Commentary
The year 2022 has been the worst period on record for cryptocurrencies.
The industry is on life-support. The crypto market has been rocked by scandals, mismanagement, bankruptcies, and potential fraud. Investor sentiment and trust is possibly the lowest it’s ever been, even after the Mt. Gox scandal in 2014, when the equivalent then of $460 million in Bitcoin was stolen by hackers.
This begs the question, will this be the last crypto winter ever?
No, I’m not predicting cryptocurrency market will be on the upswing from here. The real question is, will this be the end?
Since the beginning of the year, the total crypto market capitalization has fallen from $2.2 trillion to $850 billion. This represents potentially the biggest burst of a financial bubble ever within a year. In the same span, Bitcoin—the largest crypto asset—has fallen around 65 percent.
This year has witnessed the epic fall of FTX, a large international exchange, and the indictment of its founder and former CEO—and former crypto savant—Sam Bankman-Fried. Two leading crypto lenders, Celsius and BlockFi, have also declared bankruptcy. Last year’s third-biggest stablecoin, TerraUSD, lost all of its value. One of the biggest crypto hedge funds, Three Arrows Capital, also collapsed.
But likely you were aware of all of that. So we have yet another question: what will the future hold?
Let’s begin by examining two external factors.
The first one is macro. The forces that have driven crypto value lower this year—aside from potential fraud such as FTX—will likely persist. Interest rates are likely to remain elevated regardless of inflation, putting pressure on all risk assets, including crypto. Money supply will remain tight around the world, reducing liquidity and allocations to speculative asset classes such as crypto. The crypto market’s famed accessibility and liquidity, such as its 24/7 trading, also makes it one of the easiest assets to sell if an investors needs to raise cash.
A second factor is the regulatory regime. Despite the U.S. Securities and Exchange Commission (SEC) announcing charges against Bankman-Fried last week, the allegations are fraud and misappropriation of client funds. But the SEC isn’t any closer to regulating the industry in substance. Fraud is bad. But such fraud can arise from any industry lacking any regulatory framework. Without substantive regulation of the underlying industry, such as the historic Securities Act of 1933 and the Securities Exchange Act of 1934 which arose out of the market crash of 1929, these indictments just seem reactive and too little, too late.
Can Crypto’s Future Be Tamed?
Will regulation finally come? Market watchers believe so, but it’s been too slow to develop, and the inherent nature of blockchain makes it difficult. But it needs to start somewhere, potentially among stablecoins, which serve as the plumbing for much of the crypto trading market.
There are issues within the crypto industry that could determine its future, or lack thereof.
Industry proponents believe the FTX collapse will move the crypto market forward to a truly decentralized future. Part of FTX’s issue is its centralized nature. Investors and stakeholders were putting their trust in an institution. By its very definition, a centralized institution could be sabotaged by bad actors. No matter how noble centralized institutions such as FTX, Binance, and Coinbase present themselves, there’s a lack of transparency and risk that their leadership could make a mistake or, worse, commit fraud.
Decentralized finance (DeFi), decentralized autonomous organizations (DAOs), and zero-knowledge (ZK) ecosystems will be the future, claim some industry experts. These protocols run on the blockchain, with published policies and procedures determined by users as opposed to central authorities, and full transparency. This type of organizations are what crypto was intended to facilitate, not entities like FTX that mimicked legacy banks and exchanges.
Another advancement this year was the Ethereum Merge, where its blockchain shifted from proof-of-work to proof-of-stake, reducing Ether’s energy usage by more than 90 percent.
Goldman Sachs, despite announcing job cuts and expense reductions, declared in early December that it was in the market to potentially buy cryptocurrency companies.
The problem is, does any of this matter? And is there anything worth regulating? Many large crypto firms have collapsed in 2022, and there is almost zero contagion across traditional finance. That says something.
Critics believe that the crypto market is a closed loop of self-established investment and lending schemes that entirely drove its recent growth, buoyed by nothing more than hope and marketing. Indeed, Google searches for “Bitcoin” and “crypto” are at multi-month lows (and as an aside: the fact that a financial asset can be measured by Google search popularity is itself comical).
Financial services is at its core a trust business. No ordinary bank can withstand a full bank run, just like how Celsius could not withstand its clients pulling funds all at once. To a degree, almost every financial investment is partially built on demand driven by hope and marketing. The risk is somewhat mitigated because of financial regulations that have been in place for almost 100 years.
On Dec. 16, crypto-friendly accounting firm Mazars Group indicated that it would pause providing “proof of reserves” work for crypto clients such as Binance and Crypto.com. Armanino, another accounting firm that services crypto clients—and was the auditor for FTX.us—is ditching crypto firms altogether. One can debate the practical value of auditors, but they are a foundation of any good financial markets framework and contribute to investor trust.
For crypto, that trust may be depleted—and perhaps permanently.
