State of the Digital Asset Market: ‘Crypto Winter’ and Silver Linings

Sun rays shining through clouds

Hugo Jack

Photo by Jonny Clow on Unsplash

For investors in digital assets, and cryptocurrencies in particular, the last couple of months have been something of a nightmare. Ongoing macro and geopolitical pressures have continued to hit the digital asset ecosystem as investors – both retail and professional – have continued to exit the market as uncertainty around the regulatory and fiscal environment remains. While 2021 was officially the year in which institutional investors entered crypto in significant numbers, it is fair to say that the digital asset sector is still reminiscent of the early days of the Internet, evidenced by ecosystem failures, the misallocation of capital, and poor investor protection.

That said, while a much-needed shakeout (mostly of irresponsible leverage trading) is taking place, a digital asset future is still very much on the cards. Just as the tech bubble in 2001 paved the way for the Internet success stories of today, now global banks, financial institutions and FinTechs are continuing to invest and build new operational models and DLT-based infrastructure. The scope for this new environment is not just cryptocurrencies, which constitute a meaningful but relatively small asset class, but all financial instruments including equities, bonds, funds and alternative assets that will in time all likely run on blockchain rails. That said, as cryptocurrencies currently comprise the largest part of today’s real use cases for digital assets, it is worth taking a look at what is happening today: where things are going wrong, but also the continuing positives driving the industry forward.

Digital assets continue to dive amid macro uncertainty and ecosystem failures

In the past couple of weeks the cryptocurrency sell-off has continued as bitcoin crashed to its lowest level in two years. The period from May to June has seen one of the largest month-on-month declines with over USD 416 billion wiped from the total market capitalisation, which now sits at USD 933.0 billion. Considered a key line of support, bitcoin crossed its 200-week moving average (200W MA) last week, which has reportedly only occurred three times in its 13-year history. Historically, this has usually correlated with a market bottom. That said, central bank tightening is likely applying greater pressure to markets globally, which in crypto is compounded by miners of bitcoin needing to sell their BTC rewards to cover their operational costs which currently stand at approximately USD 20,000 per bitcoin. Consequently, there may still be some way to go before any sign of a true turnaround can be found.

The crypto markets are still reeling from the collapse of the Terra/Luna ecosystem in May, which impacted tens of thousands of investors globally including a well-known Dubai-based crypto focused hedge fund, Three Arrows Capital (3AC). It was quickly reported that 3AC was facing insolvency after incurring at least $400 million in liquidations. It failed to meet margin calls and is now considering multiple options including an asset sale, or a bail out by another firm. Celsius, a crypto lending platform which at one point claimed more than USD 20 billion in assets under administration, has come under pressure by investors in an old-fashioned “bank run”, with depositors scrambling to pull assets from the platform. On Monday 13 June Celsius released a community memo announcing its decision to pause all withdrawals, swaps and transfers between accounts, an option which it reserved under its terms of use. According to reports, Celsius is similarly in the process of considering insolvency proceedings and has appointed a legal firm that specialises in business restructuring, as well as hiring Citigroup as an independent advisor to brainstorm possible financing options. Nexo, another lending platform, put forward an unsolicited offer to acquire “any remaining qualifying assets”, although following a swift initial rejection it is unlikely the offer will be accepted.

It is unclear where the market goes from here. A significant amount of speculative capital has been put into the crypto ecosystem over the last couple of years during a period of exceptionally loose monetary policy and government stimulus; however, a flight to safety is now well underway across all asset classes. In addition, well established and high profile firms have put their reputations on the line and acquired significant amounts of bitcoin; the poster child for this tactic is MicroStrategy (Nasdaq: MSTR) which has 130,000 bitcoin, acquired at a cost of circa USD 3.97 billion, on its balance sheet, bought with cash from sequential debt offerings totalling nearly USD 2.4 billion. As a significant holder of bitcoin, all eyes are on the institution which at current prices is facing an unrealised loss of over USD 1 billion. In May it was reported that if bitcoin fell to USD 21,000 then a margin call would be triggered on a USD 205 million loan it took with Silvergate Bank in March to purchase additional bitcoin. That number was reached last week and has in the following thereafter gone as low as USD 17,744 as of Saturday 17 June. There is an inevitable concern that further liquidations would panic the market even further, however, MicroStrategy CEO Michael Saylor confirmed last week that a margin call had not been made, and that the company has reserves to protect against bitcoin dropping much lower.

