My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

Is the Crypto winter over?

All sorts of information is available on cryptocurrencies – written materials / analyses, on-line and in-room classes, audio podcasts, and videos on YouTube, Instagram and even on TikTok. More and more mainstream institutional investors are looking at crypto (if not already investing), and even large, well-known brokerage firms – including the likes of Fidelity Investments, Charles Schwab and TD Ameritrade – are offering their customers the opportunity to invest in crypto futures contracts or crypto ETFs. As the acceptance of cryptocurrencies has grown, an infrastructure has sprung up focused specifically on cryptocurrencies, including institutional buy-side investors like crypto-focused hedge funds, crypto exchanges / brokers and (for better or worse) crypto lenders. The financial press also provides regular coverage of the cryptocurrency market. Even as I write this, cryptos have moved so much into the mainstream that @Bloomberg just sponsored yesterday the “Bloomberg Crypto Conference: Building the Future”. Like it or not, and whether you understand them or not, cryptocurrencies have arrived and are destined to stay.


In the spirit of full disclosure, I am fairly removed from this market other than as a keen observer and as a “tangential investor” via crypto broker Coinbase (COIN) (A). I am letting you know this so that those involved more deeply in cryptocurrencies can skip this article simply because you might find it too basic and / or boring. Also, there is so much to discuss about cryptocurrencies that it is impossible to cover it all. In this article, I will touch on the following:

  • The arguments in favour of cryptocurrencies

  • The arguments against cryptocurrencies

  • Cycles of crypto winters

  • The counter-cycle: crypto summers

  • Bitcoin and its performance compared to gold, stocks and high yield bonds

  • Gaining credibility – CBDC

  • The difficult journey for cryptos since May 2022


Also in this article, I refer most often to Bitcoin because it is the most popular and well-known cryptocurrency. BTC serves as a reference for much of the analysis contained in this article.


The arguments in favour of cryptocurrencies


Believers in cryptocurrencies site a number of reasons for their passion in this emerging asset class, including:

  • A libertarian view that the world should have a currency that is not controlled by central banks or governments.

  • Extending this logic, creating only a finite amount of a given cryptocurrency would ensure that inflation in that currency by definition remains in check. (Only 21 million BTCs will be created, of which around 19 million already exist.) A finite stock of a currency also eliminates the ability of central banks to manipulate the business cycle via monetary policy, although keep in mind that this can cut both ways.

  • The use of cryptocurrencies in transactions would be peer-to-peer, reducing the need for a “middleman” like banks and payment companies to be involved in transactions as they are today. Lower transaction “friction” means lower costs to consumers. Cryptocurrencies are also not bound by country borders, thereby de facto eliminating foreign exchange transaction fees (or wide bid-ask spreads on FX transactions) for both consumers and businesses (for commerce or trade). Banks and payment companies would suffer as far as profitability as the increased use of cryptocurrencies in day-to-day commerce would effectively be a form of consumer finance disintermediation.

The case against cryptocurrencies


The reasons highlighted in favour of cryptocurrencies are reasonable, and I do suspect that digital currencies in one form or another will arrive at some point. However, there are way too many shortcomings for me to believe that this time will be soon, including:


  • Cryptocurrencies are not a store of value and are far from stable.

  • Mining cryptocurrencies takes a tremendous amount of computer power and hence energy, creating a very poor carbon footprint – see Cambridge Bitcoin Energy Consumption Index

  • It is impossible to develop metrics other than pure demand & supply to determine the “fair” value of a cryptocurrency – who really knows what any given cryptocurrency is really worth?

  • There are too many fringe cryptocurrencies (or “alt coins”), some with cult followings

  • There are too many highly vocal supporters of cryptocurrencies trying to rally people to get involved by suggesting that they should allocate most or all of their assets to cryptocurrencies ,or that they should aggressively use margin to buy as much cryptocurrency as possible (even going so far as mortgaging your house). Clearly, that has not worked out well for those that have invested in cryptos in the last 12-18 months, many of which have probably lost everything.

  • The cryptocurrency market is unregulated and this allows fringe and often unreputable players (and blatant criminals) to use cryptos for illicit transactions that cannot be easily traced. There have been many accusations of fraud, money laundering and tax avoidance. Generally ,the use of cryptos for illegal / illicit transactions is believed to be widespread. This undoubtedly stains the reputation of cryptocurrencies.

Cycles of crypto winters


Bitcoin (BTC), Ethereum (ETH) and many of its longer-standing brethren clearly go through severe pricing cycles as history has shown. First, great enthusiasm and interest cause prices to indiscriminately rocket higher drawing in speculative (and generally naive) investors, and this eventually gives way to a period of regrets, confusion and an erosion in confidence as prices plummet and speculative money leaves the asset class. In this article, I refer to periods of rapid price appreciation as crypto summers and periods of rapid price depreciation as crypto winters. Of course, the history of cryptocurrencies is relatively short. BTC came into existence in 2009, and ETH came into existence in 2015. Cryptocurrencies trade 24/7, so all dates used below and in the subsequent tables refer to the price of the cryptocurrency at the last trade of the day. The graph below illustrates the price history of BTC and ETH since 2015, so you see how prices have gyrated over this short seven-year period.


