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You know times are hard for crypto investors when they scramble to sell their Rolex watches to cover their losses, yet here we are.
The crypto markets have been particularly hard hit, and even Bitcoin (BTC) is down YTD by over 40%. However... we all know the markets are rough right now, and I don’t want to write yet another pity piece. Instead, let’s focus on 4 key lessons that you can learn from the cryptocurrency crash and use that to determine a strategy to move forward with.
It’s important to understand that cryptocurrency is heavily impacted by the fate of the wider stock market. Fears of rising inflation, global instability, and supply chain challenges have encouraged investors to consolidate their assets into “safe havens.” This has hit risk assets particularly hard, and cryptocurrency is probably the ultimate risk investment.
This can be seen in the strong correlation between the general cryptocurrency market and tech stocks. There are two reasons for this. The first is that in a bear market, many assets naturally trend the same way — more specifically down — which will increase overall correlation.
The second is that cryptocurrencies, and crypto-related companies, are not yet in a position where there is a significant differentiator to enable certain tokens to break free and operate as individual breakaway assets with any kind of sustainability.
Readers with a strong understanding of the crypto market narrative will probably now be scratching their heads... Bitcoin’s reputation as digital gold has convinced a large portion of the crypto community that it is a good hedge against inflation. The problem with this analogy is that Bitcoin is still not well integrated into our financial systems, and there are many question marks hanging over the future of cryptocurrency — both legal and technological.
For most investors, Bitcoin is at best a high-risk emerging asset class (I’ve discussed that previously here), and at worst a straight gamble. This means that more traditional investors will naturally move their assets away from Bitcoin during a bear market, and into safer places.
The key takeaway here is that crypto investors should be looking at the wider markets for indicators about how cryptocurrency will likely perform. As money floods back into capital markets, we should expect to see a significant uptick in the interest in cryptocurrency again as investors look to capitalize.
With all that said, while markets are heavily impacted by external factors, each has its own nuance, and something strange has happened during this crash: Bitcoin dominance hasn’t increased as much as it should.
For investors heavily leveraged in cryptocurrency, Bitcoin acts as a (relatively) safe anchor to their portfolio. In previous crypto downturns, this could easily be seen in the Bitcoin dominance chart. As crypto markets soured, Bitcoin dominance would increase. When times were good and innovation was strong, people would make more speculative investments — and the total market share of Bitcoin would decrease.
This can be seen relatively clearly in 2017 when there was a frenzy of cryptocurrency investing leading to a proliferation of projects. However, a major crypto market crash caused investors to flood back to Bitcoin in the hopes of protecting their assets and finding a new entry point into the wider market as things recovered. This is not what’s happening in 2022.
Despite brutal losses in the second half of 2022, Bitcoin dominance has barely nudged. Instead, investors seem to be quite happy to keep their assets in existing projects, particularly Ethereum (ETH) which has a market share of nearly 18% on its own footing.
So what’s changed? Well, the big one is undoubtedly the Ethereum merge. This is the moment where the Ethereum network will move from the legacy Proof of Work (PoW) consensus mechanism to Proof of Stake (PoS). You can read more about the Ethereum merge in my article here.
In the simplest terms possible: Ethereum will no longer require miners to process transactions — instead users will be asked to “lock” their ETH tokens into accounts in order to validate transactions. This is sort of like putting money in a long-term, high-interest savings account (don’t you miss those days?).
Why is this important? Well, when users stake their Ethereum, it takes time (and transaction fees) to unstake it. Indeed all ETH currently staked cannot be withdrawn until the main net merges. With around 10% of total ETH supply currently staked, that’s approximately $19 billion in Ethereum that can’t be withdrawn from the market.
Additionally, many investors are excited about the merge. Even concerns about disgruntled miners splitting the network have been unable to dampen enthusiasm. Proof of Stake is generally viewed as the future of the Ethereum network, so many investors are likely holding onto their ETH in anticipation of a price bump once the merge finally goes live.
There is one final reason that this merge is so important: Decentralized Finance (DeFi). Ethereum forms the backbone of most of the DeFi ecosystem, and its biggest problem by far has been transaction fees caused by Proof of Work. The shift to PoS (Proof of Stake) is seen as a major first step in solving this problem, and owning Ethereum means owning a piece of the infrastructure for future Web 3.0.
Assuming Ethereum can successfully pull the merge off, it is likely that it will become a secondary safe-haven asset alongside Bitcoin with a major differentiator. Bitcoin is backed by the perceived value of the assets stored within it; Ethereum will be backed by the perceived value of the entire cryptocurrency ecosystem that uses its protocol. It’s the difference between owning gold and buying into Amazon (NASDAQ: AMZN) just as it started rolling out Amazon Web Services.
