Podcast: the end of the beginning for crypto?
Meltem Demirors of CoinShares and fund manager Alex Tedder debate the severity of the crypto crisis and what it means for the future of crypto currencies.
This is a transcript from the Investor Download podcast: “The end of the beginning for crypto investors?” It was prepared by an automated transcription service. This version may not be in its final form and may be updated.
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David Brett (DB): In February this year, 208 million people tuned in to watch LA Rams beat the Cincinatti Bengals in Superbowl 56. It’s the most-watched one-off sporting event in the world. Eclipsing the Football world cup and even the Cricket world test championship final. The Superbowl is huge. And because it’s watched by so many it can charge huge premiums for advertising space during the game.
The most sought after slots are during half-time show. And in 2022, advertisers had to pay an average of 6.5 million U.S. dollars to air a 30-second long commercial. Up until recently, those ad spots were taken some of the biggest companies in the world. But 2022 saw a new breed of business barrel into town: Crypto firms
That was Hollywood star Matt Damon starring in an advert for crypto.com. But crytpo.com wasn’t the only one and it certainly didn’t spend the most. During the game, for a minute, a mysterious QR code bounced hypnotically around millions of screens like one of those old fashioned screensavers. That code was part of an ad for the cryptocurrency exchange Coinbase. It took those who scanned it to the company’s website, where it offered customers a $15 promotional sign-up bonus.
Coinbase spent nearly $14 million on the commercial, according to Sporting News. And the commercial generated so much interest that record traffic crashed Coinbase’s app. So much money was spent on advertising during Super Bowl 56 it was nicknamed the crypto bowl. But at the same time crypto firms were spending big at the Super bowl, they were losing big in the crypto market. By the time those Superbowl ads aired on February 13, the value of the global crypto market had already fallen 33% from it’s peak just months before. And that proved to be just the tip of the iceberg.
Amid fears of a global downturn, investors had already begun to ditch risky assets, and crypto, well that’s considered among the riskiest of them all. But the collapse of Terra USD, one of market’s stable coins – supposedly stable because its value is pegged to other assets – shattered investors’ already brittle confidence in the market. The domino effect contributed to the entire value of all crypto currencies globally to fall from around $3 trillion in November 2021 to just over $900 billion six months later, according to data from coinmarketcap.com.
Meltem Demirors (MD): It was concerning to see how many people had put capital into it without realizing what it is they're putting their capital into.
DB: That’s Meltem Demirors, Chief Strategy Officer of CoinShares, an investment firm that manages $750M with a focus on digital assets.
MD: But certainly I think it was an important reminder to really understand what it is you're putting your money into.
DB: No crypto currency was left unscathed as the shaky foundations on which they are built began to collapse. Even Bitcoin, the leading light of the crypto market, has seen its value fall below $19,000 from nearly $70,000 seven months ago.
Alex Tedder (AT): We've seen some really big corrections and there's some really big recoveries and, you know, arguably those corrections have been tremendous opportunities for investors brave enough to step in at the right time.
DB: That’s Alex Tedder, a fund manager at Schroders and an investor in disruptive innovation.
AT: The issue this time around, I think, has simply been that confidence was definitely shaken considerably more by the stable coin collapse than it has been historically with cryptocurrency.
DB: So is this the beginning of the end or the end of the beginning for crypto currencies? We’ll get to that later in the show. But in part one, we’ll take a look at what’s been happening in the world of crypto currencies and how it’s managed to get into its current state.
Part one: The collapse of Terra USD
DB: The story of crypto is now pretty well know and we’ve covered it ourselves in a previous episode. We’ll link to that in the show notes. But needless to say, in financial markets terms, crypto is a nascent asset class. In brief, the original idea for a crypto currency, which turned out to be Bitcoin, was laid out in a white paper in 2008 by Satoshi Nakamoto, although no one knows who or what Nakamoto is. In the paper, bitcoin was described as “a purely peer‐to‐peer version of electronic cash [which] would allow online payments to be sent directly from one party to another without going through a financial institution”.
And the original idea behind bitcoin works up to a point. Where it fails, according to some, is as a legitimate form of payment or reserve currency as its volatility remains far too high. Microsoft, for instance, began accepting bitcoin as payment, but stopped in 2018 for exactly this reason. Just imagine, for a second, accepting a Bitcoin as payment for a car say for the value of $70,000, then that same Bitcoin being worth two-thirds less just a few months later. The original narrative was that as Bitcoin matures its volatility would decrease. But this hasn’t happened, as witnessed by its recent steep decline.
