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.

Basel Committee Lags the Market in Digital Asset Regulation

Vlad Totia

The Basel Committee on Banking Supervision has announced it is to revert and revisit a set of rules on
capital adequacy requirements for cryptoassets held by banks that were viewed as punitive, resulting in
substantial pushback from a coalition of trade associations and a wide range of other market participants.
The controversial proposals were for banks to reserve capital to cover the value of cryptocurrency holdings
in full. This requirement would equate cryptocurrencies to the very riskiest assets, including those for which
banks lack the information to calculate exposures.
The coalition argued that this capital requirement would make it economically unviable for banks to
participate in this market, and put them at a competitive disadvantage while hindering progress towards a
digital future for the financial services industry.
The BIS has overshot in its attempt to create a legal framework for the market and push institutional
adoption and use of digital assets. While there clearly is an argument for the responsible management of
an inherently volatile asset by financial institutions, the strong market resistance shows that there is a lot
more appetite for innovation in the private sector.
The market is running ahead of regulators in this regard, but approaches vary between those banks that
are pushing ahead with digital asset engagement – potentially building competitive advantage but exposing
themselves to risk as regulation catches up – and those that are holding back pending regulatory clarity.
The longer it will take to have a functioning framework, the more difficult it will be for the ecosystem to
develop robust common standards. With the BIS scheduling its next consultation for next summer, banks
and other market participants are now facing the prospect of another year’s delay.
The Committee will now reassess its proposals and has stated: “Members reiterated the importance of
developing a conservative risk-based global minimum standard to mitigate prospective risks from
cryptoassets to the banking system, consistent with the general principles set out in the consultative
document. Accordingly, the Committee will further specify a proposed prudential treatment, with a view to
issuing a further consultative document by mid-2022.”

Navigating the Future: Network Managers Get to Grips with Digital Assets

Digital assets become a strategic priority

Institutional exposures to digital assets are rapidly rising. A recent study conducted by Global Custodian and Citi found that 43% of asset managers anticipate interest in digital assets and their related services will grow, while 38% of respondents acknowledged they were already actively participating in the nascent market.

As institutional investors increasingly pile into digital assets, some of the leading banks are beginning to develop their own proprietary crypto-custody solutions, providing safekeeping of private keys to digital assets, as well as crypto-brokerage and even crypto-derivative clearing services. For example, SC Ventures, the innovation arm of Standard Chartered, recently collaborated with Northern Trust to launch Zodia, an institutional-grade custody solution for cryptocurrencies. Elsewhere, Citi is reportedly looking to expand upon its digital asset servicing capabilities including in areas such as trading, financing and custody.

Beyond the banks, a number of fintechs have also established digital asset custody solutions aimed at supporting the growing chorus of institutional investors now participating in the market. As institutional-standard providers increasingly offer these services, investors will become more comfortable with buying digital assets. This comes following the Citi/Global Custodian survey, which found that broker-dealers’ biggest concern about digital assets is the absence of secure market infrastructures.

Aside from investing into digital assets, a number of Central Banks are looking to launch so-called Central Bank Digital Currencies (CBDCs), i.e. digital versions of their own currencies. These are distinguished from today’s mostly electronic forms of money by their cryptographically secured and fault-tolerant distributed nature. While they differ from the original goal of cryptocurrencies to avoid centralised control, they still bring many of the advantages of crypto to governments’ toolkits. CBDCs should not necessarily be seen through an investment lens but rather as a tool by which to obtain massive trade settlement efficiencies.

Proponents of CBDCs argue that the technology could even result in the emergence of instantaneous settlement or DVP (delivery versus payment). “CBDCs [are] mostly about settlement and the unification of asset and payment cycles. The adoption of digital tokens would allow exchanging tokenised financial instruments by simple token swaps to enable instant and atomic exchanges where both legs of the transaction need to succeed or none of them will, thereby eliminating open positions in trading and all settlement and credit risks”, says an article by the London School of Economics.

A number of tests involving CBDCs have been conducted. For example, one high-profile CBDC pilot involved a EUR 100 million bond issuance by the European Investment Bank on the Ethereum blockchain, which was subsequently settled using a CBDC from the Banque de France, the country’s central bank. Elsewhere, The Bank for International Settlements is currently overseeing two pilot schemes – Project Nexus and Project Dunbar – to build prototype platforms in order to conduct cross-border settlements in CBDCs between multiple countries.

Network Managers must prepare for change

The shift away from traditional financial instruments towards digital forms will create challenges for Network Managers, but these ought not to be insurmountable. As demand for digital assets increases, Network Managers have a greater imperative to recalibrate their due diligence efforts to conduct checks on digital asset servicers and infrastructures. Today’s assessment questionnaires and methodologies are not entirely appropriate for the digital asset ecosystem, and omit several new critical considerations.

