The digital currency market, which had until recently grown at a startling rate, has been shaken to its core by some of the most serious shocks it has received over its short lifespan so far.
Belying its stated purpose as a hedge against volatile stock markets, cryptocurrencies have been dragged down into the global financial bear market. Meanwhile, some prominent crypto companies have added fuel to the fire through risky and irresponsible behavior.
Many believe this one-two punch is a reckoning for the crypto industry as a whole. The party’s over, says The Wall Street Journal. The Ponzi scheme has collapsed, says The Guardian.
While conscious of the very real blows the crypto market has received, some of them self-inflicted, our view is that the current crisis is a healthy function of the increasing institutionalization of crypto and that this process will ultimately strengthen the crypto industry, making it more sophisticated and safer.
Given all the losses and panic selling, it can be hard to look under the hood of this moment in a calm and collected manner, but that is what we must do to preserve the once-in-a-generation innovation that crypto and the blockchain promise to deliver.
Major Trends
Two major trends are driving what’s happening now: Crypto’s growing correlation to capital markets, and the failure of major Decentralized Finance (DeFi) players to properly quantify risk.
Firstly, global capital markets have been declining since the beginning of the year into a real bear market. Looking closely at how this is affecting crypto, there is now enough data showing a growing interconnectedness between virtual assets and financial markets.
What’s driving this correlation is that over the past two years, institutional money, mainly from US hedge funds, pension funds and others, has started pouring into crypto. This money is greatly affected by market volatility, and when there are declines or ambiguities, institutional money traditionally flies to cash.
The crypto market, led by bitcoin, can no longer be used as a hedging instrument against stock market declines, and, despite the pain of that right now, on the whole this is a positive and important trend, which indicates the necessary institutionalization of the crypto field as it moves away from its Wild West beginnings. We do not see institutional finance walking away from crypto forever.
The great cycle
Rather, we are at the beginning of a great cycle of institutional adoption of crypto, and contrary to the recent flight-to-cash, we will see a lot more institutional capital pouring into crypto over the coming months, years and decades.
Some of the recent internal factors are potentially more concerning. The collapse of the Luna cryptocurrency and its associated terraUSD stablecoin shows that unfortunately, and unsurprisingly, no mechanism was built that could properly deal with very strong demand for withdrawals and drainage scenarios. Crypto investors have lost billions, sending shockwaves throughout the market.
Then came the Celcius meltdown. The crypto-lending platform that branded itself as the bank of the future, lured investors with high interest rates and had a "book" of deposits from many small retail investors, who put money in for short periods and in many cases on locked loans.
Celsius failed in one of the most basic aspects of banking: the balancing of risks between assets and liabilities, known in banking as ALM (asset and liabilities management).
Traditional banks have to undergo regularly mandated stress tests to make sure that under extreme scenarios they still have money should there be a run on the banks. Central banks have laws for this, and we could see some form of this regulation enter the crypto industry following this latest crisis.
But DeFi is no ponzi scheme, as some believe. In the last two years, the field has grown at an incredible rate, bringing a great deal of innovation and becoming a very attractive channel for small and large investors, who have enjoyed high-interest rates and returns on their money.
Rather, we believe this moment shows that many investors were unaware of how to quantify the risks they faced. They also did not understand the volatility of these currencies and the possibility that the counterparty in the transaction --platforms like Celcius and others-- may not meet its obligations (counterparty risk). Additionally, some counterparties neglected to properly assess their liquidity risk -- their ability to cash out in a crisis.
There is an important distinction, often lost in the jargon and hype, between stable digital currencies and conventional currencies in that the former do not hold reserves of conventional currencies, like dollars, while the latter have coverage in other currencies, like Bitcoin or Luna.
Crypto declines
The problems begin when the crypto market as a whole experience sharp declines --which happens every 3-4 years --and counterparty platforms find it difficult to guarantee one-on-one payouts to the dollar.
In 2018 the crypto market lost about 80% of its value in the disillusionment that followed the madness of Initial Coin Offerings (ICOs). There was then a great deal of unsophisticated and careless money pursuing unrealistic dreams in a market that lacked almost any regulation.
Still, the collapse of 2018 brought into the crypto market the regulators, who since mid-2019 have been implementing a series of domain-defining rules and regulations, setting precedents, and pursuing and suing anyone who commits fraud. And that's great.
In this last crisis, the mechanisms Terra/Luna and Celcius implemented, or failed to implement, simply lost effectiveness and failed to stay pegged to the dollar.
Most investors did not properly assess this risk and so they pulled out billions of dollars in Terra/Luna. This has US regulators concerned that the collapse of stablecoins could ripple across the broader financial system.
Terra/Luna and their domino effect on Celcius have exacerbated the negative trend in crypto far more than what’s happening in the broader capital markets --and we shouldn’t lose sight of that.
In many ways, the DeFi market is today in a similar situation as the whole crypto market was in 2018: this time too there is almost no regulation in a market that has grown at an enormous rate fueled by the money of many investors who did not understand the models or the risks they were investing in.
Just as in 2018, those who came to make a quick buck folded. However, other companies came out stronger and better suited to the long road ahead. Those companies who successfully come out the other side of this current crisis will have a great many attractive opportunities.
Their new protocols, platforms and products will further accelerate crypto’s tremendous momentum of innovation. The market, as always, will recover.
The underlying innovation that blockchain and crypto bring to a range of industries, particularly the financial industry, is impressive and important, and is not affected by rising or declining prices of various cryptocurrencies. And when the market recovers, we believe its recovery will be stronger and more pronounced than ever.
The writer is the CEO of Silver Castle, a global asset management and hedge fund investment house for digital currencies.