The table below provides more specific return information on four down cycles of Bitcoin (i.e., the crypto winters) that I have identified since late 2014. The table shows the price peak and trough, the loss during the journey down, and the length of time it took BTC to decline from its peak to reach its trough. For the fourth crypto winter, I have assumed the trough was reached on July 2, 2022, although I suppose this remains to be seen (although BTC has rallied 13% off its lows of July 2).

The declines are clearly severe in each of the four crypto winters illustrated in the table above, showing how volatile cryptocurrency prices are, and how important entry and exit timing is for investors. For example, for investors that jumped on the crypto bandwagon after the pandemic, it matters very much when they bought in. BTC ended March 12, 2020 at $4,971, the first time it had fallen below $5,000 since April 2019. By June 2020, BTC was back above $10,000, and it rose above $20,000 in December 2020. BTC continued to rise, peaking on November 8, 2021 at $67,567 and then began its decline until early July 2022, which is the fourth crypto winter. If you bought BTC during the window between December 2020 and November 2021 when BTC was above $22,000, you are nursing best-case breakeven, and more likely losses, perhaps significant losses.


As you can also see in the right-most column in the table, volumes have increased sharply since mid-2015, although they decline as prices decline. This can be viewed several ways, but my opinion is that these downturns flush out the fringe players that were largely speculative punters, not a bad thing in the long run.


The counter-cycle: crypto summers (BTC)


Every crypto winter has been followed by a crypto summer. Following the pattern of the table illustrating crypto winters, I reoriented the table below for crypto summers, using the same end points.

This table shows that for every winter, there has been a summer that followed which in fact took BTC to new highs. Of course, the most significant returns in BTC from a percentage standpoint were early on because the starting base prices were so low back then. To again illustrate the importance of timing, had you bought BTC at its crypto summer 2 high of $19,497 in December 2017, you would be sitting on only modest gains today. Again, it is all a matter of entry / exit points, or in other words, timing. Predicting the highs and lows is also an art, or to me, closer to a guess.


Taking a longer-term perspective, it is important to note that even though the price declines have been sharp and losses severe during the crypto winters, the price from the first trough ($178 on Jan 14, 2015) to the most recent trough ($19,242 on July 2, 2022) generated a return of 10,710% over this period, or an average of 87.2%/annum. Similarly, the price from the first peak ($457 on Sept 17, 2014) to the most recent peak ($67,567 on November 8, 2022) generated a return of 14,674% over the period, or an average return of 101.1%/ annum. These are ridiculous numbers, and rest assured that you would be extremely hard pressed to find any asset class that has delivered this sort of performance over the last seven or so years!


Bitcoin compared to other (more traditional) financial assets


The table below shows the gyrations of BTC since mid 2015 compared to changes over the same periods in the price of gold, the level of the NASDAQ Composite index, and total return on high yield bonds. I included the latter two since these are the more volatile segments of the US equity market and US bond market, respectively, and their performance is more likely to reflect to “risk on” / “risk off” attitude of cryptocurrency investors. The table below shows the performance of these more traditional assets during the crypto winters for BTC.

As the table illustrates, the downturns in BTC have been much deeper than those of the other three more traditional asset classes. It is also interesting to note that in the last crypto winter, the performance of riskier assets like the tech-heavy NAASDAQ and high yield bonds have performed very poorly, too (albeit not as poorly as BTC). Although I did not look at this in detail, this could imply that the correlation between cryptocurrencies (with BTC as a proxy) and other “risk” assets like equities and high yield bonds in strengthening.


The table below shows the historic returns of BTC on July 2, 2022 (the recent crypto winter low) starting with some of the key dates included in the crypto winter and summer tables above, compared to the same three asset classes for the same periods.

As this table illustrates, returns of BTC have far outperformed the returns on the other three asset classes over the five periods I have used, with the exception of the most recent crypto winter period (last row). This is perhaps because the trough for BTC is so recent. Time will tell if BTC can make yet another ascent as it has time and time in the past, which is in fact likely.


Gaining credibility – CBDC


For cryptocurrencies to gain a wider following and eventually become accepted in commerce will require that the issues I highlighted earlier in this article be addressed. Although far from perfect from the perspective of true crypto disciples, perhaps a viable first step would be for a G7 central bank(s) to develop a digital currency itself, known as a Central Bank Digital Currency, or “CBDC”. A CBDC would of course not meet the complete set of objectives of crypto advocates. However, a CBDC would be instantly credible (or perhaps I should say as credible as any central bank can be today after the pandemic smorgasbord of liquidity that was showered on the masses). As it stands now, cryptocurrencies are rarely used in commercial or trade transactions, the value of cryptos are impossible to precisely determine, prices of cryptocurrencies are highly volatile over time, the entire crypto infrastructure is fragile which is exposed each time there is a downturn, and there are too many fringe cryptocurrencies circulating that in many ways reduce the seriousness off the entire cryptocurrency market. The market is also unregulated, and this leads to more fringe players, more fraud, and the use of cryptocurrencies for illegal / illicit transactions which further stains the reputation of cryptocurrencies generally. A CBDC would at least provide stability and support for the use of such a digital currency in commercial transactions. From the perspective of governments that are “sponsoring” CBDCs, a digital currency would not strip monetary policy control from central banks and would also provide a better regulatory system. As distasteful as this might be to cryptocurrency advocates, such a move would at least pave the way to eventually a more centralised use of digital currencies.