The takeaway? Ethereum is probably going to become a more dominant cryptocurrency player post-merge, and I would argue that ETH may well be the catalyst needed for the cryptocurrency market to truly decouple itself from other markets and start operating on its own merits, largely due to our next big takeaway: DeFi.
By far, the biggest difference between 2022 and 2018 was the proliferation of DeFi loans. These loans were largely unsecured, or collateral-based loans, with little to no oversight. When the market turned sour, many of these loans simply could not be paid back, which caused a number of high-profile liquidations.
The now defunct Celsius Network LLC epitomizes this dynamic. The company encouraged users to stake large amounts of cryptocurrency within its ecosystem by promising absurdly high interest rates of 18% or more. It then in turn loaned these assets out… making a tidy profit in the process. The model proved hugely popular, and at its height, Celsius held around $12 billion in assets with $8 billion lent out to clients.
This is where we come to the problem, and it’s one we’ve discussed before in relation to Tether (USDT) (here) — lack of oversight leads to stupid decisions. The first signs of major problems appeared in early June when Celsius released a memo stating that they were preventing all new cryptocurrency withdrawals. The opening paragraph was telling:
“Due to extreme market conditions, today we are announcing that Celsius is pausing all withdrawals, Swap, and transfers between accounts. We are taking this action today to put Celsius in a better position to honor, over time, its withdrawal obligations.”
These extreme market conditions would prove fatal. Less than a month later, Celsius would file for Chapter 11 bankruptcy. This bankruptcy would primarily impact its retail consumers, and many lost hundreds of thousands in assets overnight. The company has attempted to placate judges by arguing that this was out of its control, and that its Bitcoin mining business could eventually repay investors.
Now, this would be bad enough if it weren’t for the fact that many big crypto players were reliant on loans from each other. This meant that the risk of contagion — one company’s failure spreading to multiple companies — was massive.
For example, ThreeArrows (3AC), a crypto-focused hedge fund famous for its high-leverage bullish bets, found itself unable to meet a margin call from crypto lender BlockFi which led to the fund defaulting on a US$660 million dollar loan from Voyager Digital. Ultimately, 3AC would go into liquidation.
The problem came down to risk management, which is a major issue across the entire cryptocurrency industry. There were companies more than willing to loan enormous amounts of money to companies that were incredibly high-risk, without taking steps to mitigate that risk for the lender. When the markets turned south, they had no way to protect themselves, or more importantly, their investors.
The lesson here is that high-yield crypto lending platforms should be looked at with extreme skepticism. It is also likely that the ongoing bankruptcy trials will set new legal precedents for the kinds of protections that investors can expect in the future, if any, which leads us neatly into our next point: Regulation.
In 2018, crypto winter (slang for a recession in the cryptocurrency space) mostly impacted individual novice investors who had overleveraged themselves and lost a lot of money. This irritated regulators, but they had bigger problems to deal with than people who took risky bets on unregulated innovations.
But the 2022 crash was beginning to impact real-world financial institutions. Cryptocurrency regulation has gone from an issue that regulators wanted to kick down the road to a real problem that needed solving now.
While we haven’t yet seen any rapid changes coming into force, we can see a glimpse of the future through the Coinbase Global (COIN) incident. In late July, a former Coinbase product manager was charged with insider trading. Specifically, he had leaked information to help his brother and a friend buy tokens just before they were listed on the exchange and experienced a price pop — netting over $1 million in profits.
The words of the Federal Prosecutors read like a rallying cry:
“Today’s charges are a further reminder that Web3 is not a law-free zone." Manhattan US Attorney Damian Williams said in a statement. "Our message with these charges is clear: fraud is fraud is fraud, whether it occurs on the blockchain or on Wall Street.”
It’s not just Coinbase. Another major cryptocurrency exchange, Kraken, has come under fire for allegedly breaking US sanctions against Iran. This resulted in another attempt by the US government to disprove the crypto community’s thesis that “code is law,” and reassert the primacy of the United States in the realm of financial law.
At first glance, this could seem problematic for the cryptocurrency industry. After all, a key aspect of cryptocurrency’s appeal is the ability to innovate in ways that banks or more traditional financial tech companies can’t — hopefully even breaking existing monopolies.
