What the bitcoin bloodbath reveals about the cryptocurrency market

The shakeout in the cryptocurrency sector is prompting renewed questions about the foundations of the highly volatile digital asset market
Such assets were never meant to be a hedge against inflation, and the end of an era of cheap money has accentuated their long-standing weaknesses

Nicholas Spiro

Published: 10:00pm, 23 Jun 2022

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Another year, another dramatic sell-off in cryptocurrencies. This is prompting renewed questions about the functioning and foundations of the highly volatile digital asset market.

It should be clear by now that taking a punt on cryptocurrencies, still a nascent asset class with a large number of flighty retail investors, is a perilous undertaking. Even so, the latest bout of turmoil has been more severe and consequential for virtual currencies and the rapidly developing infrastructure underpinning them.

Since its peak in early November last year, the market capitalisation of cryptocurrency assets has plummeted nearly 70 per cent to around US$900 billion. Bitcoin, the most widely traded token, is down 55 per cent since the end of March to around US$20,000.

More worryingly, cracks in so-called stablecoins, which are supposed to be pegged one-to-one to the US dollar to facilitate trading across the cryptocurrency market, have deepened. Tether, the largest stablecoin, failed to maintain its link to the US currency last month, partly because of a lack of detail about the reserves it had amassed to match the value of its coins in circulation. Some of Tether’s smaller rivals have imploded.

Many cryptocurrency lenders have also come under severe strain, fanning fears of a more rapid unwinding of highly leveraged bets on digital assets. For a sector that was on the cusp of going mainstream, the bloodbath could not come at a worse time.

The Bank for International Settlements, a well-known sceptic of virtual currencies, said in a report published this week that “the fact that stablecoins must import the credibility of central bank money is highly revealing of crypto’s structural shortcomings”.

Part of the problem is the persistent disconnect between the hype and fallacious narratives around digital assets and the enduring appeal and significant potential of blockchain-based decentralised finance. With cryptocurrencies under such intense scrutiny, the shakeout in the sector is an opportune time to set the record straight about virtual currencies.

First, bitcoin is not, and was never meant to be, a hedge against inflation, much less an “uncorrelated safe haven” as some proponents have claimed. On the contrary, digital tokens have been the biggest casualty of the abrupt and dramatic tightening in monetary policy that has clobbered risk assets across the world.

While traditional safe havens have proved less resilient than anticipated during recent periods of turmoil, bitcoin has displayed all the characteristics of a highly speculative asset that is acutely vulnerable to sharply deteriorating economic and market conditions.

Not only has it lost most of its value this year, it has shown itself to be strongly positively correlated with other risk assets, notably battered technology stocks. While bitcoin’s record-breaking rallies in the past two years suggest it makes sense to include it in a well-diversified investment portfolio, the bottom line is that it failed the most important test: outperforming in an intensely risk-off environment.

Second, the end to super-cheap money has accentuated cryptocurrency’s long-standing weaknesses. Investors have become much more discerning and are shunning speculative assets in favour of high-quality ones, particularly companies with clear business models and healthy balance sheets.

The disruptive technology that powered virtual currencies is now seen mainly through the prism of an unregulated, unaccountable and fraud-ridden system sustained by the sale of coins for speculation.

Moreover, in addition to the familiar criticisms of digital assets – limited use in everyday transactions, excessive energy use required to mine the coins and patchy oversight – it is now clear the promise of decentralised finance was illusory. The cryptocurrency ecosystem has proved far more centralised and prone to governance abuses than its enthusiasts would care to admit.

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Third, the carnage in digital asset markets masks the remarkable staying power of bitcoin. Despite experiencing a succession of bubbles in the past several years which burst in spectacular fashion, the dominant cryptocurrency has rebounded and gone on to scale new peaks.

The severity of the market reaction to bitcoin’s latest tumble is itself a sign of how far it has come since taking off in 2017. Wider institutional acceptance of cryptocurrencies is a double-edged sword. While it creates a more liquid and mature market, it increases the threat of financial contagion.

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Fourth, perceptions of virtual currencies differ depending on the country. In low-income economies, where access to banks is limited and people have grown accustomed to financial volatility, the willingness to experiment with digital wallets is stronger. El Salvador went so far as to adopt bitcoin as legal tender last year, becoming the first nation to do so.

The “weaponisation” of the US dollar to punish Russia for invading Ukraine, coupled with the dramatic tightening in US monetary policy, have heightened concerns about the dollar-based financial system. Many developing economies, which prioritise financial inclusion and fear the loss of monetary autonomy, are fertile ground for cryptocurrency adoption.

Bitcoin is a risk asset through and through, and it is still struggling to gain wider acceptance. Yet, its capacity to bounce back and the innovative potential of digital assets should not be underestimated.

Nicholas Spiro is a partner at Lauressa Advisory

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