Crypto Edition

by
Leo Wealth

The Digital Assets Financial Crisis

Harmen Overdijk, CFAAleksey Mironenko

In our view, the 2022 “crypto winter” led to a healthy shake-out in the whole digital asset space. In the past three months, the crypto world has found out that the “laws” of financial markets also apply to the new digital asset space. Digital assets are a technological breakthrough. But they are still traded in financial markets. By people. This means they are subject to the same dislocations and inefficiencies experienced by all financial assets. 

Traditional macro factors like market liquidity, risk sentiment, and interest rate movements also greatly impact the crypto space. Several relatively new digital asset players discovered the perils of using leverage without proper risk protocols. It started with the collapse of Terra, which was a stablecoin based on an unrealistic assumption that the Luna coin would always be valuable enough to act as a counterweight for Terra. That was, of course, based on trust in Luna, and when that disappeared, the whole algorithm collapsed.

This set off a chain of events not dissimilar to banking during the Global Financial Crisis. The collapse of Terra and Luna led to the demise of 3 Arrows Capital, which was a highly levered hedge fund, invoking parallels with the LTCM collapse in 1998. This led several 3AC lenders, like Voyager Digital and Celsius, to go bankrupt as their balance sheets couldn’t absorb the losses due to poor risk management. In the wake of this, the market cap of the whole crypto space fell by 70%. We think this was a healthy shake-out as there were excesses that had built up in the digital ecosystem. It is unlikely we will have another bull market like we had last year any time soon, no matter what crypto hopefuls think. That is not how financial markets work.

Does it mean you should not invest in digital assets? On the contrary, what happened is an important step in creating a more mature digital asset market. From a macro point of view, we believe inflation will peak. The Fed will raise interest rates but is unlikely to become more hawkish, allowing risk sentiment to return to equity markets. Taking this into account, it is probably a good time to build up positions in digital assets again.

Crypto’s Changing Role and Its Signal Today

Diehard fans view cryptocurrencies as anti-inflation and anti-fiat alternatives to gold. Skeptics point to Bitcoin’s collapse despite inflation in 2022. In our view, both are right but over different time horizons. In the near-term, crypto is pointing to risk for global equity markets.

The long view: Bitcoin’s finite supply makes it not unlike gold – a limited resource that has value to those who believe in it. Bitcoin has no use and consumes a lot of energy. Gold similarly takes energy to mine, while its real-world usage is laughable. Only 3% is used for medical and industrial purposes. The other 97% is used for investment and jewelry (the very definition of belief in value). So how do we explain gold’s relative steadiness through 2022 inflation (down 6% YTD) vs. Bitcoin’s collapse? If inflation is a monetary phenomenon caused entirely by money supply increases, then it makes sense for Bitcoin – a liquid, digital form of gold – to react to the cause rather than the symptom of inflation. Much like the stock market, Bitcoin looks ahead. Its growth is a multiple of global money supply growth, which peaked in 2021 (chart). Money supply growth is a feature of the fiat system, which means that Bitcoin pricing will continue to have long-term upside.

The trading view: Despite mass adoption claims, Bitcoin is traded by 50-100MM people globally, less than the number of gold savers in India alone. Given such low adoption, short-term pricing is influenced by “at the margin” trading and ongoing adoption, i.e., risk on/off sentiment. In fact, the 90-day correlation of Bitcoin to S&P 500 is now 0.64. The relationship is clear when Bitcoin is viewed on a log scale. Both rallied in 2017 and then corrected in 2018. Both rallied again in 2019, fell during COVID, and rallied again. Finally, both peaked at year-end and corrected in unison in 1H22. In nearly all cases, the Bitcoin move was not only larger but also more violent, or earlier, than the S&P 500.

What should investors make of this? Bitcoin’s rally (+25% in July) may well be a preview of the S&P 500 direction in the short term. Bitcoin can be a coincident, maybe leading, indicator of risk-on sentiment in markets. It’s suggesting a rally in the months ahead. Longer term, volatility will decrease as usage moves beyond early adopters, allowing Bitcoin prices to grow in line with money supply. It will become a long-term fiat hedge. For investors, the risk is asymmetric: a price of 0 is unlikely at this point, whereas an eventual price of 100k has money supply growth as a permanent tailwind. Investors should size appropriately and trade at the margins but maintain exposure long-term.


DEFINITIONS & DISCLOSURES

The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to the accuracy, completeness, or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency. 

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

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