However, this renewed interest in policing cryptocurrency (rather than banning it), is positive for good projects. One of the best examples is a group we’ve mentioned earlier, Circle (USDC). Unlike other stablecoin providers, the project has pivoted into ultra-transparency, and their cautious approach appears to be paying dividends, particularly after the collapse of the Terra stablecoin.
In June, the company released its first (sadly unaudited) financial report, and it looks promising. The report shows total reserves of US$55.7 billion made up of $42.122 billion in 3 month Treasury bonds, and $13.5 billion in cash invested in regulated financial institutions in the United States.
This is huge because it means that Circle can actually cover the tokens they’re issuing in the event of a run on the bank without collapsing outright.
I’ve given Circle a buy recommendation before, and I’m happy to repeat that. The company is planning to go public in Q4 of 2022 via its SPAC Concord Acquisition Corp (NYSE: CND), which alongside plans for an EUR backed stablecoin should put the company in a strong position to perform long term.
Cryptocurrency has entered a new phase of its existence where dreams of a financial system being displaced by crypto are beginning to give way to more sensible aspirations — namely new integration into real-world finance and specific cryptocurrency powered future projects.
With this in mind, I see two main ways for investors who want exposure to the cryptocurrency space to move forward.
In the short term, Ethereum (ETH) still represents the best cryptocurrency bet you can take. The merge will undoubtedly cause a pop in price, and the reduction in transaction costs should encourage projects to continue using the Ethereum network as their go-to infrastructure, providing broader exposure. As markets improve, you can then look at taking advantage of new projects and making direct investments that way.
In the longer term, well regulated cryptocurrency companies like Circle (USDC) represent a safe bet. The key is to look for projects that are not making the same mistake as 3AC — those that are providing exposure to the cryptocurrency space sustainably and protection against the (common) case of a cryptocurrency downturn.
Finally, I’d strongly recommend that investors do their best to filter out “hype.” An excellent example of this is betting too early on Web 3.0 and putting too much focus on metaverse projects so early in the game. While there are some great crypto metaverse projects out there, the market demand isn’t there yet, and I do expect we will see a number of them collapse over the course of this bear cycle.
Instead, investors should be focused on investing in cryptocurrency “infrastructure.” I personally divide this into three separate baskets:
These are companies that are mining cryptocurrency or staking cryptocurrency in order to make money from existing assets. The best-in-class investment here is undoubtedly HIVE Blockchain Technologies Ltd (NASDAQ: HIVE).
HIVE is interesting for two reasons. First, they have an excellent cost structure that stands around 35% below industry average. Second, the company is trading at a low, largely due to cryptocurrency woes, despite releasing very positive financials in July that show year-on-year revenue growth of +216%.
They are my go-to crypto miner at the moment, and snapping some up while it’s cheap might be a good idea.
The other side of crypto infrastructure is decentralized apps (dApps), and while I like Cardano (ADA), Ethereum (ETH) is still the best bet for most investors. I reiterate, the merge offers great opportunities for growth and should accelerate Ethereum’s role as the blockchain of choice for decentralized apps.
I believe this also means that Bitcoin should no longer form the only anchor of the “pure” crypto part of a portfolio. Instead, investors should include at least some amount of Ethereum in order to gain broader exposure to the DeFi space, where much of the value of cryptocurrency will be derived from in the near future.
The final piece of the puzzle is the bridge. These are the companies that enable money to flow into and out of the financial ecosystem and into cryptocurrency. Early signs are that governments are looking to regulate these heavily to limit the contagion that a volatile crypto market can cause to financial markets more generally.
While exchanges like Coinbase are an option, they typically offer leverage services which add an additional layer of risk. I would prefer to focus on companies that have a clear, simple offering, and there’s none that fit the bill as well as Circle (USDC).
Circle’s clear focus on transparency is beginning to pay off, and their emphasis on voluntarily complying with SEC regulations will help to prevent a lot of headaches in the future.
To most investors, the cryptocurrency markets look pretty grim today, but there are a number of opportunities that will pay real dividends in the long term. I believe that we are witnessing the cryptocurrency markets mature during this trying time, which will create many new opportunities in the year to come.
In the meantime, do your research, and decide if now is the right moment for you to adjust your crypto investing strategy, or form a completely new strategy moving forward.
Saul Bowden, Contributor
for Investors News Service
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DISCLOSURE: Saul Bowden holds Ethereum, Bitcoin, and other crypto assets. He also holds shares in Concord Acquisition Corp. (NYSE: CND).
DISCLAIMER: Investing in any securities or cryptocurrencies is highly speculative. Please be sure to always do your own due diligence before making any investment decisions. Read our full disclaimer here.