Crypto: What We Have Learned and Where We Go From Here

By Sloan Smith, MBA, CAIA, CPWA® and Steven Fraley, CFA, MBA

It’s no secret that 2022 was an incredibly challenging year for global markets. Stocks fell, across the board, by 15% or more and traditional bonds declined by as much as 20%. But there was one asset class that took, arguably, the largest and most painful hit in 2022: cryptocurrency. Most assets in the space fell by 50% or greater throughout the year. It wasn’t just the economic and monetary backdrop that caused challenges. In fact, this was just the “tip of the iceberg” that ultimately exposed extensive leverage in the cryptocurrency ecosystem, some notably bad actors, and the need for better regulatory oversight.

Excess Leverage

While crypto assets, specifically Bitcoin, have been around for well over a decade, they really gained in popularity coming out of the 2020 global health pandemic. Spurred by record low interest rates, an expanding monetary policy, and a strong economy, crypto assets grew rapidly in both price and adoption. Money poured into the asset class at an alarming rate as everybody wanted to cash in on the next hot investment. This drove the price of Bitcoin from just over $5,000 in March of 2020 to over $60,000 one year later.

Source: CoinDesk.com and highcarts.com

Early in 2022, central banks reversed course and began to raise interest rates and decrease market liquidity. Investors started to lose interest in speculative asset classes like crypto and turned their attention to lower risk investments with increasingly better yields. Projects like Terra and its cryptocurrency, Luna, a darling during the crypto bull market, began to implode as investors exited the crypto markets at an increasing pace. Terra’s algorithmic stablecoin (UST) completely de-pegged from the U.S. Dollar, causing billions of dollars in investor losses. This started a ripple affect that spread throughout the crypto ecosystem. Centralized finance (or CeFI) institutions like Celsius Network, Voyager Digital, and FTX had lent out significant assets to various cryptocurrency hedge funds. With the continued sell-off and collapse in asset prices, these leveraged hedge funds started to default on loans owed to many of the CeFI companies. Individual user funds held on these platforms were frozen, and investors were unable to access their assets. Unfortunately, several users lost their funds completely. 

Bad Actor(s)

One of the primary reasons crypto has risen in popularity over the years is because blockchains are decentralized, meaning banks and governments cannot manipulate the value like they can traditional fiat currencies. Unfortunately, the underlying assets are traded and custodied on centralized exchanges that are vulnerable to corruption, greed, and bad actors.

In November 2022, FTX, one of the most heavily utilized cryptocurrency exchanges in the world, filed for bankruptcy. The firm’s founder, Sam Bankman-Fried, allegedly transferred customer funds to Alameda Research, a cryptocurrency hedge fund that he also founded. Once the connection between FTX and Alameda was discovered, withdrawals of approximately $6 billion were requested from the FTX platform. Unfortunately, due to leverage and poor performance in Alameda, FTX lacked the necessary capital to fulfill the requests. Ultimately, these actions led to the firm’s insolvency. Currently, Sam Bankman-Fried is facing an eight-count federal indictment that includes charges of wire fraud and money laundering.

The fallout of FTX provided insight into the lack of controls within the cryptocurrency space. For years, cryptocurrency was an asset class that created outsized returns where successful entrepreneurs in the space were viewed as idols. The “return chasing” and “fear of missing out” mentality led to minimal questioning and poor due diligence from prospective investors. Cryptocurrency as an asset class is still in it is infancy and detailed research is required before considering an allocation. Otherwise, investors are susceptible to future scams, frauds, and blow-ups.

Source: CoinDesk.com and CoinDesk Indices and Research

Need for Regulatory Oversight

The long list of failures in 2022 underscores the need for greater regulation. Outright fraud, irresponsible allocation of consumer deposits, and leveraged trading might have been avoided with proper risk controls and government oversight.

For traditional currencies, the issuing authorities are usually central banks. These entities are trusted to manage the production, supply, and distribution of their nation’s currency. With cryptocurrencies, there is no central bank or issuing authority. This lack of a regulatory framework enables cryptocurrency businesses to grow but leaves potential customers vulnerable to numerous risks. According to the International Monetary Fund, the objective is “to create a system that is coordinated, so it can fill the regulatory gaps that arise from inherently cross-sector and cross-border issuance and ensure a level playing field; consistent, so it aligns with mainstream regulatory approaches; and comprehensive, so it covers all actors’ aspects of the crypto ecosystem.”[1] Progress in this area is still an outstanding item.

Conclusion

Crypto has undergone significant growing pains in 2022, but it is important to note that none of the failures were caused by the underlying blockchain technology itself. In each situation, it was poor financial decisions, excess risk taking, and a complete lack of oversight and transparency that led to the end result. These unknowns and challenges are still very prevalent and likely to continue to weigh on the asset class going forward. If the crypto ecosystem can overcome these challenges, it should ultimately lead to continued adoption and a more viable investment in the future.

[1] Source: “Regulating Crypto”

https://www.imf.org/en/Publications/fandd/issues/2022/09/Regulating-crypto-Narain-Moretti