Friday Focus: Digital Assets 2022 Review
Most digital asset investors and enthusiasts can’t wait to put 2022 in the rearview mirror. While it's hard to look away from the SBF/FTX collapse in November, that wasn’t the only impact from the meteor shower that was 2022. Before we say goodbye, let's take a look back at the big events that shaped the environment for digital assets this year. Cryptocurrencies hit an all time high market cap of $3 trillion in November 2021, and it's been downhill from there, as the space entered a crypto winter, and some of the worst abuses of the nascent markets came into full view.
Macro + Crypto:
Over the last two years, Bitcoin and by extension the entire crypto complex became highly correlated with global stocks, and subject to some of the same market drivers, especially rising interest rates. In the macro backdrop of inflation fighting, rate hiking central banks, crypto moved down with stock, but with more volatility than all but the hardest hit companies.
In May, the Terra/Luna ecosystem implied, triggered by a depeg of the algorithmic stablecoin TerraUSD, and the cratering of its related Luna, which was part of the “stabilization” mechanism which failed under market pressure. This triggered the first major wave of digital failures, most notably the bankruptcy of Three Arrows Capital (3AC), which managed lending/borrowing programs for now bankrupt Voyager Digital, Celsius, and many others.
In spite of all the seeming momentum of digital assets of regulation earlier in the year, nothing was passed by congress. President Biden’s executive order in March was a wakeup call to government agencies to get up to speed on digital assets and coordinate their efforts. Several bills were introduced to move more power to the CFTC and away from the SEC. Even before the FTX debacle, high-profile bills like the Wyoming Republican Cynthia Lummis and New York Democrat Kristen Gillibrand and Debbie Stabenow and John Boozman of the Senate Agriculture Committee were stalled in congress. The SEC continued regulation by enforcement, including the famous long running court case against Ripple (XRP), and the summary judgment against the LBRY digital content network.
SBF/FTX demonstrated both the need for sensible legislation and consumer protection and set it back. Sam Bankman-Fried was the face of the digital asset industry and was working with congress on legislation while committing fraud behind the scenes. Following the collapse of FTX, we can expect the US and other countries to be under pressure to move crypto regulation to the top of the legislative docket over the next couple of years.
DeFi suffered a setback in 2022, with some of the biggest hacks, including the Wormhole bridge in February where $325 million in ether was stolen. This showed vulnerability of bridge protocols which enable interoperability between different blockchains. Total Value Locked, a measure of DeFi usage and confidence, declined from to $96.3 billion in September from $302.8 billion in December 2021. This follows a surge of 1200% in 2021.1 Still, developers continued to build, and the risk of keeping cryptocurrencies on centralized exchanges and lenders demonstrated the need for safe decentralized exchanges.
This has saturated the news since FTX declared bankruptcy on November 11, so we are not going to spend time on it here. We will just comment this has elements of the Enron, MF Global, and Madoff frauds, where due diligence gave way to a compelling growth story, with the added twist that an offshore company was apparently manipulating crypto markets from the beginning.
One thing we have learned is that when digital institutions fail, there are no government bailouts like we saw during the global financial crisis. This purges the system of bad actors and excessive leverage. As Jeff Dorman, CIO of Arca put it ‘Some may say this is a failure of the system; others might say it’s what makes it beautiful. Broader contagion is not a risk, as the digital assets industry largely operates in its own world, with no government support to buoy the market. It rises and falls organically and shows us an alternative market structure free of government manipulation. Those that fail are allowed to fail and fail fast. Those that succeed do so on their own merit.” 2
TradFi goes DeFi:
Traditional financial institutions are moving into digital assets. Goldman Sachs executed its first OTC crypto trade this year, and is reportedly looking to buy some FTX assets out of bankruptcy, Cowen is planning to offer spot trading capabilities to clients, Bridgewater has announced plans to start a digital fund, and Fidelity announced plans to offer crypto in retirement accounts.
A few meteors fell in 2022, but digital assets continue to attract money and talent. Crypto startups raised $20 billion of capital across 616 deals through September 30, 43% higher than the first three quarters of 2021, according to Pitchbook 3. The future of the space will be shaped by regulation, which is sure to follow the market abuses this year. With sensible regulation and continued innovation, we believe digital assets, DeFi, and blockchain will recover from 2022 and continue to grow.
