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July 2022
As painful as the crypto winter has been for investors this year, it will likely lead to more regulation and potentially greater acceptance of digital assets by institutional investors.
Most risk assets have borne the brunt of soaring inflation and aggressive interest rate hikes by the Federal Reserve, but the damage has been particularly harsh in the cryptocurrency market.
The market’s capitalization plunged to a year-to-date low of $900 billion on June 20, from a $3 trillion high last November (2021).1 The price of Bitcoin, currently the largest by market share of some 19,000 coins making up the market, slumped to a low of $17,628 in June from an all-time high of around $69,000 in November last year,2 while Ether, the second most popular cryptocurrency, hit a low of $900 in June, 81% below its November highs.3 Although both Bitcoin and Ether recovered some lost ground in July, they were still well below their all-time highs, with trading levels of around $21,794 and $1,509.48 respectively.4
Major disruptions have emerged throughout the digital asset ecosystem as a result of the rapid decline in prices of the largest crypto coins. The most high-profile example has been the collapse of TerraUSD, an experimental algorithmic “stablecoin” – cryptocurrencies designed to maintain a 1-1 peg with a hard currency such as the U.S. dollar or a commodity like gold.5 TerraUSD’s downfall exacerbated the general market selloff, which snowballed into mass capitulation and forced margin calls as well as liquidations upon certain crypto funds and Decentralized Finance (DeFi) lenders.6
Yet as painful as this year’s crypto crash has been, 2022 will likely mark a pivotal moment in the development of the asset class, by prompting better regulation and potentially greater participation by institutional investors.
“This is what happens in nascent markets,” says Chris Rogers, head of the Capital Market Advisory Group at BNY Mellon Wealth Management. “It’s a steep learning curve, and it’s by trial and error that we will move forward with greater regulatory clarity, wider institutional adoption, and a more mature market.”
Recent events have shone a light on where the cracks are in the crypto pipes and what needs to be done to improve the market’s infrastructure, says Rogers. We sat down with him to get his take on the developments in crypto this year, and where he thinks the market is going. Here’s what he had to say:
Bitcoin’s crash is slightly different this time
This is not the first crypto winter Bitcoin has gone through. It has experienced three 80% downdrafts in its short history, before the latest rout. But this time the downturn is slightly different because there is a more diverse universe of participants with different agendas in the market, and that should provide long-term support. Institutional investors have been involved in the market for the last few years, whereas previously it was dominated by retail buyers. A PwC survey estimated hedge fund investments in crypto rose 400% in 2021 versus 2020 inflows, and according to database firm Pitchbook, venture capital funding for cryptocurrency and blockchain companies more than quadrupled to $25 billion last year.7
Exhibit 1: Bitcoin's Trading History
Bitcoin Not Performing As Inflation Hedge
One of the big lessons for investors this year is that Bitcoin has not performed well as an inflationary hedge, as many investors had hoped. Bitcoin appeared to be correlated with inflation when prices were low and stable, but it decoupled when inflation started to rise in the fourth quarter of 2021 and has remained persistently less correlated in 2022.
Exhibit 2: Crypto Decouples from Inflation
While gold hasn’t been much of an inflation hedge either this year, the chart below illustrates that it has at least shown resilience as a store of wealth in a volatile period, while Bitcoin’s value has dropped.
Exhibit 3: Gold as a Store of Value vs. Bitcoin
Bitcoin Has Been Trading Recently As A Risk Asset
What Bitcoin has been highly correlated with, however, is the equity market. As you can see from the chart below, Bitcoin has been trading as a risk asset, with its correlation to the tech-heavy Nasdaq 100 index having hit new highs in May. Although correlation has fallen in the past month, it still remains elevated compared to its short history.
Exhibit 4: Bitcoin's Correlation with Nasdaq Index
Stablecoins
Another important takeaway is that not all stablecoins are the same. Stablecoins are integral to the crypto market because they are designed to maintain a stable 1-1 value relative to a national currency or other reference assets such as baskets of currencies, commodities like gold, or even other cryptocurrencies. This enables investors to use them as a bridge between cryptocurrencies and the traditional banking system. Because cryptocurrency prices are highly volatile, stablecoins enable investors to quickly de-risk into the equivalent of holding cash during times of turbulence.
Where stablecoins differ from one another is how they maintain their 1-1 peg. There are two main kinds of stablecoins.
The first type of stablecoin is backed by reserves of commodities or physical currencies and cash-like assets, with the U.S. dollar assets and gold being the most common.
These stablecoins have shown resilience to this year’s market volatility, although there has been some flight to quality, with many investors favoring stablecoins that are fully backed and over-collateralized by the U.S. dollar and cash-like equivalent securities.
The second type is the algorithmic stablecoin, which hit the headlines in May when TerraUSD imploded. TerraUSD had no currency or commodity reserves, and instead sought to maintain a 1-1 peg to the U.S. dollar via a blockchain smart contract, coded to automatically increase and decrease the supply of TerraUSD.
TerraUSD collapsed in May after, among other reasons, a wave of selling went beyond what the smart contract was programmed to adjust on any given day to maintain the peg.
Regulation Ahead
Although the largest stablecoins backed by fiat currency reserves and cash equivalents have to date shown resilience, we believe we could see more regulation around the type and amount of reserves stablecoins need to hold. In early June, the New York State Department of Financial Services (NYDFS) issued guidance on the issuance of U.S. dollar-backed stablecoins.8 The guidance includes requirements relating to the redeemability of such stablecoins and the kind of reserve assets used to back them.
There are also multiple crypto frameworks being considered on Capitol Hill, including the Responsible Financial Innovation Act,9 and the Digital Commodity Exchange Act of 2022.10 Although unlikely to be addressed this year, there is a possibility that legislation could gain traction in 2023.
This year has been painful for crypto enthusiasts, and the events underscore why we have not recommended cryptocurrencies for client portfolios. However, we think the correction may eventually be seen as a blessing in disguise. We expect it will lead to more regulation, which should lead to a critical mass of institutional and corporate engagement with digital assets.
Footnotes
1 Nov. 7, 2021.
2 Jun. 19, 2022
3 Ether high: $4,775.56 Nov. 9, 2021. Ether’s $900 low occurred on Jun. 18, 2022.
4 Jul. 25, 2022
5 BLOOMBERG.COM May 21, 2022
6 FT.COM Jun. 19, 2022
7 BRIDGEWATER.COM accessed Jul. 25, 2022
8 Department of Financial Services, New York State: “Virtual currency Guidance” Jun. 8, 2022
9 KIRSTEN GILLIBRAND PRESS RELEASE Jun. 7, 2022
10 CONGRESS.GOV accessed Jul. 25, 2022
The information in this paper is current as of July 2022. It is based on sources believed to be reliable, but its accuracy is not guaranteed.
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