AT: And this is, this is the one number one problem we've got with crypto's currently is how do we value crypto? If it is to be a store of value, we need to be able to value it. And we just can't do that. And therefore it becomes a speculative asset. And as I said, subject to these very wild swings in sentiments, driven by demand and supply, and often exacerbated by leverage.
DB: Which brings us to stable coins. Stable coins were meant to solve that issue.
MD: We have been using stable coins in the crypto ecosystem for nearly a decade now, U S D T or tether was the first stable coin that allowed us to settle Bitcoin transactions for cash on the same settlement layer, tether currently around 80 billion of it in circulation. It is backed by currency reserves, commercial paper, variety of other assets. The second, most widely used stable coin is U S D C, similar to tether in construction in that it's backed by bank assets and, and real world assets.
DB: So, stable coins are supposed to mimic traditional currencies. Stable coins are supposed to be pegged against other assets to keep them, well, stable, so if there is a sell-off the assets the stable coin is pegged against can be used to support it. Much like when fiat currencies like the dollar or pound were on the gold standard, but with the added benefits of blockchain technology, which is essentially an undisputable digital ledger of transactions – again check previous episodes for a fuller explanation.
There are many different stable coins, but briefly they can be grouped into three categories: Ones that are pegged to a currency such as the dollar. Ones that are pegged to other crypto assets. And ones that are driven by computer programs, so pegged using financial engineering, algorithms, and market incentives. But whatever peg they use the peg should prevent the value of the stable coin falling below the value of one. However, in early May the two main stable coins from the crypto project Terra went into free fall.
MD: The specific stable coin you're referring to was a slightly different construction was an algorithmic stable coin that was backed by endogenous collateral or a cryptocurrency token, which started to fluctuate in value caused a lot of skittishness. People started cashing out the price of the cryptocurrency started to fall rapidly. People realized there was nothing backing this algorithmic stable coin.
DB: The run on Terra USD caused contagion in the market as investors panicked. According to data from the Block Research, between May 2021 and May 2022 the total supply of stablecoins circulating the crypto sector rose from $87 billion to $181 billion. However, after Terra’s collapse that dropped to $155 billion.
MD: I think it was just a very important reminder to everyone in the crypto ecosystem that we need to be more careful with the terminology and the language we're using. And we need to be more careful with how we're describing these investments, these opportunities, these assets, particularly to think retail users, retail traders, who may have been sold a different bill of goods or who maybe do not have the propensity to do as much research as potentially market makers, traders, investors, or other types of market participants.
DB: A loss of confidence ripped through the crypto world. Investors, fearing their investments would be routed, withdrew funds in record volumes, raising concerns of broader contagion in financial market. But how much should we fear the ripple effects from the fallout of the crypto rout? That’s coming up in part two.
Part two: Are we heading for a crypto apocalypse
DB: Crypto’s short history can been defined by five resets. The first came in 2014 when what was basically the only bitcoin exchange in the world, Mt. Gox, imploded following a nearly half-billion-dollar hack. The second, in 2016, was The DAO Hack, when an attacker tricked a smart contract into giving away $60 million worth of ethereum, worth $8 billion today. The DAO was a decentralized autonomous organization. The third, in January 2018, occurred when the Inititial Coin Offering, or ICO, bubble popped, starting a year-long decline, wiping out 60% of the crypto market or more than $700 million mostly in the form of worthless junk tokens.
The fourth took place in March 2020 when crypto lost 40% of its value along with most other global financial markets. But back then, the crypto world was so small and its links within financial markets so tenuous, that it had little impact outside the world of crypto. Each time the crypto market has reinvented itself. Each reset has not only lead to an increase in value, but they’ve also cleared the way for rapid innovation. But now we’re going through the fifth reset in eight years, and the stakes are getting higher.
MD: Crypto is a new domain. Anytime we have new domains just as we saw when the internet and internet based companies and publicly listed equities in the internet space were starting to emerge. There is a lot of hype, people want to allocate capital to it. Whenever there's paradigm shifting technology, there's also massive accompanying financial bubbles.
DB: The problem is, with this fifth reset there’s a lot mor people exposed to it than before. For instance, an annual survey from the Federal Reserve found that 12 percent of Americans, that’s 31 million people, used crypto purely as a form of investment in the last year. So, the pain felt by many individuals from crypto crash will be real and painful. And they’re not the only ones.
