Melting down: Crypto facing an existential crisis as it collides with reality

There is a generation of investors who didn’t experience the dot-com boom and bust of the late 1990s and early 200os) and likely has little if any knowledge of that tumultuous period. Some of those investors are now, however, experiencing something very similar.

The crypto asset ecosystem is in a tumult analogous to that which engulfed the dot-com stocks in 2000.

The value of crypto assets has shrunk from just over $US3 trillion to less than $US1 trillion in a matter of months.Credit:Bloomberg

Then, investors – retail and institutional – were piling into anything with a dot-com tag next to its name even if they had little if any understanding of what the companies were doing, or not doing.
Retail investors were being attracted by what author Michael Lewis described at the time as the “pure possibility” of the stocks. To be desirable, he wrote, an internet company had to be “slightly unknowable.”

Institutional investors were motivated by the returns on offer and a desire not to lag the returns of their rivals or underperform benchmarks that were being inflated by the inclusion of the soaring valuations of the tech stocks. Cynically, they hoped to play “pass the parcel,” ditching their exposures ahead of the collapse in these mostly empty vessels that the more sophisticated investors knew would eventually occur.

When it came, the collapse wiped out most of the dot-com and telecom stocks. The Nasdaq index had soared about 400 per cent in the five years leading up to its March 2000 peak. Then it imploded, losing about 80 per cent of its value over the next six months.

There were, however, survivors. Amazon, Google, Apple, PayPal, Ebay, Facebook and a range of other tech-based companies that are dominant in their sectors today not only survived the crash but subsequently prospered.

There are a lot of crypto investors who’ll be desperately hoping that something similar recurs and that they have backed the right assets after the accelerating meltdown in crypto assets since last November has seen the market capitalisation of all crypto assets shredded. It’s fallen from just over $US3 trillion ($4.3 trillion) to less than $US1 trillion.

The sector is in crisis, with a number of crypto lenders freezing withdrawals in the midst of liquidity crisis. Other firms are laying of staff – Coinbase, the largest crypto exchange in the US, is firing about 1100 employees, or nearly 80 per cent of its workforce.

Bitcoin, the bellwether for the sector, traded close to $US70,000 last year. It traded below $US18,000 at the weekend before recovering, modestly, to just over $US20,000 this week.

This isn’t the first time that the crypto world has faced what appears almost an existential crisis.

There was a period of about 18 months from early 2018 when the value of the crypto market fell about 80 per cent – Bitcoin slumped below $US4000 – that the sector’s more experienced players refer to as the “crypto winter.”

The high-profile tech stocks that survived the dot-com crash prospered. Crypto investors will be hoping for a similar story. Credit:Bloomberg

This, however, has larger implications because the sector is so much larger and participation in it so much wider and deeper. At its peak in 2018 the crypto universe was valued at less than $US80 billion. Even after the events of the past few weeks the market is valued at about $US910 billion.

It not just the tech nerds who are exposed to cryptos. The boom in risks assets generally over recent years has attracted massive retail investor interest along with institutional money – hedge funds, investment banks and fund managers — and has seen the deployment of the more sophisticated trading techniques employed in traditional financial markets.

Margin lending, arbitrage strategies, algorithmic trading, short-selling and leveraged trading have all emerged in the crypto markets as the professional money moved into what was seen as a new asset class with potential diversification benefits and one which, because trading was relatively unsophisticated, offered easy profits.

As it has transpired, crypto assets don’t provide diversification but mirror, in an exaggerated fashion, the performance of other risky asset classes. The increased sophistication of the investors and firms within the crypto market hasn’t reduced volatility or losses but increased them.

The implosion of the algorithmic stable coin, Terra and its sister coin Luna in late May – assets that were supposed to be never worth less than $US1 for anything other than moments were obliterated by a wave of selling – removed a veil over the operation of a key pillar of the crypto system.

Another was removed when Celsius Network, a cryptocurrency lender, suspended withdrawals last week. Other lenders are also freezing redemptions.

Celsius had attracted more than $US20 billion in crypto deposits at one point from more than a million depositors by offering interest rates as high as 18 per cent.

This second bout of crypto winter might be a harsh one for crypto investors and the sector but ultimately, if it experiences the kind of cleansing that occurred with the dot-com crash in 2000, that might be a good thing for the sector and its remaining investors.

As with most of the “DeFi” (decentralised finance) companies, it isn’t clear what Celsius was doing to generate the income in order to offer those rates although it appears the firm was lending money and providing leverage to other players in the crypto market.

In effect, it was funding speculators, so it isn’t surprising that, with the value of all crypto assets tanking, its depositors decided they’d prefer to have their money/cryptocurrencies back than have exposures to leveraged crypto investors. “Pure possibility” is only appealing until reality strikes.

The same, very rational, sentiment seems to be impacting all the crypto lenders and contributing to what has been a form of “run” on a sector that, unlike traditional regulated lenders – banks – doesn’t have lenders of last resort standing behind it.

As the leveraged investors have been trying to unwind their positions, of course, that has simply exacerbated the overall liquidity crisis in the market and magnified the impact on asset values.
The sector’s key stablecoin, Tether’s USDT – dubbed by the New York Times as “the coin that could wreck crypto” – has so far weathered the storm and maintained its peg to the US dollar but has been forced to conduct an audit of its reserves amid scepticism over their quality and suspicion that they aren’t as high-quality or liquid as it claims.

What the crash in the markets has exposed is that there is a high level of interconnectedness within the crypto ecosystem and that some of the key conduits between the conventional financial system and crypto world are opaque and vulnerable. The market is not quite as “unknowable” as it was previously.

Indeed, the opacity of the entire crypto market has proved to be a vulnerability in times of stress. It’s hard to trust and remain invested in a market when the underlying assets, financial condition and financial relationships of entities pivotal to the market’s functioning are largely unknown.

Inevitably, some crypto assets will, as happened in 2000, disappear without trace. Others will be absorbed by a relatively small cohort of survivors. Regulators, who have been talking about how to regulate the sector, will impose regulation. There will be some level of regulated transparency and, presumably, some level of liability.

This second bout of crypto winter might be a harsh one for crypto investors and the sector but ultimately, if it experiences the kind of cleansing that occurred with the dot-com crash in 2000, that might be a good thing for the sector and its remaining investors.

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