1 “Total value locked in DeFi drops 70% in 2022 to below $100 billion”, Ana Nicenko, Finbold, 9/27/22.
2 “That’s Our 2 Satoshis - 2022 Year in Review and Current Market Focus Points”, Jeff Dorman, Arca blog, 12/18/22
3 “2022 Crypto Venture Funding On Pace To Break 2021 Record”, Shalina Nagarajan, 12/8/22
“2022 – Crypto Markets: A Year in Review”, Jackson Wood, Coindesk, 12/8/22
“SEC wins LBRY case, but the victory may have little impact in the greater cryptoverse”, Derek Andersen, Cointelegraph, 11/14/22
You must evaluate your financial circumstances to determine if trading cryptocurrencies is appropriate for you. You should not invest funds in cryptocurrencies that you cannot afford to lose. The trading of cryptocurrencies can result insubstantial losses, including most if not all of your investment. For that reason, you should not use funds that are earmarked for special purposes, such as retirement funds, debt repayment funds, amounts needed for emergency expenses, tuition or household expenses or funds otherwise required by your lifestyle, to trade cryptocurrencies.
Unique Features of Cryptocurrencies
Cryptocurrencies are digital instruments that are intended to function as a store of value or a medium of exchange.Although cryptocurrencies are often exchangeable for various fiat currencies, unlike fiat currencies, cryptocurrencies are not backed by any government or central bank and do not constitute legal tender. Cryptocurrencies have no intrinsic value and there is no investment underlying cryptocurrencies. The price of cryptocurrencies is based on the agreement of the parties to a transaction, which may or may not be based on the market value of the cryptocurrency at the time of the transaction.
Cryptocurrencies derive their value from the markets in which they trade, and the markets for cryptocurrencies are global.The price of cryptocurrencies is based on the perceived value of the cryptocurrency and subject to changes in sentiment, which make these products highly volatile and unpredictable. The fluctuations of cryptocurrency prices are much greater than the price fluctuations of fiat currencies, which are also risky to trade. Certain cryptocurrencies have experienced daily price volatility
of more than 20%, including sudden drops in price. If participants in a given cryptocurrency market change their view about the value of a given cryptocurrency versus fiat currency, the price of the cryptocurrency can decline precipitously. It may be difficult to liquidate a position in cryptocurrencies at all or, if possible, such liquidation may occur at a significant loss. It is possible that the market for a given cryptocurrency can collapse altogether.
Valuation and Liquidity
Cryptocurrencies can be traded through privately negotiated transactions and through numerous cryptocurrency exchanges and intermediaries around the world, each with its own pricing mechanism and/or order book. Generally accepted auditing methods for cryptocurrencies do not exist and cryptocurrency platforms do not have consistent methods for auditing their holdings and some do not have audits at all. The lack of generally accepted auditing methods and a centralized pricing source pose a variety of valuation challenges. In addition, the dispersed liquidity may pose challenges for market participants trying to exit a position, particularly during periods of stress.
Cryptocurrencies and digital assets are commonly targeted by hackers and criminals who commit fraud, especially through social media platforms. The cybersecurity risks of cryptocurrencies and related “wallets” or spot exchanges include hacking vulnerabilities, cybersecurity attacks and a risk that publicly distributed ledgers may not be immutable. A cybersecurity event could result in a substantial, immediate, and irreversible loss for participants that trade cryptocurrencies. Cryptocurrency transactions may be irreversible, and, accordingly, losses due to a cybersecurity event are not recoverable. Even a minor cybersecurity event in a cryptocurrency is likely to result in downward price pressure on that product and potentially other cryptocurrencies.
Opaque Spot Market
Cryptocurrency markets are volatile and are subject to fraud and other trading aberrations. Cryptocurrency balances are generally maintained as an address on the blockchain and are accessed through private keys, which may be held by a market participant or a custodian. Although cryptocurrency transactions are typically publicly available on a blockchain or distributed ledger, the public address does not identify the controller, owner, or holder of the private key. Unlike bank and brokerage accounts,
cryptocurrency exchanges and custodians that hold cryptocurrencies do not always identify the owner. The opaque underlying spot market poses asset verification challenges for market participants, regulators and auditors and gives rise to an increased risk of manipulation and fraud, including the potential for Ponzi schemes, bucket shops and pump and dump schemes, which may undermine market confidence in a cryptocurrency and negatively impact its price. Most cryptocurrency platforms do not have surveillance
systems and rules intended to prevent market manipulation or other forms of abusive trading nor do they have the ability to enforce such rules.
