- Despite a laundry list of bankruptcies, stolen money, and hacks, crypto has embarked on a defiant rally on the back of misplaced, unfounded optimism.
- Back in 2021, we highlighted (i) fading momentum as one of the asset class’s headwinds, (ii) the dangers of excessive leverage buildup, and (iii) vulnerability to further monetary tightening, all of which have played out in 2022.
- The last factor we highlighted was regulation, which we think will escalate in the coming months - a major concern given the space's poor positioning for this transition.
- With the return of risk-on sentiment likely to be short-lived, crypto's end-use case remaining elusive, and regulatory tightening on the horizon, we would like to remind investors to stay clear of this 'Greater Fool' asset class.
Crypto’s rally over the past month continues to dispel any notion of the asset class as a risk or an inflation hedge. The prospect of a Fed pivot has meant that it has mimicked other risk-on asset classes like tech, rallying on the prospects of a less hawkish Fed, but it has also led to calls about the end of “crypto winter”. This optimism barely lasted for two days before yet another heist in the Solana ecosystem tempered investor sentiment – just the latest entry in a rapidly increasing list of incidents.
Chart 1: Despite a laundry list of incidents, crypto has defied the bad news
Since we last published our article in June, the crypto space has continued making the same mistakes. We have seen the same scams, the same rug pulls, and the same exploits being taken advantage of, reinforcing our belief that crypto founders are yet to learn any lessons despite the billions of dollars lost. We have also seen various major institutions within the crypto space declare bankruptcy and halt withdrawals, including crypto lending company Celsius, hedge fund 3 Arrows capital, and local brokerage platform Hodlnaut.
Related Reading: Back to Terra Firma - Lessons to be learnt from the Luna/Terra debacle
In light of this, the optimism seems sorely misplaced and unfounded. For investors tempted by the recent rally, we yet again reiterate our stance – do not chase the momentum. We remain unconvinced by the short-term and long-term story behind cryptocurrencies, as well as the narrative that the crypto winter is over. In fact, we think it might not even have begun.
Return of risk-on sentiment likely to be short-lived
This recent revival was driven by a return of risk-on sentiment as markets have started to price in expectations of a Fed pivot. At the recent Fed meeting, stock prices rose as markets took Powell’s statements – that the central bank would begin making rate decisions on a meeting-by-meeting basis – as a signal that rate hikes might soon slow down.
Similar to the rally in tech and other long duration stocks, this has driven crypto prices up.
This sentiment has since been dispelled by a flurry of statements by Fed officials, and with inflation still at elevated levels and employment robust, we believe that we are still en route to a new reality with higher inflation and interest rates – which means more rate hikes to come.
Even though inflation seems to be trending in the right direction, upward price pressures remain broad-based. As such, the Fed is nowhere near done in its ongoing battle against inflation, and is unlikely to make a huge policy pivot from where they are.
Related Reading: Inflation may have peaked, is it time to buy US equities?
Crypto’s end use case remains elusive
In the short term, with the Fed pivot likely to be wishful thinking by overeager investors, we think much of this rally will likely be tempered as the global monetary environment continues to tighten. Bitcoin has exhibited a strong correlation with global money supply, and in light of this, its near-term outlook looks bleak.
Chart
2: Cryptocurrencies are exceptionally driven by liquidity
In the long term, we continue to question the viability of cryptocurrencies. Despite being around for more than a decade (with the underlying technology having been conceptualised as early as 1981), the end-use case for the asset class (and underlying technology) has remained elusive. While crypto proponents continue to wax lyrical about the long term prospects and even current applications of various coins and technology, these often come with caveats and limitations – and are often far from the ideal solution for the issue they are trying to solve. Considering the hype and attention around the industry, if there was a best-use, scalable application, we would have certainly heard of it by now – and the lack of such a case remains extremely telling and worrying.
Within the limbo of current crypto “innovation”, the result is often a repackaged version of the same product – born out of its wilful ignorance of past lessons.
As such, it has failed to rectify or improve on any of the issues to a significant degree.
Crypto is a poor currency: It’s notoriously volatile and has a scalability problem
One often touted use for cryptocurrencies, especially Bitcoin, is its use as a form of money transfer or currency. There are two aspects of Bitcoin that makes it decidedly unsuitable for such a purpose – namely its volatility and its transaction frequency.
Firstly Bitcoin’s volatility makes it unsuitable as a medium for transactions, which is very simply illustrated by the infamous Bitcoin Pizza Day. On 22 May 2010, a man in Florida paid for two pizzas with 10,000 Bitcoins (worth over 300 million today and even more at its peak). Without this stability, prices of daily goods can become incredibly volatile, which is a less than ideal environment for everyday citizens. There is a reason why price stability is often a target for central banks and governments, and Bitcoin as a currency fails to meet that simple requirement.