The rocky road since May 2022


Since Bitcoin and Ethereum peaked in November 2021, they have fallen sharply as the fourth crypto winter has progressed. Earlier in the period of decline, the pain seemed to be largely confined to investors that had bought in at significantly higher prices, and – as had sadly become more common – used leverage (i.e., bought cryptocurrencies on margin). The unwinding of these leveraged transactions resonating from margin calls exacerbated the decline, providing growing downward momentum. Having seen BTC bottom (for now) in early July, the hope of course is that much of this excess leverage and more speculative buying has washed through the system. Consumers weren’t the only ones feeling the pain though, as sharply lower cryptocurrency prices undermined stable coins, hedge funds focused on cryptocurrencies and crypto-specialist brokers.


Stable digital coins are meant to be just that – stable. Parity is achieved by linking the stable coin to a fiat currency (e.g., the US Dollar) or to a basket of fiat and / or other digital currencies. In the case of the latter, a complex algorithm continuously adjusts the underlying basket to ensure that the currency maintains a stable price. However, as prices of cryptocurrencies fell in a sharp and disorderly manner in March and April, some stable coin sponsors were figuratively caught with their pants down because the underlying algorithms failed to work. Moreover, the composition and weighting of the underlying currencies or other assets in the baskets were often not disclosed, compounding the uncertainty and erosion in confidence. Some stable coins came under intense pressure, and several even drifted away from parity. This put pressure on the entire cryptocurrency ecosystem, further undermining confidence and contributing to further price declines broadly. The biggest and most visible stable coin casualty was (former) $18 billion market-cap terraUSD, which lost its 1:1 peg on May 7th and fell to $0.35 within two days. Terra has hovered between $0.05 and $0.10 since then. The sister / pairing currency underlying stablecoin Terra was algorithm-driven Luna, which promptly fell from over $80 to a few cents by May 12th and has since been abandoned. Fortunately, this issue with stablecoins was not widespread, and did not significantly expand beyond Terra / Luna. There are a number of stablecoins that have held their value at the 1:1 peg, including Tether, USD Coin and BinanceUSD. Should you be interested, you can view a more comprehensive list of stablecoins here (CoinMarketCap website).


The failure of Luna and huge decline in Terra had other collateral effects on the crypto ecosystem. For example, many crypto-brokerage companies came under intense selling pressure as investors started to worry about overall liquidity and the value of their portfolios held at brokers. One of the most visible casualties (measured by share price decline) was Coinbase Global (COIN), which has seen its shares decline 84% in the last six months from its November high of $357.39/sh to a close on Monday of $58.67/sh. Many large cryptocurrency brokers are private, including the largest ­– Binance – which is headquartered in the Cayman Islands. Binance’s subsidiary Binance.US operates in the US, as the parent company is under investigation by the Justice Department and the IRS and is also under various forms of investigation in the UK and the EU. On June 13th, Binance halted redemptions of BTC as the collateral damage from price declines worsened, which was fortunately temporary and lasted only two hours. This sharp price declines also bled into Celsius, one of the largest cryptocurrency lenders. On July 14th, Celsius filed for bankruptcy with assets of around $4.3 billion and liabilities of around $5.5 billion. Celsius was one of the largest cryptocurrency lenders, at one time having $18 billion of assets and offering clients as much as 18% on margin loans against cryptocurrencies. The lender halted withdrawals in June and it has since then been a slow burn into bankruptcy, not atypical of finance companies that lose their funding and access to liquidity. Numerous hedge funds focused on cryptocurrencies have also run into trouble or closed their crypto funds. Three Arrows Capital (3AC), a 10-year old crypto-only focused hedge fund with over $10 bln in AuM as recently as March, filed for bankruptcy on July 1st. Several days after 3AC filed for bankruptcy, its largest creditor – brokerage firm Voyager Digital – also filed for bankruptcy.


Conclusion


Cryptocurrencies have arrived. Cryptos are an emerging asset class that might merit a small position in an investor’s portfolio. In my opinion given the unpredictable price direction and very high volatility, cryptos should certainly not be purchased on margin, although it is remarkable how many crypto advocates were suggesting a strategy of “going all in” during the rapid pandemic price rise, which arguably undermines the credibility of the asset class. Time will tell if this asset class can become more mainstream. Personally, I like to stay on the fringe because I have no idea what any particular coin is worth or how to value it. It all seems very speculative to me!

(A) Also, for complete disclosure, I have owned cryptocurrencies in the past (last time early 2018) and do have a dormant cryptocurrency brokerage account at a well-known (US-based) crypto broker.


 

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