The Crypto Winter
The cryptocrash, and how investors are responding
As the total value of digital assets plummets from $3.1tn at their peak in late 2021 to just $1tn by June, crypto investors are urgently refocusing on fundamentals and increased diligence.
The end of the crypto bull market
Digital assets have always been highly cyclical, with bull cycles (peaking in 2013, 2017 and 2021) typically followed by bear cycles (so-called “crypto winters”). The period of 2020-2021 saw the greatest bull market yet, with Bitcoin rising to an all time high of $69,000. Historically low interest rates, coupled with vast money supply creation as a result of government stimuli during the Covid-19 pandemic, caused many investors to search for yield outside of traditional markets.
In early 2022, the market turned. A sell-off in riskier technology stocks, coupled with rising inflation, led to declines in digital asset valuations as investors moved to safer assets. By April 2022, Bitcoin was trading at around $40,000.
Confidence in risky assets plummet
A correction became a crash in May, when algorithmic stablecoin Terra and its sister currency Luna collapsed in spectacular fashion. The collapse – which saw insiders get out at par, leaving other investors to suffer some $18bn in losses – caused a loss of confidence in riskier cryptoassets and a flight to safety among investors.
In early June, DeFi network Celsius announced that it was blocking withdrawals. Celsius is essentially a crypto bank – taking short term deposits which are then lent out on a longer term basis – which suffered a classic bank run when users lost confidence and rushed to pull out their deposits. At the time of writing, Celsius is widely understood to be insolvent, with little hope of depositors getting their assets back.
A number of other well known market players also imploded, or came close. Crypto hedge fund Three Arrows Capital, which had suffered heavy losses in recent months, suffered a likely fatal liquidity crisis when it failed to meet its lenders’ margin calls. DeFi networks (and Celsius competitors) Babel Finance, Finblox and BlockFi also moved to block withdrawals, buying time to seek a restructure or bailout. Concerned to maintain stability in the market, FTX founder Sam Bankman Fried bailed out BlockFi with a $250m credit line.
Today, Bitcoin trades at around $20,000, a price at which the average investor will have lost money on their holding.
Investors refocus on diligence
The crisis has laid bare the dismal state of disclosure in the crypto markets, where few market participants have access to the information needed to accurately assess their investments. Investors are now behaving with greater caution, often commissioning specialist due diligence on their investments.
Here are four key areas to which our clients are paying close attention:
Investment Fundamentals. It is no longer sufficient to invest in the belief that the price of a particular digital asset will increase on the tide of a rising market. Investors are now looking to ensure a sustainable business proposition behind the digital asset. Stablecoins such as Terra-Luna are coming under increased scrutiny as investors pay increasing attention to the mechanisms in place to underpin price stability and prevent loss of value. As crypto moves into new arenas, such as tokenised infrastructure and real estate, verifying the real world assets that sit behind the blockchain, will become an increasingly important part of the investment process.
DeFi Exposure. There are widespread concerns that DeFi networks such as Celsius lack the risk management controls required to avoid a Lehman-style collapse. Investors looking to earn a return on their cryptoassets by depositing them into a lending protocol are paying increasing attention to the solvency and risk management controls in place. In many cases, investors have not been satisfied as to these controls and have decided to withdraw their deposits from DeFi protocols.
Inside Information. With no effective conduct rules, crypto markets have frequently been subject to actions which would amount to market abuse or insider trading had they taken place in a regulated space. Investors are now realising that insiders – such as the venture capital backers of a project – are potentially able to use their informational advantage at the expense other market participants. For example, VCs backing play-as-you-earn Web3 games often receive an interest in the game-based token as a condition of funding, and may have an incentive to liquidate this interest quickly as a way to de-risk the investment. Scrutinising the structure of a project, as well as previous transactions in the asset, is essential to understanding the potential risk of insiders abusing their status at the expense of other investors.
Reputational Diligence. Greater prudence has also made investors keener on conducting deeper due diligence to understand the reputation, track record and probity of the individuals behind a project. The gold standard involves an analysis both of an individual’s on-chain behaviour in the digital asset world and off-chain behaviour in the real world. In a market where people often use pseudonyms and operate through distributed anonymous organisations (“DAOs”), exercises such as this can be a highly effective way to uncover previous associations with frauds or scams.