In addition, due to the energy and computing power required to process a transaction, Bitcoin can only realistically process about 4 – 7 transactions globally per second, and takes about ten minutes for a transaction to be processed. In comparison, a Visa payment takes seconds, and can process over 1700 transactions per second. If Bitcoin is to be used as a global currency – the transaction rate is certainly not going to be sufficient.
Crypto proponents often tout El Salvador adopting Bitcoin as national tender as a positive example of its real world applications as a currency. After allocating a significant portion of the national budget to ingrain Bitcoin into the economy, the use of the cryptocurrency and its corresponding app, Chivo, has plunged. Only 10% of Chivo users have continued to use the app in 2022, with virtually no new downloads this year, and only 3% of businesses see any value in it.
Digital remittances – another common end-use case touted by crypto enthusiasts, accounted for less than 2% of remittances in El Salvador. Citizens and businesses as highlighted the volatility as an issue – making it risky to spend and hold the cryptocurrency, and the government has been driven further into debt as the value of Bitcoin has plunged this year. All in all, it is hard to argue that the experiment has been a success.
What about stablecoins? Stablecoins are cryptocurrencies that attempt to peg their market value to external sources of reference. Be it to currencies like the US dollar or to the prices of commodities such as gold, one key aspect of stablecoins is to maintain price stability by ensuring sufficient reserve assets as collateral, or through algorithmic formulas to control supply. We have previously issued a warning about stablecoins – how the term is a misnomer and only give the illusion of stability. The unverifiable collateral of collateralised stablecoins (the very structure of which is based on an outdated banking practice) and the faith-based nature of algorithmic stablecoins (which are reliant on inducing demand) yet again highlights this problematic “house of cards” structure made to appear safer than it actually is, with plenty of shenanigans going on behind the scenes that could cause a collapse at any moment.
A zero-sum game more akin to gambling than investing
Another often touted use of crypto today is its use as an inflation hedge or diversifier in one’s investment portfolio - a poor one, considering its performance this year. We have also warned investors (in June last year, close to the crypto peak) about the pitfalls of investing in cryptocurrencies, with the inherent flaw being their lack of intrinsic value, and how it is impossible to determine any due to their inability to generate income or cash flow, their lack of real life utility, and the lack of a long term relationship with economic fundamentals.
Without any intrinsic value, investors could be unknowingly buying into an asset bubble, with no easy way to gauge capitulation and/or downside risk, and incompatibility in a long term investment portfolio. Without income or cash flow generated by cryptocurrencies, the only profit that an investor could possibly generate is from another investor’s speculation – making it a zero-sum game that is more akin to gambling than investing.
Chart 3: Wild swings, with no way to gauge capitulation, bubbles, or downside risk
This lack of applicable valuation models has haunted investors this year, as various cryptocurrencies have experienced major selloffs. We have seen various claims about Bitcoin’s value in a portfolio – such as its position as an inflation hedge or its strength as a diversification tool – all of which has been proven false as Bitcoin continues to exhibit a high correlation with future tech stocks - and at even higher volatility.
Chart 4: Positive correlation continues to remain elevated
Chart 5: Except Bitcoin is more volatile and prone to violent corrections
We would like to take this opportunity to highlight the other pitfalls of cryptocurrencies that we have highlighted back in 2021. Back then, we highlighted (i) fading momentum as one of the asset class’s headwinds, (ii) the dangers of excessive leverage buildup, and (iii) vulnerability to further monetary tightening, all of which have played out in 2022. We also highlighted the crypto industry’s vulnerability to regulatory tightening – an event that we are starting to see escalate.
Regulatory tightening imminent for the crypto space
Its meteoric rise, proliferation of unethical behaviour, and the potential for contagion into traditional financial markets have rightly attracted regulator attention, and we believe that this will be a major concern for the crypto space.
The US Securities and Exchange Commission (SEC) chairman Gary Gensler has come out to admit that Bitcoin remains the only cryptocurrency he believes is a commodity – which also implies that the rest of the space could be subject to regulatory tightening in the near future. With a new bipartisan bill titled “ The Responsible Financial Innovation Act” targeted at digital assets (read: cryptocurrencies) currently making its way through congress, these regulations could come sooner rather than later.
This is a result of the industry’s movement towards proof of stake validation (compared to the proof of work validation of Bitcoin), which is driven by (i) its greater energy efficiency compared to proof of work validation, and (ii) the ease of the format in generating wealth for its founders (aka greed).