Re-evaluation of business needs triggers firing and hiring

The bear market and general downturn is causing concern across the industry, as companies grapple with the implications of a looming recession and even stagflation. Financial considerations are being made a priority amidst declining revenues. Consequently, some digital asset institutions have announced reductions in head count. Coinbase (Nasdaq: COIN), one of the leading digital asset custodians and exchanges, announced cuts to staff of 18%, or approximately 1,100 staff, and furthermore rescinded 300 new hire offers. Gemini, an equally established exchange, expects to lay off 10% of its employees, while BlockFi and, more retail focused entities, will reduce headcount by 20% and 5% respectively, citing a “dramatic shift in macroeconomic conditions worldwide” which are impacting growth. However, at odds with the trend is Citibank, which this week announced its intention to hire 4,000 tech workers in a $10 billion effort to enhance online customer experience. It is joined by Binance and Kraken, two of the largest and most well-known cryptocurrency exchanges, which have similarly advertised their on-going efforts to recruit for 2,000 and 500 new positions respectively.

Longer-term sentiment remains positive as adoption increases

Despite the obvious pain that is being felt by the market during the latest crypto winter, sentiment around the future of the ecosystem and about cryptoassets remains positive. This week, Bank of America carried out a survey in which 91% of US adults said they plan to buy more cryptoassets over the course of the next six months, with 30% of respondents confirming their intention to hold their assets for at least the next six months despite the uncertainty. Echoing this sentiment, PwC’s Global Crypto Hedge Fund Report showed that allocations by crypto-focused and traditional hedge funds have increased over the past year, with 38% of traditional hedge funds currently investing in digital assets, up 21% from a year ago. Furthermore, 27% of the traditional funds that had not yet invested in digital assets reported that if the main barriers to adoption were removed they would accelerate their investments in them. Capgemini, a leading technology consulting firm, also released its 2022 World Wealth Report last week. Of the 2,973 global High Net Worth Individuals (HNWI) polled, 71% of them have allocated capital to cryptocurrencies and other digital assets. Furthermore, in assessing the demographic of respondents, 91% of under 40s have invested in digital assets, with Capgemini observing that cryptocurrencies remain their favourite digital asset investments for now. Even J.P. Morgan – whose chairman and CEO Jamie Dimon has been famously anti-bitcoin – has declared cryptocurrencies its new favourite alternative asset in preference to real estate, and has set a ‘fair value’ for bitcoin of USD 38,000, nearly twice its current price. And a joint PayPal and Deloitte survey of 2,000 senior U.S. retail executives found that nearly 85% of them expect digital currency payments to be ‘ubiquitous’ within the next five years.

Continued growth in institutional products and services

In other news, Goldman Sachs (GS) has launched a derivatives product linked to ether (ETH). The non-deliverable forward will enable investors to speculate on the price of ether without having to hold it directly. It comes at a time when investor confidence is low in the short term, however the firm reinforced its belief that digital assets are still desirable, stating that “institutional demand continues to grow significantly in this space”, with this offering helping the firm to evolve its nascent cash-settled cryptocurrency capabilities. And despite the reputation of stablecoins taking a knock of late, demand for them remains high as Circle Internet Financial – creator of the popular USDC dollar-pegged token – launches a new regulated euro-pegged stablecoin, EUROC, fully backed by euros held in custody by US qualified custodians.

Digital infrastructure for the repo market is also having a good month. BNP Paribas recently joined J.P. Morgan’s Onyx Digital Assets system, a tokenisation platform whose Intraday Repo application has processed over USD 300 billion of US treasury-based transactions in the year since it launched and is now looking to tokenise money market funds and other traditional securities as collateral. Meanwhile, Finteum’s DLT-based intraday FX swap and repo trading platform – due to go live next year – has been successfully tested by 14 banks, including Citi, NatWest and Barclays.

In Japan, the country’s two largest banks are making further moves in the digital asset space. Nomura – already one of the backers of custodian Komainu – will launch a new wholly-owned subsidiary to offer a range of digital asset services to institutional clients, with an unnamed executive quoted as saying, ‘If we don’t do this, then it’s going to be more difficult down the line to be competitive’. Meanwhile, Tokyo cryptocurrency exchange Bitbank has partnered with Sumitomo Mitsui Trust to create a new institutional digital asset custodian to be named Japan Digital Asset Trust. And the country has just become the first to pass legislation to limit yen stablecoin issuance to licensed institutions and guarantee their redemption back into fiat currency at par, a move that come into effect next year as a consortium of 74 Japanese banks and corporations moves to launch a private sector yen stablecoin.

Growing pains belie a maturing sector

The current market shake-up is inflicting short-term pain on investors, and the drying up of the previous flood of cheap capital that led to poor investment choices is now consigning thousands of weaker tokens and their associated projects to the scrap-heap. Investors are being reminded of the need to focus on utility and fundamentals over speculation. The last crypto market crash occurred in early 2018 when cryptocurrencies were the preserve of retail investors and the bravest of hedge funds, and institutional-grade services and infrastructure were not yet established. Four years later, the build-out of the foundations of the future financial system has got off to a strong start and continues apace. At the same time, regulation is beginning to catch up with the exuberant growth of this sector. We are witnessing the latest shift in a free market that should lead us to a more robust digital asset economy. Perhaps this moment will be seen in retrospect as an inflection point in the march towards a future financial system that encapsulates the best aspects of both stability and innovation.

