Is the crypto crisis good for the system? Is the crypto crisis good for the system?
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Is the crypto crisis good for the system?

Is the crypto crisis good for the system?

Top-down macroeconomic and bottom-up crypto-specific headwinds have been blowing strongly for digital assets resulting in the biggest ever drawdown

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With digital assets, we are witnessing the rise of a new and nascent asset class built on a technology that has the potential to revolutionise the global financial system. This year, both top-down macroeconomic and bottom-up crypto-specific headwinds have been blowing strongly for digital assets resulting in the biggest ever drawdown in terms of the level of value destruction we have seen in the space.

Central banks
Since the initial announcement from the US Federal Reserve in November 2021 to taper their asset purchases and tighten monetary policy, risk assets have suffered from strong selling pressure. As a high volatility asset class, digital assets were not immune to this pivot away from risk assets, which ultimately saw the total market capitalisation fall by around two-thirds from the peak.

Therefore, during the first few months of this year, top-down macroeconomic factors rather than token-specific factors were thus in the driving seat for cryptos. As the cross-crypto correlation have remained elevated since the initial tapering announcement, there was no place to hide as almost all tokens moved lower in lockstep. Furthermore, we believe that these elevated correlations amongst the leading tokens suggests a currently low level of sophistication and differentiation between the value propositions of different digital assets.

Stablecoin shakedown
Stablecoins initially attracted investors with the touted benefits of decentralisation and blockchain technology, while mitigating the infamous volatility of free-floating cryptos such as Bitcoin and Ethereum. While there are many different types of stablecoins, one of the increasingly popular methods of construction became algorithmic stablecoins. These instruments rely on complex automated mechanisms and incentive structures to maintain their 1:1 peg with the underlying fiat currency, without holding fiat-denominated cash or near cash securities.

The DeFi liquidity crisis
The total value of crypto assets locked into DeFi protocols, so called TVL, is one of the main metrics that investors use to gauge the level of activity and overall value in the DeFi ecosystem. In this regard, we have seen a dramatic decline in values since the beginning of the year, with the overall TVL falling from over $250bn to well below the $100bn level at present. Lending protocols in particular saw a very big chunk of their TVL drop as investors were spooked by the TerraUSD collapse, driving them to exchange tokens held in lending pools into stablecoins, with the ultimate intention to cash out into more secure fiat currencies.

Wall Street spillover
With digital assets becoming increasingly accepted as a new asset class, the last months and years have seen an increasing number of institutional investors warming up to digital assets. This push by institutional investors such as hedge funds and other asset managers into digital assets has not gone unnoticed by the Wall Street, with several high-profile banks rapidly building up their digital asset’s expertise and capabilities.

Three Arrows Capital was the first high-profile name to report significant losses from their crypto trading activities. In mid-June, with significant exposure to the Terra/Luna ecosystem and other leading crypto assets, reports started to emerge that the hedge fund had failed to meet a series of margin calls. As the fund filed for bankruptcy, records indicating creditor claims of $3.5bn, as well as estimated losses running into billions of US dollars over the 2021-22 period, marking one of the largest hedge fund trading losses of all time.

Does it make sense to hold crypto in a portfolio?
When considering the recent crypto crisis and its multiple episodes, the question now arises: Is there still merit in holding cryptos and, if so, what proportion of a portfolio should be allocated to digital assets? Due to the nascent nature of the asset class, we have based our analysis on Bitcoin, which is the largest, most established, and most mature crypto coin.

Conclusion
All in all, we continue to see crypto primarily as a return enhancer in a portfolio. Historically, this assessment is backed by the fact that the addition of cryptos to a portfolio beyond a small weight of 1 per cent or less has caused an increase in realised returns as well as realised volatility. Allocations up to 5 per cent may be appropriate for risk seeking investors, while higher allocations would cause a significant change in the portfolio’s characteristics and may ultimately result in lower risk-adjusted returns.

We thus maintain our view that cryptos are only suited for investors who have the ability and willingness to bear the related risks. However, these risks could be rewarded with very appealing returns due to the potential disruptive power that we see primarily in the world of decentralised finance. Risk seekers should also exercise caution, as digital assets are still a very unregulated area. Rising regulation should instill trust in the asset class and ultimately foster adoption. Due diligence is key: if something seems too good to be true, it probably is.

Sipho Arntzen is the next generation research analyst at Julius Baer

Read: Gulf Business enters non-fungible token space, launches GB Crypto NFT

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