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It has been a while since we last turned our focus on crypto, one of the most pressured market segments this year. Given heightened sensitivity to liquidity conditions, digital assets ran into turmoil very early on, in fact before the latter spread to broad financial markets at the beginning of this year. For the record, digital assets in total nearly reached a market capitalisation of USD 3 trillion last November.

An impressive market recovery

Yet by the end of the first half of 2022, they had given back more than two-thirds of this. Now, along with other risk assets, the crypto market experienced a recovery in July. Total crypto market capitalisation is back above USD 1 trillion. Does this mean the so-called ‘crypto winter’ is over?

The jury is still out, as a great deal depends on the trajectory of financial conditions – in the near term, the asset class remains acutely vulnerable to a renewed tightening. By now, the pandemic stimulus impact has been entirely reversed. Gains accrued to investors who parked their stimulus cheques and excess wealth in digital assets in the run-up to the pandemic recovery have been wiped out.

Looking for the positives

While the performance picture remains bleak year-to-date, there are some positive developments beneath the surface. In what we called a cleansing effect, the market rout relentlessly exposed questionable business models only viable under ample liquidity conditions. Most prominent examples include the collapse of several unbacked algorithmic stablecoins, bankruptcy filings by crypto-lending platforms, as well as a forced liquidation of one of the largest crypto hedge funds.

In the case of crypto-lending platforms, investors were essentially lulled by the promise of “guaranteed” yields (can you hear the alarm bells ringing?) at absurd levels. In fact, these platforms employed strategies requiring the use of outrageous embedded leverage, while being backed by insufficient, poor quality, or sometimes even no collateral.

Ultimately, the inherent asset-liability mismatches – liquid liabilities given generous redemption terms coupled with an asset side burdened by illiquid yield strategies – of these business models surfaced, boosting withdrawal requests and eventually exacerbating the downturn.

There is nothing new about this chain of events. Throughout history, financial markets have seen several credit crunches that followed a similar sequence, most notably the Great Financial Crisis. This time around, fortunately, crypto markets are not as big or as interconnected yet to pose widespread risks affecting broader financial markets, thus the damage is limited to idiosyncratic failures such as those listed above.

What role will regulation play?

Unsurprisingly, the latest casualties led to renewed calls for regulatory intervention in the space, including from the US Federal Reserve Vice Chair Lael Brainard.

Sound regulatory oversight is to be welcomed per se, as it enhances consumer protection, addresses financial stability concerns, and ultimately facilitates institutional adoption, but incoming legislation on both sides of the Atlantic also speaks for itself – regulators do not expect the digital asset ecosystem to fade into obscurity. Neither do we.

We continue to like the optionality offered by a small allocation to digital assets in a portfolio context. A recent study by the CFA Institute Research Foundation found an allocation of up to 4% to be appropriate for risk-sensitive investors. Using historical data, such an allocation would have left key portfolio risk metrics largely unchanged, whereas an allocation of more than 4% would have disproportionately affected them.

The analysis examines the addition of Bitcoin in isolation, however, we believe emphasis should be put on a diversified, carefully selected exposure. Latest market action ruthlessly revealed that prudently managing idiosyncratic risks in the space is of paramount importance.

In summary, the fundamental case for the disintermediation enabled by blockchain technology is far from dead. Viable commercial applications of blockchain technology are slowly but surely emerging. Remember, while the dot-com crash led to the failure of some of the hottest internet stocks at the time, among the survivors were highly competitive companies that introduced e-commerce, social media, online streaming, and cloud computing – the rest is history.

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