MD: There are plenty of institutions that we're engaged in just extremely speculative investing with long tail risk. And that worked in the environment we were in with low rates with very loose policy. And now that things are tightening up, I think we're seeing a lot of things that people invest in are fundamentally unsustainable.
DB: But could it affect the broader economy? Central banks have already written white papers and warned of the potential for a crypto crisis to bleed into the broader financial markets. However, how and when it might happen has been harder to predict. There is one reason we might not be seeing the crash cascading through the economy. That’s because apart from El Salvador, the majority of countries, companies and financial institutions have been reluctant to accept cryptocurrencies as a legitimate form of payment.
DB: Most real world use cases for crypto currencies and Bitcoin come on the black market or dark web. However, that’s not to say that the fallout from the crypto crash has been confined only to crypto currencies. It has bled into the stock market.
AT: One of the issues is that crypto is highly correlated with equities. I guess a lot of that has to do with the fact that that interest rates are rising and the environment for any kind of duration asset, if we can call it that, is a lot tougher.
DB: Duration – it’s a measurement of an assets sensitivity to interest rate rises. So if an asset is highly sensitive it’s price will fall, and vice versa. Before the pandemic, crypto assets such as Bitcoin and Ether showed little correlation with major stock indices. In fact, they were thought to help diversify risk and act as a hedge against swings in other asset classes.
But it all changed after the extraordinary central bank crisis responses of early 2020. A lot of people had more money in their pocket. In the case of the US government, they were sending out cheques in the post. And people expected interest rates to remain low for longer, so they invested it in riskier assets in the hope of better returns.
So, crypto prices and US stocks both surged amid easy global financial conditions and greater investor risk appetite. And in the process became more correlated. For instance, Bitcoin volatility explains about one-sixth of S&P 500 volatility during the pandemic, and about one-tenth of the variation in S&P 500 returns, according to a report by the International Monetary Fund. The message from the IMF is that Bitcoin and the broader crypto world aren’t likely to offer protection against downturns in equities. Crypto’s volatility is spilling into equity markets, and vice versa
MD: I think if you look at the chart of tech IPOs that have happened over the last two years, right during the pandemic and the subsequent period of massive monetary expansion and loosening of monetary policy, a lot of those tech sucks today are down anywhere from 75 to some cases, 95% of their, their value. We see similar patterns in crypto crypto is cyclical nature. And for many of the longer tail assets in crypto, they, we have seen draw downs of 80 to 90%. And many of those assets won't recover because they're fundamentally not investible assets.
DB: As central banks begin to raise interest rates and tighten monetary conditions the most risky assets have begun to retreat. Most major stock markets around the world, for instance, are in bear market territory, which is a fall of 20% or more from their recent peaks. And while tech stocks have born the brunt of the sell off with some well-known names such as Netflix falling 50% and other lesser-known names down more than 70%, the sell-off has been widespread.
AT: I mean, there's been a pretty big reset in a wide variety of areas, biotech, energy transition, communications and, and tech. There's been, you know, some really big drawdowns, because we were in a period of irrational exuberance and that's now coming out of the market, that's healthy, that's part of the market process.
AT: We're seeing a very significant shakeout in companies that don't make money and possibly won't ever make money. And that that's part of this reset. That's very important, I think for markets, but I'm going to stick to my view, which is until we come to the point where a cryptocurrency or maybe several cryptocurrencies represent their Fiat equivalence in a fully defined, regulated way, these are speculative assets at best. And, in my view, not an asset class.
DB: Regulation looks like it is coming. US President Joe Biden signed an executive order in March 2022, asking government agencies to work toward creating a regulatory framework for crypto-asset markets. But that’s a way down the road. The concern at the moment is will what’s happening now spread beyond the boarders of the stock market? How contagious might the crypto crash be?
MD: Think in terms of contagion and in terms of correlation. What's interesting, we look at a lot of data around correlation between crypto and other assets. Again, you know, the last six months of data are informative, but not enough to sort of give us a consistent trend. I think that relationship between tech equities and crypto in particular has been all over the place. I don't think crypto has any contagion today on broader capital markets. Crypto's a tiny asset class. It's a $1 trillion asset class. US equities alone are $50 trillion asset class, global equities, over a hundred trillion dollars.
DB: Crypto is also an asset class that, at the moment, is getting significantly smaller. So are we seeing the end of the beginning or the beginning of the end for crypto? That’s what we’ll discuss in the final part of the show.
