart at the seams in early November. Leaked financial documents from Alameda landed on Coindesk, and its report revealed that the trading firm had billions worth of illiquid FTT, a token issued by FTX, sitting on its balance sheet.

It was a glaring red flag that prompted Binance CEO Changpeng Zhao, a former investor in FTX, to announce that his company would begin selling off its stash of FTT. At the time, Binance held roughly $584 million worth of FTT—more than 5% of the entire token supply.

The move spooked FTX investors and clients, and the resulting bank run on FTX drained billions from the crypto exchange in a matter of days. Binance initially announced its intention to bail out and acquire its struggling rival, but it ultimately backed out and said that FTX was “beyond our ability to help.”

Two days later, the biggest domino yet would fall: FTX filed for Chapter 11 bankruptcy protection, and Bankman-Fried resigned. But the contagion is unlikely to stop there.

Already, BlockFi—a company that FTX swooped in to save in June—has been forced to shut down and file for bankruptcy. More recently, Genesis, the crypto lending company owned by industry giant Digital Currency Group, has been rocked by the FTX fallout. 

At the start of the year, Genesis along with 3AC were instrumental in helping LFG fill its reserve with the BTC meant to protect Terra’s stablecoin. But 3AC’s bankruptcy left Genesis holding $1.1 billion worth of bad debt. Now FTX's bankruptcy has forced Genesis to suspend withdrawals while it searches for $1 billion in emergency funding to help it fulfill the $900 million it owes clients, according to anonymous sources who’ve spoken with the Financial Times.

Digital Currency Group, its parent company, broke its silence on its exposure at the end of November. In a letter to shareholders (published in full by CNBC), DCG CEO Barry Silbert wrote that the company has more than $2 billion in liabilities, itself having borrowed $575 million from Genesis that’s due in May 2023 and absorbing the $1.1 billion 3AC still owed when it filed for bankruptcy.

There’s still no sign of relief for Genesis or certainty that DCG can survive if its lending arm becomes insolvent. If Digital Currency Group falls, there’s no telling how far the contagion will then spread.