Parilov - stock.adobe.com
As corrections go, the cryptocurrency crash of 2022 was particularly brutal.
In November 2021, the market had surged to a peak valuation of almost $3tn. By June 2022, it had lost over two-thirds as inflationary pressures and a gloomy economic outlook spooked investors. Inevitably, questions were raised about the role and function of crypto assets in the wider economy – a debate pitching passionate supporters against critics.
Touted as a democratically advantaged alternative to conventional currencies, cryptocurrencies are considered by some to be an alternative to gold, capable of beating stock market downturns and hedging inflation. But their short history has been plagued by their own volatility.
Sceptics argued vindication after the rapid 2022 crash and resulting high-profile failures of stablecoin issuers and crypto platforms, which further dented confidence. You could go as far as to suggest that there is an inherent and almost irreconcilable tension between the fact that the things that make cryptocurrencies attractive – decentralisation and anonymity – also make them risky and hard to regulate.
Yet while some people would have you believe we have reached the end of the road, in my view the story is far from over.
Before the fall
Things have moved a long way since the 2008 whitepaper in which the pseudonymous Satoshi Nakamoto first outlined the idea of a digital currency that could operate without financial institutions acting as intermediaries. Tellingly, the paper was published just weeks after Lehman Brothers collapsed during the height of the financial crisis, shaking public confidence in those who look after our money.
Over the following decade, the crypto asset market simmered, then boomed, and the expectation born of a passionate group of supporters soon followed. There were multiple drivers for this success, ranging from developments in blockchain technology – most notably decentralised finance (DeFi) – to the sheer amount of investment into crypto businesses – particularly through initial coin offerings and venture capital funding.
A harsh winter
This cocktail of investment and rapid growth of the DeFi ecosystem helped drive sharp growth. Some of crypto’s more enthusiastic backers touted digital currencies as immune to the pressures facing conventional fiat currencies, an ominous mix of surging inflation, but successive macroeconomic and geopolitical challenges have shown this assertion to be flawed.
Various market participants felt the chill, from crypto exchanges and brokerages to lending and borrowing platforms. Many retail and institutional investors, alongside venture capital funds, found themselves exposed due to rapidly declining investments and loan defaults. It is my contention that, unfortunately, this spiral has not stopped – more insolvencies are to be expected.
Even the institutional crypto miners that underpin the most popular proof-of-work blockchains, such as bitcoin, are feeling the pressure of soaring energy costs and lower crypto prices. Many have departed from their longstanding “hodl” (hold on for dear life) strategies and are selling their earned tokens at an alarming rate. If the miners faulter, the knock-on impact will be felt across the industry.
There is also the possibility that we may see the harsh winter extended by claims arising in respect of mis-selling and as a result of exchanges halting trading. Aggrieved parties may claim to have lost out because of any such decision because they did not have enough time to cash out or margin calls. Evidence suggests that the number of cases like these is already on the rise.
That said, it is far from clear how and when insolvencies will materialise. The fact is, different jurisdictions measure financial health differently. Take Australia, for example, which has a concept of insolvent trading that is measured by a company’s ability to pay its debt in fiat terms. Similar concepts exist in Singapore and the UK. For all three jurisdictions, it is unclear how liabilities play out where the assets and obligations of a company are significantly in crypto.
Crucially, crypto assets themselves will be relevant during insolvency. While their precise status is still being worked out under many legal frameworks, Australia, Singapore, New Zealand and the UK are all among jurisdictions likely to consider certain types of crypto asset as property, which can be enforced against in proceedings. At the front of mind should therefore be whether a distressed company or third-party custodian holds crypto assets, and whether it is possible to secure them upon an insolvency event.
A promise of spring
Of course, clear skies follow every storm, and the crypto players that have weathered 2022 are alive to the resulting opportunities. One of my colleagues noted recently that we are already starting to see a degree of market consolidation being driven by big players snapping up the little ones that don’t have the runway to see it through this crypto winter.
At the same time, the idea of an irreverent and decentralised environment defined by regulation meant for a previous era is looking increasingly impracticable for much of the crypto market. Senior policymakers are alert to this. Earlier this year, the vice-chair of the Federal Reserve stressed a need to “future-proof [the US] financial stability agenda” and “ensure the regulatory perimeter encompasses crypto finance”. A similar view is being taken in many other countries.
There is also an important and often missed distinction to be made between crypto assets and the blockchain technology that underpins them. Distributed ledger technology – of which blockchain is one type – can bring real benefits and will continue to evolve. Ethereum’s recent high-stakes move to a new platform (dubbed “The Merge”) is a striking illustration of this. The second most dominant blockchain underwent a transition from being a vastly energy-intensive “proof of work” system – which relies on powerful connected computers solving complex puzzles to add new transactions to the blockchain – to “proof of stake”.
This move, which was completed just a few weeks ago, addresses one of the most potent criticisms of the crypto market – its vast energy use at a time of global warming and rising prices. The energy these systems need can be astronomical and increases all the time. Bitcoin, for example, today consumes more energy than Argentina.
But this isn’t just about slashing energy use. For the Ethereum blockchain, The Merge paves the way for radical upgrades that will enhance transaction speed and stabilise costs on the platform. In my view, it is a good test case for an industry that is driving towards a greener future that will help it move further into the mainstream.
The technology advances
It would be easy to imagine that institutional lenders – the entrenched financial elite that crypto has so often defined itself against – would be feeling a sense of schadenfreude since the crash. But many, including banks, are keenly watching as the technology advances and use cases diversify.
The most nimble challenger banks have already started to capitalise on the continued customer demand for crypto, with some registering as crypto asset firms with regulators in what could be read as a bet that they are here to stay.
With this in mind, the question of whether crypto assets are reasonable investments or glorified punts may be justified, but also misses the bigger picture. They – and the blockchain technology they run on – are increasingly moving into the mainstream and will continue to reshape the financial landscape. The result is that attention on potential regulation will continue to intensify, as regulators grapple to balance innovation with consumer protection.
The European Union is in the process of implementing a landmark package, the Regulation on Markets in Cryptoassets (MiCA), which is designed to protect consumers and increase transparency in the European crypto market. At the same time, regulators in Australia have been exploring a draft bill to regulate certain providers of crypto assets, while the UK is moving towards regulating cryptocurrencies and stablecoins as part of government plans to make the jurisdiction “a global crypto asset technology hub”.
At the end of the day, financial markets move in cycles and we are living through a significant and noteworthy one for crypto. How long that takes to run its course, and what it will look like on the other side, are anyone’s guess. But blockchain technology and crypto assets will continue to have a role in modern financial ecosystems – there is clearly value in them.