SEC Prompts Crypto Custodians to Move Client Assets On-Balance Sheet

Coinbase logo on laptop

Andrew Wright

Coinbase logo on laptop
Photo by PiggyBank on Unsplash

Coinbase, one of the world’s largest crypto custodians, has disclosed that “in the event of bankruptcy, crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings.” The admission was part of a quarterly earnings report the company filed with the US Securities and Exchange Commission (SEC). Coinbase CEO Brian Armstrong revealed that this was because of the recent publication of SEC Staff Accounting Bulletin (SAB) 121 which requires any crypto asset custodian to ‘present a liability on its balance sheet to reflect its obligation to safe-guard the crypto-assets held for its platform users.’ The SEC expects such disclosures to be made by all businesses that ‘custody’ crypto assets no later than in financial statements covering the first interim or annual period after 15 June, so we will potentially see a wave of similar disclosures in the near future.

Coinbase’s declaration that customers’ assets may potentially form part of any bankruptcy estate, and that the customers may be treated as general unsecured creditors, has caused a stir within the crypto industry. Were Coinbase to go bankrupt, the implication is that many of the assets it holds for customers may go with it. Coinbase Custody, which has a New York state banking licence, points out that it has never had a security incident in over 7 years of operations. However, customers choosing from competing custody services will want the absolute minimum risk in exchange for their fees.

Coinbase’s custody business is standalone from the rest of the group and only provides cold storage, so it could rapidly end up being obsoleted and out-competed by traditional, larger bank custodians. This is a view shared by Nadine Chakar, the head of State Street Digital, as expressed at a recent Fund Forum panel discussion. Global Custodian reports Chakar as commenting, “unless you have larger custodians moving into the space and be the big kids at the table, it’s (digital assets) unlikely to see institutional adoption”. She called for more regulation to provide clarity.

SAB 121, published on 31 March, expresses the views of SEC staff but is not a formal rule. Despite this, it is very prescriptive regarding the detail and format of disclosure it expects to see. The financial statement impact is as simple – and dramatic – as moving the value of assets under custody onto the service provider’s balance sheet through a liability and matching asset at the fair value of those assets at the time of each filing (broken down into each significant crypto asset in notes to the accounts). The suggestion is that this should take place regardless of the entity’s assessment of the actual “legal ownership of the crypto-assets held for platform users, including whether they would be available to satisfy general creditor claims in the event of a bankruptcy”. As such, it would mark a sharp divergence in practice compared to the accounting treatment for assets under custody in traditional asset classes. Further, there should be a detailed discussion of the technological and legal risks and uncertainties facing the business in relation to safekeeping digital assets in other areas of filings outside the financial statements.

Coinbase’s lawyers will doubtless have considered the potential impact of this disclosure but, due to the lack of clear legislation and regulation cited by Chakar, and a desire to be seen as compliant with SEC expectations, have concluded that they should acknowledge that clients’ custodied assets “could be subject to bankruptcy proceedings”. It remains to be seen whether other crypto custodians will fall into line given the arguably optional nature of this guidance, pending the debate it is causing being worked through to a conclusion.

The new guidance overrides the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification 940, which states that broker-dealers holding client assets should keep them off-balance sheet – although the SEC is not yet licensing broker-dealers for crypto activity – and that otherwise custodians should assess whether they have a sufficient degree of control over those assets, as they would with traditional assets under custody. In other words, the FASB treats this as a judgment-based decision that may hinge on aspects such as the degree of customer control of their own assets through measures such as key sharing.

One of the five Commissioners of the SEC, Hester Peirce (a Trump appointee) has responded to the bulletin. Her view is that the SEC and the market have been aware of risks for a long time and already review custodians’ financial statements; that an interpretive Staff Accounting Bulletin is not the appropriate place to make rule changes; and that the SEC has itself been partially responsible for creating the legal and regulatory risks that have driven this accounting treatment by failing to provide adequate guidance on crypto assets. She also believes that some consultation with the FASB and with affected companies would have been helpful.

These are fair points, if politically motivated; the end result may be worthy, but Peirce is far from alone in denouncing the SEC’s methods. Around the same time, on 16 March, members of Congress from both parties wrote to Chair Gensler to criticise the SEC’s behaviour relating to crypto businesses, pointing out that its many requests for voluntary disclosures outside its remit amount to a jurisdictional land-grab by stealth, and also set it up in competition with the CFTC in some areas. These requests are accompanied by enforcement actions and fines despite clear guidance from the SEC; a reluctance to license broker-dealers and to authorise crypto-backed ETFs; and a determination that interest-bearing lending products are unlicensed securities. President Biden’s recent Executive Order may effect a change in attitude, particularly as one of its main goals is to ensure that the US is a competitive and attractive market for digital assets and related technologies.