Crypto’s future in the balance

Regulation will play a key role in the crypto industry’s recovery

While 2022 was a challenging year for global financial markets, it was a catastrophic one for the crypto industry, which saw almost US$1.5 trillion of its market value wiped out. 

First came the collapse of the TerraUSD algorithmic stablecoin in May, blowing away $18 billion of investor capital. And then there was the implosion of FTX in November, exposing shocking fraudulent acts reminiscent of Bernie Madoff’s Ponzi scheme which unravelled during the 2008 global financial crisis.

According to CoinGecko’s annual industry report, global cryptocurrency market capitalisation dived 64% from $2.3 trillion at the start of 2022 to $829 billion by the end of the year.

The fallout from FTX, which was the world’s third largest crypto exchange, and the subsequent contagion, impacted over one million depositors, creditors and investors. It erased billions of dollars of investments made by ordinary people, venture capitalists, pension funds and other traditional institutions.

Meanwhile, the price of bitcoin plummeted 75% from a record high $64,949 in November 2021 to $16,547 at the end of 2022, according to data from CoinMarketCap.

The crypto industry is hoping that the downturn will turn out to be cyclical, like a bear run on Wall Street, and that it will recover eventually. 

But critics are less optimistic. Even though they do not foresee the death of crypto, many think that the scale and ferocity of last year’s decline marks the beginning of an industry shake-out that may lead to the disappearance of numerous players, similar to what happened when the dot-com bubble burst in the early 2000s.

Weaknesses exposed

Bitcoin was created in early 2009 as a way to bypass established financial middlemen, whether a bank or government, by leveraging blockchain technology to provide transparency and integrity. It aims to correct misdeeds that gave rise to the 2008 financial crisis, revolutionise the global economic system by creating a decentralised finance or DeFi ecosystem, and make it easier for people to do business directly with each other. 

There are now more than 21,000 different crypto coins trading on 170 exchanges globally.

But unlike its original thesis, today’s crypto market structure includes centralised players in a supposedly DeFi system. Investors go through exchanges and other centralised entities to invest in crypto. These entities lack governance and are prone to manipulation in the free-wheeling crypto world. 

According to a Financial Times commentary last November, the crash of FTX exposed two Achilles heels of the crypto sector. Firstly, the balance sheets of crypto players are often opaque and it’s very difficult to know what assets underpin them. FTX and its trading arm Alameda Research were both considered well capitalised until it was discovered that their balance sheets were inflated with massive holdings of a digital token called FTT issued by FTX itself.

The second weakness highlighted in the commentary is custody. Sam Bankman-Fried’s empire was simultaneously a broker, proprietary trader, lender and custodian. Lack of independent third-party oversight to provide check and balance, a time-proven best practice of the traditional financial system, resulted in large-scale misappropriation of client assets.

As an investment asset, crypto’s success thus far has largely been based on speculation. 

Prices are highly volatile and subject to the same global macroeconomic factors like mainstream assets. When the US Federal Reserve began hiking interest rates in early 2022 to fight inflation, investors started offloading their risky assets, which triggered crypto selloffs and ended the euphoria.

A cryptocurrency doesn’t have fundamentals like a publicly traded company that generates cash flow and allows investors to analyse its value. It doesn’t pay income unless there are third parties such as Genesis BlockFi and Celsius Network involved to provide deposits and lending services as an intermediary. But during the FTX fallout, these firms suspended customer withdrawals and some filed for bankruptcy because they were unable to continue operations due to liquidity problems.

A cryptocurrency has no intrinsic value. The reason it has value is because other people perceive it to have value and are willing to adopt it. This creates a “network effect” as long as there are real dollars.

It’s similar to how gold and other precious metals are viewed. Apart from some industrial use, the value of gold is largely derived from its scarcity, and being accepted as valuable by people over many generations.

Bitcoin, ethereum and some other cryptocurrencies have vastly increased their network effect over recent years, especially during the Covid-19 pandemic. Interest rate cuts made it cheaper to borrow money for investing in speculative assets, and easy-to-use stock trading apps and new crypto exchanges simplified the buying and selling of crypto coins. Hundreds of millions of retail investors as well as Wall Street firms, venture capital funds and traditional money managers are holding crypto positions. 

According to crypto.com, global crypto ownership jumped 39% to 425 million by the end of 2022 from 306 million at the beginning of the year. The US led with 46 million, followed by India, Pakistan and Nigeria.

Growing calls for regulation

The crypto sector has gained significant scale and is increasingly being accepted as part of mainstream financial markets. Should crypto die, the spillover effects will be far reaching. 

But a major shake-out is inevitable for the industry to survive. Many tokens won’t survive, nor will many exchanges and crypto lenders. The survivors will have to work hard, perhaps in collaboration with reputed mainstream institutions, to convince users that they are not the next FTX in waiting.

Regulation will play a key role in facilitating this evolution. The crypto market itself has come around to this view. Some of the most passionate crypto advocates now say the market needs government regulation to regain trust, and to bring in established financial institutions for collaboration.

Institutional interest in crypto persists in spite of the crash but they want a revamp of the industry. Institutions are “very clear that they are looking for three key things: regulation, security, and innovation”, Oliver Linch, chief executive officer of Bittrex Global, wrote in an article published on Nasdaq in January.

Regulation and safeguards for crypto were at the top of many agendas for discussion at the World Economic Forum meetings in Davos this January. 

In the US, the White House released a series of reports last year to shape the national policy on crypto, while the European Union has approved the Markets in Crypto-Assets Regulation, aiming to drive the crypto industry forward. 

In Asia, Hong Kong is launching a new virtual asset licensing regime, following in the footsteps of Japan and Singapore. 

Letting crypto play a regulated role in economies is considered the optimal way to promote the advantages of innovation that the assets can bring, while curtailing the potential downsides. 

FTX was a case of a bad actor in a nascent industry which hasn’t been paying much attention to transparency, allowing players to have centralised power without proper governance. This has happened in almost every industry in the past, including technology and finance. 

Crypto and blockchain are revolutionising the exchange of value, and they can help make the existing financial system more inclusive, more efficient and more accessible. 

Given crypto’s borderless nature, there is an opportunity to collaborate with the broader financial industry and its governing bodies globally to establish unified codes of conduct and mitigate regulatory arbitrage in order to safeguard consumers while supporting innovation. India, host of the Group of 20 meetings in 2023, is making a push on this.

Crypto has made a strong comeback in the first few weeks of the year. At the time of writing on February 18, bitcoin was trading at $24,641.

That doesn’t necessarily mean the crypto winter is giving way to spring. The crypto world will need to evolve to be sustainable. The industry has to “regroup with humility, rebuild with integrity, regain trust, rise again,” Sandra Ro, CEO of the Global Blockchain Business Council, wrote on crypto news site CoinDesk recently.

Regulation will define the future of crypto, and how well a balance is maintained between investor protection and innovation will determine their further adoption by investors.

*This article was published in Asia Asset Management’s March 2023 magazine titled “A future in balance”.