“At the most rudimentary level, Network teams will need to familiarise themselves with new technologies, principally the distributed ledger technology that facilitates the trading and settlement of digital assets, and how asset servicing requirements such as income distribution, tax, corporate actions and proxy voting work in this environment. They may also need to assimilate new ‘blockchain events’ such as forks, airdrops, staking and mining into their processes. Network Managers need a firm grasp of the mechanisms that support the core ‘custody’ of digital assets – chiefly the protection and management of the private cryptographic keys that unlock the transfer of assets which exist ‘live’ on the Internet (in the form of distributed ledgers). This differs greatly from the traditional model of a central ledger in which a trusted authority acts as the ultimate record-keeper of ownership. In addition, Network Managers should improve their understanding of cyber-security, given some of the challenges cyber-crime has caused in the digital asset marketplace. This is an area where Network Managers will need to call on IT experts from within their organisations and trusted advisors to support them. Apart from these new areas, assessments of digital asset service providers – versus traditional custodians – will still rely on most of the principles familiar today. Many of the standard risk assessment components such as reviewing balance sheet capital strength or monitoring Straight Through Processing levels and settlement rates will continue to contribute to the due diligence process when applied to digital asset service providers,” says Andrew Wright of Thomas Murray Digital.

Adaptations to the market review process will also need to be made. Whereas some of the more advanced economies are in the process of introducing meaningful regulations to help oversee digital asset trading and settlement, such as the EU’s Markets in Crypto-Assets Regulation (MiCA), there are concerns about some of the more laissez-faire policies being pursued in certain emerging markets such as El Salvador. “Network Managers must ensure regulatory standards, investor protection measures and asset safekeeping mechanisms – as they apply to digital assets – are robust across markets and at the service providers that operate in them. Again, this will require Network Managers to leverage the expertise that they have obtained when conducting traditional market reviews and to apply it in a digital asset context. Bringing this rigorous approach to the sector will be one of the ways that banks can begin to make up for the ground lost to fintech providers, who may lack the risk management approaches and depth of regulatory relationships enjoyed by traditional service providers,” notes Wright.

Moving into a new investment universe

Traditional assets are not going to be swept aside abruptly. Instead, the general consensus within the industry is that conventional financial instruments will co-exist alongside digital assets for a long time to come, until the point at which they have all transferred to run on digital rails – either as new assets issued natively on blockchains, or existing assets represented in new token form. As Wright concludes, “Network Managers undoubtedly need to improve their understanding of digital assets and how they work if they are to remain relevant and flourish moving forward. Fortunately, many of the skillsets synonymous with contemporary Network Management can be adapted so that they can be applied to digital assets. Opportunities are there for those that are willing to invest that effort.”

Bitcoin Adoption in El Salvador Raises Policy Questions for Cryptocurrencies

El Salvador has been everywhere in the news recently as the first country to adopt bitcoin as legal tender. This puts the cryptocurrency on par with the US dollar, which has held this status since the country abandoned its own currency, the colon, in 2001. The move marks the first time in history that a country has adopted a fully digital and decentralised currency for official national use. Salvadorans can now transact, take loans and pay tax with bitcoin, if they so choose. Slowly but surely, adoption of digital assets has moved on from something solely for retail users, or used in niche circumstances such as paying wages to sporting stars, towards the mainstream of public sector acceptance.

While the launch of the programme did not run perfectly smoothly, with the government’s official Chivo wallet experiencing a temporary blackout due to usage exceeding system capacity, the infrastructure is now in place for one of the most interesting economic experiments in recent history. With this adoption come many questions, particularly surrounding how central banks and other national and international financial institutions will deal with settling payments with the small Central American nation. Will the Central Reserve Bank (CRB) of El Salvador take bitcoin and exchange it for USD? Will it eventually issue its own central bank digital currency (CBDC)? Given the volatility of cryptocurrencies today, will the CRB take steps to hedge against massive price movements?

One solution that could offer more long-term stability to the national economy would be for the CRB to create a stablecoin – a token pegged to and backed by a reliable underlying asset – against its own reserve of bitcoin, and issue that same stablecoin for use as a form of payment. This solution would be similar to a CBDC, essentially a tokenised version of the national currency, but would give the government the possibility of amending the peg should circumstances such as major price swings require it to take action to protect its economy, giving it some degree of monetary control.

With many other potential challenges ahead for this first-of-its-kind experiment, it is clear that policymakers all over the world will pay close attention to how the Latin country goes about tackling them. El Salvador may be the first country to take this leap but, given the noises from several other nations, it may very well not be the last.