Part 3: The end of the beginning or the beginning of the end for crypto?
DB: Crypto currencies and digital assets provoke an emotional response. Thanks Matt Damon. But tell that to the person that might have invested $100 in Luna, the crypto currency linked to Terra USD, one month ago, the fourth most popular cryptocurrency at the time, and it’s now worth nothing. A lot of ordinary people who swallowed the crypto pill hawked by Damon and a fleet of other celebrities have taken an absolute beating.
MD: But again, I think the trend in crypto would always, what I always say is we do have higher highs, but also higher lows.
DB: If you’re a die hard believer it can be easy to justify the swings in the crypto market that have been wilder than the wild, wild west. But for others there remains a crucial barrier to entry.
AT: A currency has to fulfil a number of different, you know, aspects. It, it's obviously got to be a means of exchange. That's got to work and I think crypto will end up doing that, but it's also gotto a representation of the value, the underlying value in an economy or a country, or however you like to define it. Right. And to my mind, crypto does not do that. It's decentralized, it's unregulated. And therefore it is not a store of value or indeed an asset class at this point.
DB: But there is a counter argument.
MD: Bitcoin is backed by energy and computation, both of which are real world assets. And the Bitcoin network is backed by data centers around the world who are utilizing energy to secure the Bitcoin network. So I do think there's tremendous value. The Bitcoin economy has over 300 million participants around the world for using the Bitcoin network to perform trillions of dollars of financial transactions per year. And look again, I think it's just a question of where your perspective is. I've been in this industry for eight years and certainly it feels much more real to me than many of the regulated companies we interact with. There are many publicly listed companies who are a little more than shells and have zero actual value behind them. So filing some paperwork with a regulator, I don't think is a good barometer to use.
DB: Which might be true. The crypto market is supposed to be decentralised after all, meaning no one person or institution is responsible for overseeing it. The market participants, of which there are many and who ratify each crypto transaction using the blockchain, are the supposed guardians of the market. However, perhaps because crypto is so new and investors are too used to the old world of investing, for the moment, the trust isn’t quite there …yet.
AT: I might have given the impression that I'm, you know, wary of cryptocurrencies and, and I am today … but actually we do end up in the same place on a kind of 10 year view, which is cryptocurrencies aren't going away. They're going to get a lot bigger and a lot more important. I just have to think the process is going to be quite a difficult one, quite a turbulent one, certainly continue to be volatile. One very difficult for investors to work their way through this, particularly if they're inexperienced and I come back to the issues you have with valuing things like Bitcoin, what does anyone know about Bitcoin?
DB: Apart from there’s around 19 million of them in circulation and there will be 21 million in total, unless the program that creates them is altered, not much beyond its wild swings and illegitimate usage. But that won’t stop people investing in the hope they’re onto the next big thing that could make them millions. However, because of the uncertainty surrounding the asset class investors should tread carefully.
MD: Once you've made the decision to allocate, you know, the best performance for crypto has typically come from five to 10 trading days every year. So I think it's just a good asset for investors who are comfortable with the volatility and are comfortable with this idea of having a small slice of exposure to this new digital infrastructure in their portfolio. But I do think that assets like Bitcoin in, in this allocation can be great way again, to add a bit of diversification, add a bit of exposure. And lastly, just one thing I'll add, I do think the outcome here is, is rather binary. If public blockchain infrastructure does what I believe it will, I think, you know, the potential is absolutely tremendous. Now, again, there's some active management required in terms of understanding what those assets will be and what those investment opportunities are. And by the way, there's also ways to play that theme in the public equity side. So it's not necessarily buying exposure to cryptocurrencies themselves directly. There are a lot of different ways we can get exposure to crypto through publicly listed equities, but I do think new slice in the portfolio, a small one to 4% allocation, adjusting quarterly. And then again, really viewing it as a long term opportunity rather than something you're constantly adjusting and, and sort of re relocating too,
MD: As we know, as investors changes in sentiment are typically followed by changes in portfolio allocations may take time. There may be lag. I think many allocators are trying to figure out their, their approach. But I do think we will see some major moves over the coming months and years that I think will start to really catalyze a more formal, large scale movement into the crypto currency sector. And again, I think the question is where and how that will shake out who the beneficiaries that will be that's my job is figuring out how to invest in that shift.
AT: This is a long term trend that's not going away. So this is the very beginning of it. I'm not surprised there's a lot more interest because people are waking up to where this might go at some point. I think it's more about the timeline than anything else at this stage.