The nominal value of the global crypto asset market started the year at USD 2.2tr, but as of the publication of this article, it stands at USD 833.4bn, a decline of 62%, according to CoinMarketCap. Bitcoin prices have fallen 64% this year, while Ether has suffered a similar decline, plunging 65% year-to-date.
Changing tides: Shocks from rising costs of capital are a headwind for non-profitable businesses…
While crypto assets already had a high correlation with high-beta technology stocks, that correlation increased further in 2022 following the rapid rise in interest rates as the Federal Reserve front-loaded rate hikes. These higher rates disproportionately hurt market segments with low or no earnings, like crypto assets and a number of technology companies.
…amplified by idiosyncratic problems
In addition to these global drivers, crypto markets were shaken by numerous crypto-specific events, which accelerated the decline in prices.
In June, the collapse of the Terra Luna stablecoin (UST) caused a ripple effect across the industry, leading to multiple bankruptcies. The spillover from UST brought down a large lending platform, Celsius, and a leading hedge fund, Three Arrows Capital. Voyager, a digital asset brokerage, also suffered large losses. After disclosing its exposure, the firm received an emergency credit line from Alameda, a trading firm controlled by FTX crypto exchange owner Sam Bankman-Fried. Other prominent victims of the collapse include the institutional service provider Babel as well as the decentralized finance (DeFi) exchange Bancor.
Then, in early November, one of the biggest crypto exchanges, FTX, and closely linked proprietary-trading firm Alameda, failed. Around 40% of Alameda's assets were in a crypto token, FTT, created by its sister company FTX. The FTT token does not give the holder equity ownership rights to FTX, or rights to capital in the event of bankruptcy, like debt. Rather, the value of its token was set by market participants trading FTT on crypto exchanges. Alameda had borrowed against these illiquid assets, until this practice became more widely known following the leak of Alameda’s balance sheet information. Over the course of six days, the crypto exchange collapsed due to a sudden liquidity crunch. The collapse was exacerbated by the fact that Bankman-Fried, the founder of these two firms, had assumed a high-profile role in the industry. He and his firms had been instrumental players in the ecosystem, from working with politicians and regulators crafting legislation, to acting as a lender of last resort to firms experiencing liquidity problems, as was the case after the collapse of UST. However, nobody moved to bail out FTX, which filed for Chapter 11 bankruptcy in the US on 11 November 2022, together with a further 134 affected entities, causing the crypto market to tumble on contagion concerns.
Although the full implications of FTX’s and Alameda’s bankruptcies are not yet understood, they could end up costing users and investors significant amounts of money. In addition, both firms have exposure to dozens of companies and protocols.
Outside the crypto universe, we think the contagion effect will remain contained. The biggest direct impact is probably on stocks related to the crypto industry: Coinbase dropped 16% (83% year-to-date), Galaxy
Digital plunged 36% (83% year-to-date), Microstrategy plummeted by 40% (68% year-to-date), and Robinhood sank 21% (49% year-to-date) in the week following FTX’s bankruptcy. Together, the market capitalization of these stocks declined by about USD 6.3bn, according to a UBS Research report.
Each digital asset boom-and-bust cycle, however painful it may be, is a necessary step toward the maturation of an industry that is still in its nascent stage. Each cycle helps weed out the weak and acts as a catalyst for those who survive and who can take advantage of the void created by bankruptcies to establish or consolidate market leadership. With less competition for capital, more realistic valuations, and greater transparency and regulation, we think digital assets will offer a better, investable environment in the future. We, however, note that the inherent risk of investing in an early-stage industry and venture capital warrants extra caution.
Instead, we recommend seeking exposure to traditional private equity sectors that continue to offer a better risk-reward, especially following the decline in public markets, in our view. Putting fresh capital to work following declines in public markets has historically been a rewarding strategy for private equity.
In the current environment, we favor strategies that can take advantage of price dislocations. For example, we think that private deals, carve-outs, and divestitures may provide a fruitful pool of assets at relatively attractive pricing for value-orientated buyouts. Secondaries are also starting to price discounts, offering buyers exposure to seasoned quality assets at more reasonable prices. We also recommend investors to consider exposure to well-established secular trends in digitalization, healthcare, and the green economy. Assets exposed to these themes experienced fallout from the correction in listed technology companies. But this may mean better entry points for private investors.
Likely meaningful regulatory implications
While crypto assets do not (yet) pose a systemic risk to traditional financial markets, in our view, the collapse of Terra Luna and FTX is an important reminder that the crypto industry needs more regulatory oversight. We think the lack of transparency, conflicts of interests, poor liquidity, technological risks, as well as fraud and illicit activities are some of the main challenges the industry needs to overcome to be able to grow further. Improved regulatory oversight can help address some of these challenges, helping contain financial stability risks and improving investor protection. Given the decentralized nature and global scope of most crypto ecosystems, the international coordination between regulators and policymakers will likely be paramount to address these challenges effectively.
Main contributors: Michael Bolliger, Michael Gourd, Antoinette Zuidweg, Karim Cherif
Content is a product of the Chief Investment Office (CIO).
For more, see the educational note - Crypto's downward spiral in retrospect, 6 December, 2022.