Staking occurs when people use existing coins or tokens to validate transactions on a blockchain, which when completed grants newly minted coins or tokens as a reward (similar to interest). The natural consequence of this is the centralisation of power amongst a smaller number of validators, which are often early adopters as they likely hold a greater number of tokens. As this develops, this starts to appear remarkably similar to equity shareholders of a company, which is one of the key reasons that this has piqued the SEC’s interest (stocks are undeniably securities). The proof of stake model also heavily rewards founders – as they can issue themselves a large number of tokens at initiation and profit if they manage to drive the coin prices up.
Table 1: A non-exhaustive list of notable cryptocurrency regulations
|
Region/Country |
Date |
Details |
|
US |
March 2022 |
White House issues an executive order which emphasises the importance of digital assets, and the need for coordination and cooperation between government departments, agencies, and regulators. |
|
May 2022 |
Gary Gensler (SEC Chairman) beefs up SEC’s crypto enforcement team – focusing on investor protection and ensuring fair and orderly markets |
|
|
June 2022 |
Regulatory Framework for regulating the crypto industry – including stricter requirement for stablecoins, cybersecurity requirements, and disclosure requirements. |
|
|
EU |
September 2021 |
The EU establishes the Markets in Crypto-Assets Regulations (MiCA) to regulation all issuers and service providers |
|
January 2022 |
Spanish security regulators sets out new requirements for the content and format of promotional messages for crypto-asset campaigns. |
|
|
Singapore |
January 2022 |
The Monetary Authority of Singapore (MAS) published guidelines “discouraging” cryptocurrency trading by the general public, and giving effect to expectations that crypto service providers should not promote services to the general public in Singapore. |
|
UK |
February 2022 |
The UK Financial Conduct Authority restricts retail marketing, distribution, and sale of crypto-asset derivatives and crypto-asset exchanged traded notes – and we still consulting on further potential restrictions. |
|
China |
May 2021 |
China’s Financial Stability and Development Committee cracks down on Bitcoin mining and trading behaviour – effectively banning cryptocurrencies from China. |
|
Compiled as of August 2022 Source: iFAST Compilations, Bloomberg LLP, Thomson Reuters Note: For the sake of brevity, this is a non-exhaustive list |
||
Ultimately, we believe that these regulations will have a drastic impact on the crypto space, a trend that is currently driven by opportunistic founders and venture capitalists looking to make a quick and tidy profit. Without the prospect of a quick buck, we expect investment to dry up, and considering how intertwined and leveraged the crypto space is – contagion is a key concern.
With almost all cryptocurrencies likely to be recognised as securities, we are likely to see a drastic structural change within the asset class. Securitisation brings about strict regulatory and disclosure requirements focused on protecting the consumer, and currently, the unregulated nature of the space means that token issuers do not need to worry about end-use cases, business models, or investor protections. Instead, founders just need to drum up sufficient interest to drive up interest (and as a result, prices) in their tokens. This is also an outcome they are heavily incentivised to engineer – given their founder’s significant exposure to the token due to the incentives of the proof of stake validation system.
Regulations are likely to put an end to this behaviour, making it more challenging to launch a coin (due to higher disclosure requirements), outlawing the many illegal practices (e.g. wash trading, insider trading, influencer marketing) that founders use to drum up interest, and adding the prospect of criminal charges and legal consequences.
With the current crypto space rife with issues, it is not well positioned for this regulatory transition. As the regulatory hammer comes down, we are likely to see a large majority of the space lose its viability, adding to contagion fears given the highly leveraged and intertwined nature of the industry. One common reason that has been cited for the recent spate of bankruptcies in the crypto space are falling prices. When investing in an asset class as volatile as crypto – to be unprepared for falling prices is sheer negligence – a trait that is unfortunately too common in the space.
Without the prospect of a quick buck, we expect to see innovation in the space slow down significantly as well. Cryptocurrencies, and by extension, blockchain technology, remains a solution looking for a problem to solve. The lack of a scalable, cash flow generating end-use case means that when the investment money stops pouring in, there will be nothing left but empty promises.
Our stance: Don’t be tempted by the recent rally – crypto’s reckoning is yet to arrive
Once again, we would like to remind investors - avoid this 'Greater Fool Investment Strategy' asset class.
While regulations will ultimately be good for the space – we don’t expect crypto to adapt to regulatory changes well. We expect most of the space to fail to survive the incoming regulatory tightening, and with a lack of intrinsic value, there is no fundamental support. In addition, the intertwined and leveraged nature of the crypto industry – coupled with the lazy, “what could go wrong” attitude - means that contagion is all but certain, and investors should stay clear.
Crypto winter is far from over – in fact, it may not even have begun.
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