This crypto winter will be long, cold and harsh
Bitcoin and other cryptocurrency assets are notoriously volatile, routinely suffering large drops of 50% or more. This does not seem to bother the diehard crypto believers too much, who have become used to declines of this magnitude. They simply use the declines to buy more. Even so, there are still a lot of people in the space who remember “crypto winter”, the period between early 2018 and mid-2020 when prices went down and stayed down, and much of the innovation in crypto came to a halt.
So, the question is: What do we make of the recent gyrations in the space, with the Bloomberg Galaxy Crypto Index down some 60% from its peak in early November? Does this mark the beginning of a new, long winter after a short spring or is it just a pause that will refresh?
Although the selloff in crypto may not be as big as others in its history, it feels worse because the market has grown so big — to the trillions of dollars in size. The damage in crypto has been broad, with hundreds of coins having plunged by some 90%. Bitcoin, the biggest and most well-known of the cryptocurrencies, has not done as bad, but is still down a painful 56% from the peak.
At the top of the bull market last year, there was a lot of hubris, laser eyes, CryptoPunk avatars and rude behaviour to go along with overthe-top Bitcoin conferences. All of it was a sign of the tough times to come. Untold numbers of crypto sceptics ended up at the bottom of a Twitter dogpile for suggesting the bull market had bubble-like characteristics.
A speaker at a recent conference I hosted was a former Ethereum miner. He talked about crypto winter, and in the midst of the carnage, he bet pretty much every last dollar he had that crypto would rebound, buying more and more graphics processing units (GPUs) to mine Ethereum when prices rose. They eventually did, but tellingly, he is no longer in the Ethereum mining business and has repurposed his equipment for cloud storage.
Most smart people agree the blockchain technology underpinning cryptocurrencies has huge potential, though we do not really know what it will look like 10 years from now. The venture capitalists believe it, and they have been making numerous Web3 (decentralised internet) investments and receiving tokens in return. Vast fortunes have been made in non-fungible tokens, or NFTs. But the value of all these assets has been decimated over the last few months.
If you think about the normal cycle of tech investing, the dotcom bust that started in 2000 and ended in late 2002 deterred venture capital investment for almost a decade, to the point where their best ideas were FarmVille and weird cleantech ventures. The big venture capital firms raised a lot of money for crypto in the last year, and the returns are going to be abysmal for a long time. That is normal. Whenever an asset generates no cash flow and no earnings, valuation is all based on confidence. Sometimes we feel good about these assets and other times we feel bad. You are seeing this play out right now in the stock market. The stocks that have been hit the hardest are the ones without any fundamental underpinnings. This is what makes investing in crypto so risky.
In previous crypto bear markets, people wondered if Bitcoin would rebound. Now, they wonder out loud about the future of blockchain in general. There should be no question about the unlimited potential of this technology. If you own a basket of crypto today, like I do, it will probably be worth much more in the future. But how much more and when is the question that nobody can answer. Crypto will have another winter, but out of that neglect will grow another bull market, led by a handful of cryptocurrencies that will grow to far beyond what exists today.
Sometimes confidence disappears for a while, but it always comes back. Maybe instead of Web3 and NFTs, it will be a different technology that captures the imagination. It is worth pointing out, though, that many survivors of the dotcom bust went on to be spectacular winners, including Amazon, Facebook and Google — and even eBay. The capital markets are a giant sorting machine, filtering out the bad ideas and rewarding the good ones.
So, when people ask whether crypto will come back, the answer is yes, absolutely it will come back, but 98% of it won’t.
The current financial markets sell-off is a sobering moment for ardent proponents of Bitcoin as “digital gold” — the modern replacement for gold (the precious metal commodity) as a store of value and an inflation hedge. Bitcoin is failing the test on both fronts.
Inflation is rising sharply, to levels not seen since the early 1980s. And the price of gold is holding steady, as it is expected to be — its price is more or less unchanged year-to-date, hovering around US$1,800 an ounce. Bitcoin, on the other hand, has fallen more than 36% from US$46,300 at the start of the year — and peak of nearly US$69,000 in November 2021 — to less than US$30,000, at the point of writing. Far from acting as a stable store of value, the world’s oldest decentralised cryptocurrency is trading very much like a risky asset, indeed, resembling more of a highly speculative tech stock (see chart).
We have previously written about our thoughts on Bitcoin (“Bitcoin is ‘digital gold’, but less”, The Edge Singapore, Issue 976, March 22, 2021. To read the article, please scan the QR code). To recap, this was our conclusion: “We believe Bitcoin (like other cryptocurrencies) will remain a speculative asset — a ‘digital gold’, but less. Why? Gold has a long history as a strategic asset, to hedge against inflation and preservation of value, and safe haven, especially in times of heightened economic and political uncertainties. On the other hand, Bitcoin is driven by speculations for capital gains and too much liquidity. 20 So, when equity markets fall sharply, it too will likely fall and by more, given that it has absolutely no intrinsic value. Therefore, it is not a good hedging instrument in a diversified portfolio.”
True enough, recent events have proven that Bitcoin remains far too volatile an asset to be a good store of value, at least for the foreseeable future. And it has fallen by more than the Dow Jones Industrial Average (-10.1%), Standard & Poor’s 500 index (-14.2%) as well as the tech-heavy Nasdaq (-23.4%).
Warren Buffett has said: “If you … owned all of the Bitcoin in the world and you offered it to me for US$25, I wouldn’t take it.” This is because, according to Buffett, Bitcoin is a non-productive asset that does not produce any returns in terms of future cash flows. “Because what would I do with it? It isn’t going to do anything.”
This is true, and Bitcoin’s volatility means it is not a good store of value. But we also think many buy it for a reason — hope. It is the same reason people buy the lottery even though they are fully aware of the extremely long odds of striking the jackpot. Fact is, cheap and surplus liquidity created by central banks over the past decade has fuelled excessive risk-taking and speculative bubbles across financial assets, including many that make little to no sense, fundamentally — except for hope.
The recent spectacular meltdown of the Terra blockchain — which is (was) the world’s second-largest decentralised finance (DeFi) ecosystem in terms of total value locked, behind Ethereum — accelerated the broader rout for the entire crypto complex, NFTs (non-fungible tokens), SPACs (special-purpose acquisition companies) and meme stocks — as the decade-long secular trend of excessive liquidity reverses course.
If you have not read all about TerraUSD (UST) by now, it is a stablecoin, whose value is, as the name suggests, meant to be stable. Stablecoins are used to facilitate trades on crypto exchanges, for instance, to buy/sell Bitcoin and other cryptos. They are also the medium of exchange for DeFi applications — essentially financial transactions — on blockchains. The key difference between stablecoins and cryptos — where price volatility is the norm — is that they are pegged to some fiat currency, typically a one-to-one peg with the US dollar.
To maintain trust in the network, issuers of the most popular stablecoins in use, Tether and USD Coin, claim that they are backed by real asset reserves, such as US Treasuries, money market funds, commercial papers and cash.
UST, on the other hand, is a stablecoin whose US dollar peg is maintained by algorithms, linked to its natively produced token called Luna. Put another way, it is a product of pure financial engineering. Here’s how it is supposed to work. One UST is always convertible into US$1 equivalent of Luna tokens and vice versa — and the mechanics of demand and supply will ensure the UST’s parity to the dollar.
For example, if the price of UST falls below US$1, say to 95 US cents, some smart person will buy it, then redeem it for US$1’s worth of Luna and make a five US cent profit instantly. The supply of UST falls (redeemed/ burnt) and its price rises back to US$1. Conversely, if UST rises to, say, US$1.05, another very clever person will immediately burn US$1’s worth of Luna to mint a UST, sell it and make an instant profit of five US cents. The additional supply of UST will ensure its price drops back to US$1. Makes sense? Mathematically, yes — but ONLY if Luna has a value that is not zero.
The biggest use case for the Terra network was Anchor Protocol, a savings-lending DeFi app where more smart people can park funds in UST and earn yields of up to 19.5%. Here’s a timely reminder: When something appears too good to be true … Anchor was also created by Terraform Labs, developer of the Terra blockchain, as a means to attract money to the ecosystem. As the demand for UST grows, more Luna will be burnt and, therefore, the higher the value of the remaining Luna. At least, that is the playbook. It was reported that some 70% of
outstanding USTs were previously deposited in the Anchor scheme. Luna’s price rose as high as US$116 last month. As any rational person knows, however, value cannot be created out of thin air — and events of the past week have proven this, emphatically.
Terra’s problem started when some UST holders cashed out of Anchor, triggering the drop in prices for Luna, which then prompted more redemption and a further collapse in prices. The supply of Luna ballooned (owing to the redemption mechanism) — from about 346 million on May 9 to 6.53 trillion on May 13. Insiders call this the “death spiral”. The UST lost its peg — even a trillion Lunas with a value of zero will get you nowhere near US$1.
Most cryptos and NFTs are classic cases of the “greater fool theory” at work. When an asset has zero underlying intrinsic value, its price is what the next person is willing to pay, driven by sentiment. So, there is no limit as to how high prices can go — or how low, including all the way to zero. As we saw last week, confidence can be a fragile thing and the perception of value, fleeting. That said, owning an NFT is about possession of an asset — whose value could be established over time, like the Mona Lisa, or not. The point is, we cannot presume to know that values will rise overnight — and keep rising.
The demise of Terra — within a matter of days — is bound to have ripple effects on other highly speculative corners of the financial markets, perhaps even spilling over into mainstream markets. Over the past few years, many retail investors and institutions have jumped onto the crypto bandwagon, though we think a crypto meltdown is unlikely to create systemic risk at this point.
Financial transactions over blockchain technology have real, tangible benefits, including the ability to reach millions of underserved and unbanked populations at very low costs and minimal friction. Some — maybe even many — innovations (projects) must inevitably fail, just as some startups and companies fail. That is not the issue. The issue is their operations must be transparent to instil trust and adequately regulated to protect users.
“We really need a regulatory framework,” US Treasury Secretary Janet Yellen said at a congressional hearing, weighing in on the implosion of UST. “Stablecoins present the same kinds of risks that we have known for centuries in connection with bank runs.”
At present, there is no regulatory oversight as to what stablecoin issuers claim are reserves — and, importantly, full audits as to whether they actually exist and what their market values might be at any point in time. For instance, who are the issuers of the commercial papers or corporate bonds being held as reserves? Last year, sister firms, Bitfinex (a crypto exchange) and Tether, paid an US$18.5 million fine to the New York Attorney General to settle an investigation over allegations of cover-ups without admitting wrongdoing. The NYAG’s office said in its press release then: “Tether recklessly and unlawfully covered up massive financial losses to keep their scheme going and protect their bottom lines” and “Tether’s claims that its virtual currency was fully backed by US dollars at all times was a lie.” Tether also paid US$41 million in fines to the US Commodity Futures Trading Commission (CFTC) over allegedly making untrue or misleading statements on the sufficiency of its reserves.
Higher inflation and interest rates as well as liquidity contraction in financial systems are realities. The US Federal Reserve will start to shrink its US$9 trillion balance sheet in June, with the monthly roll-off rising up to US$95 billion by September. Globally, the crypto complex has lost more than half its total market value, or about US$1.5 trillion, so far this year. Year to date, more than US$30 trillion, or 15.9%, of the combined market values for cryptos, stocks and bonds have been wiped out. Market valuations may continue to shrink as investors become more risk-averse. The ongoing wealth destruction is worrying and could have consequences on the real economy. We will write more on this in the future.
The Global Portfolio recouped some lost ground during the week ended May 18, closing 0.7% higher. The notable gainers were Yihai International Holding (+8.7%), Guangzhou Automobile Group Corp (+8.4%) and Alibaba Group Holding (+5.1%) while shares for Airbnb (-7%), Postal Savings Bank of China Co (-4%) and Apple (-3.9%) ended lower. Last week’s gains lifted total portfolio returns to 24.3% since inception. This portfolio is trailing the benchmark MSCI World Net Return Index, which is up 36.7% over the same period.