Cryptocurrency Exchanges, Intermediaries and Custodians
Cryptocurrency exchanges, as well as other intermediaries, custodians and vendors used to facilitate cryptocurrency transactions, are relatively new and largely unregulated in both the United States and many foreign jurisdictions. There are no standard capital requirements for cryptocurrency platforms nor are there guarantors in the event a cryptocurrency exchange fails. The opaque underlying spot market and lack of regulatory oversight creates a risk that a cryptocurrency exchange may not hold sufficient cryptocurrencies or other funds to satisfy its obligations and that such deficiency may not be easily identified or discovered.
In addition to a higher level of operational risk than regulated futures or securities exchanges, cryptocurrency exchanges can experience volatile market movements, flash crashes, fraud, various forms of market manipulation, theft, transaction processing delays and other cybersecurity risks. Trading in cryptocurrencies may be halted by the various trading venues due to unusual trading activity, outages or other problems with a cryptocurrency platform. Those difficulties could prevent you from accessing the cryptocurrency in your account. Crypto traders and exchanges may not have sufficient financial coverage through bonds, insurance or other products to repay your losses.
Before you engage in trading cryptocurrencies, you must become familiar with the platform on which the relevant cryptocurrency trades. Generally, there is limited information about the various cryptocurrency platforms and because these platforms are complex and technically difficult for the average person to understand, you will need to put forth substantial effort to obtain the information necessary to understand the risks you are undertaking. You should understand the functions, operations and uses as well as the history for the platforms on which you invest. As described above, some platforms are subject to a variety of serious attacks, which may result in the loss of your cryptocurrency.
Different geographic locations have different rules, or oftentimes no rules, that apply to the trading of cryptocurrencies.One or more jurisdictions may, in the future, adopt laws, regulations or directives that affect cryptocurrency networks and their users. Changes in government regulation, such as the suspending or restricting of trading activity in a particular cryptocurrency or currencies, may adversely affect your ability to trade and exchange your cryptocurrencies and may decrease the value of any cryptocurrency in your account.
In the United States, cryptocurrency markets are not subject to federal regulatory oversight, but cryptocurrency exchanges are subject to federal anti-money laundering regulation and may be regulated by one or more state regulatory bodies.
As compared to regulated markets, such as the U.S. securities markets, there are no uniform regulations governing trading or other mechanisms to prevent market manipulation or to normalize the cryptocurrency markets when they experience volatility issues.
Unlike the laws, rules and regulations governing the U.S. securities markets, there are generally no laws, rules or regulations that require anyone to continue to support a cryptocurrency market, and there is no assurance that a person who accepts a virtual currency as payment today will continue to do so in the future.
Notwithstanding the foregoing, many cryptocurrency derivatives are subject to regulation by the CFTC. In addition, theSEC has cautioned that many initial coin or “token” offerings are likely to fall within the definition of a security and subject to U.S. securities laws. As a result, cryptocurrencies currently face an uncertain regulatory landscape in the U.S. and many foreign jurisdictions.
Many cryptocurrencies allow market participants to offer miners (i.e., parties that process transactions and record them on a blockchain or distributed ledger) the ability to earn a fee. While not mandatory, a fee is generally necessary to ensure that a transaction is promptly recorded on a blockchain or distributed ledger. The amounts of these fees are subject to market forces, and it is possible that the fees could increase substantially during a period of stress. In addition, cryptocurrency exchanges, wallet providers and other custodians may charge relatively high fees as compared to custodians in many other financial markets.
A number of governmental and self-regulatory agencies have published information alerting the public of the risks of digital currency. For example, see the CFPB’s Consumer Advisory , the CFTC’s Customer Advisory, the SEC’s Investor Alerts and FINRA’s Investor Alerts such as Bitcoin is a bit more risky, Getting a handle on virtual currencies, Bitcoin basics 9 things you should know about digital currency.