The Crypto Shakeout
November 18, 2022
The crypto exchange, FTX, bankruptcy filing is the latest in the butterfly effect overhanging the future of crypto. The crypto bears liken the past year’s events to a large-scale Ponzi scheme or Enron fraud, this is likely part of a larger-scale shakeout seen throughout the year. The decentralization and lack of regulation that crypto promises are plagued by those who are over-levered and interconnected. Despite the challenges, we believe crypto is down, but not out.
Crypto, under bear market conditions, may be facing a continued but shorter-term ‘winter.’ Identifying idiosyncratic (company specific) vs. systemic (market wide) risk is key to evaluating the long-term viability of investments. The systemic risks have been known since crypto’s launch: regulation, tax, money laundering, and theft. This hasn’t changed. The idiosyncratic risk rose in tandem with crypto’s popularity and was enabled by a lack of regulation.
Interconnected lending in the first half of the year led to bankruptcy claims by Celsius, Three Arrows Capital, and Voyager. FTX is the latest victim to fall to leverage and the naïve idea of holding reserves in illiquid, proprietary coins. Using customer deposits to bail out a related hedge fund took things over the edge. Importantly, none of the regulated entities – Coinbase and Gemini in the US, Hashkey and OSL in HK, etc. – have had these issues. Turns out regulation might not be such a bad thing. Regulatory reviews, set to kick off in December, will likely lead to the separation of exchanges/custody of assets and stablecoins. Short-term pain for longer-term gain.
Crypto is likely to see a continued short-term winter, while the shake-out continues, with counterparties to FTX reviewing their own leverage. In the wake of the FTX bankruptcy, trading volumes have fallen over 70% and sales to buys are now 2:1. Deleveraging, regulatory development, and separation of exchange and asset custody businesses are all beneficial for long-term crypto viability. Near-term performance is likely to follow retail investment flows and animal spirits overall. We still see long-term value in crypto, but have and will remain focused on proven coins, only buying what we know, and ensuring that client position sizes are appropriate given the risks involved.
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Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency.