Goodbye Crypto 2022 and Good Riddance

Like the weather, the crypto winds and tides are hard to forecast. Experienced crypto investors have seen bull and bear market cycles before but 2022 saw crypto break-out, shake-out, fake-out and wipe-out; erasing nearly $A2 trillion in market cap and prompting many questions about the future.

2023 cannot come too soon. After a year of drama, the crypto landscape this year is likely to see more regulation, continued bear market conditions until the broader macro environment improves, and investors taking a more disciplined approach to asset selection, whittling down the pool of 22,000 tokens to a much smaller pool of assets with clear use cases, trusted teams and user adoption.

Bitcoin remains the crypto king and the asset still most likely to attract institutional funds when the macro headwinds subside and the next halving in 2024 approaches.

Break-out

Strictly speaking, crypto peaked in late 2021 with the total crypto market cap reaching well over $A4 trillion, spurred on by excess appetite for risk, loose monetary policy, and leverage. Crypto projects boomed, acronyms such as DeFI, CeFI and NFTs entered the lexicon and punters bid up Bitcoin at a pace which meant that predictions of $A200,000 BTC seemed plausible based on popular models including stock-to-flow and Metcalfe’s law.

Yield was a distinctive feature of this phase including the rise of algorithmic stable coins such as Terra (UST) and its sister token Luna. Investors naïve and seasoned alike were lured by the promise of annual yields as high as 20 per cent supported by opaque mechanisms that worked until they didn’t.

Shake-out

Eventually macro headwinds reversed the direction of interest rates and tightened liquidity as safer yield alternatives emerged. Animal spirits began to fade and crypto prices fell accordingly, accelerating as speculative positions unwound. By late February, half the total crypto market cap had vaporised, falling from over $A4 trillion at November’s peak to $2A trillion.

The Terra/Luna implosion in May (ignited by a “loss of peg” against USD) was a significant contributor to the mayhem during this period, causing over-leveraged hedge funds like Three Arrows Capital to default on loans extended by other players. Contagion spread, ensnaring the likes of Celsius and Voyager and forcing many into bankruptcy.

In addition to falling asset prices, some retail punters were frozen out of their funds locked on centralised exchanges and CeFI platforms as they went under. Inexperienced punters learned the crypto lesson “not your keys, not your coins” in a visceral way.

Fake-out

Markets stabilised during February and March and even rose 30 per cent by mid-April as sentiment recovered somewhat. Sam Bankman-Fried and his FTX exchange appeared as a white knight to bail out CeFI lender BlockFi and other distressed companies and his position as crypto’s “golden boy” seemed unassailable.

The rise in market cap proved to be short-lived as the overall market fell back to around $A1 trillion by mid-year, but some individual projects shone. Ethereum’s “merge” involved a major network upgrade from “proof-of-work” to “proof-of-stake” and occurred seamlessly, resulting in the price of ETH doubling over two months (although it has since fallen back about 30 per cent as of writing).

Wipe-out

If Terra/Luna was crypto’s “Lehman Brothers” moment, then the shockwave caused by the FTX eruption is now being compared to the Enron collapse in the early 2000s, the largest US corporate bankruptcy at the time. Ironically, John Ray, the former chair of the re-organised company that recovered funds for Enron creditors, is now FTX’s CEO following Sam Bankman-Fried’s resignation.

Ray recently said that in over 40 years of his experience in dealing with insolvencies, he had never encountered "such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here". He should know.

Like Enron, FTX may have obfuscated its dealings and assets between supposedly independent entities, presenting a façade of balance sheet strength hiding fictional valuations. The unravelling of FTX’s complex web of companies, loans and arrangements will likely take time, but the ramifications are already being felt with plummeting asset prices and excoriating commentary from regulators, commentators and TradFI participants.

A key aspect of FTX’s collapse was the extent to which its own issued token FTT supported its balance sheet and that of its supposedly independent sister organisation Alameda Research. As soon as FTT began to be sold off, downwards momentum drove the sell-off like spraying petrol over an open flame.

In the end, FTT’s price was a chimera. As soon as market consensus turned negative, selling pressure ultimately caused a sell-off not unlike a bank run. Whatever perceived value FTT had begun to evaporate, and suddenly everyone ran towards the exit as fast as they could.

Looking forward

As 2023 looms, the future of crypto remains uncertain given the scale of 2022’s drama. Tighter enforcement of existing laws is one likely outcome.

The US Securities and Exchange Commission (SEC) chairman Gary Gensler said in a recent interview that FTX breached existing securities laws by permitting Alameda to trade using FTX customers’ assets. He referred to the prohibition of securities exchanges like the NYSE from running hedge funds and stated that the same rule applies to crypto exchanges. He encouraged crypto businesses to register with the SEC to “come into compliance” and responded to criticism that the SEC was “already suited up” to fight regulatory breaches.

(NB. Gensler has previously said that he considers most crypto projects to be securities with the notable exception of Bitcoin which he views as a commodity rather than a security).

Some observers have called for expanded measures beyond existing regulations. Two examples include:

1. Exchanges to be required to submit to independent audit to verify “proof of reserves”. This may have made transparent FTX’s reliance on its own FTT token as a reserve asset (at inflated valuations) instead of a less risky alternative such as cash or cash-like securities (or even BTC).
2. Regulators to impose limits on the ability for crypto firms to lend their own tokens, especially to other crypto firms who then use those tokens as collateral for their own loans.

Crypto investors will likely face continued bear market conditions until the broader macro environment improves and/or the next Bitcoin halving in 2024 approaches. Prior cycles have seen BTC price action leading into and following the halving, and so investors must form a view as to the likelihood of this repeating during the next cycle.

Investors are also expected to take a more disciplined approach to asset selection. Of course, separating the wheat from the chaff is harder than it looks. Bitcoin remains the crypto king and the asset still most likely to attract institutional funds when the macro headwinds subside and the next halving approaches.