Is the crypto crisis good for the system?
With digital assets, we are witnessing the rise of a new emerging asset class based on technology that has the potential to revolutionize the global financial system. This year, both macroeconomic downward and cryptographic upward headwinds have blown strongly across digital assets, resulting in the biggest drop ever in terms of the level of value destruction we have seen in the space.
Since the US Federal Reserve’s initial announcement in November 2021 to scale back asset purchases and tighten monetary policy, risky assets have come under heavy selling pressure. As a high-volatility asset class, digital assets were not immune to this move away from risky assets, which ultimately saw total market capitalization fall by around two-thirds from the peak. .
Therefore, in the early months of this year, top-down macroeconomic factors rather than token-specific factors were therefore driving the cryptos. As the correlation between the cryptos has remained high since the initial announcement of the taper, there was no place to hide as almost all tokens went down in parallel. Additionally, we believe that these high correlations between major tokens suggest a currently low level of sophistication and differentiation between the value propositions of different digital assets.
Stablecoins initially attracted investors with the touted benefits of decentralization and blockchain technology, while mitigating the infamous volatility of floating cryptos such as Bitcoin and Ethereum. Although there are many types of stablecoins, one of the increasingly popular methods of construction has become algorithmic stablecoins. These instruments rely on complex automated mechanisms and incentive structures to maintain their 1:1 parity with the underlying fiat currency, without holding fiat-denominated cash or cash-like securities.
The DeFi Liquidity Crisis
The total value of crypto assets locked in DeFi protocols, known as TVL, is one of the primary metrics investors use to gauge the level of activity and overall value in the DeFi ecosystem. In this regard, we have seen a dramatic decline in values since the start of the year, with overall TVL falling from over $250 billion to well below the current level of $100 billion. Lending protocols in particular have seen a very large chunk of their TVL plummet as investors have been spooked by the collapse of TerraUSD, prompting them to swap tokens held in lending pools for stablecoins, with the ultimate intention to cash in safer fiat currencies.
Wall Street Overflow
With digital assets gaining acceptance as a new asset class, the past few months and years have seen an increasing number of institutional investors open up to digital assets. This push by institutional investors such as hedge funds and other asset managers towards digital assets has not gone unnoticed on Wall Street, with several top banks rapidly developing expertise and capabilities in their digital assets.
Three Arrows Capital was the first big name to report significant losses from their crypto trading business. In mid-June, with significant exposure to the Terra/Luna ecosystem and other top crypto assets, reports began to emerge that the hedge fund had failed to meet a series of challenges. margin calls. As the fund filed for bankruptcy, records showing creditor claims of $3.5 billion, as well as estimated losses in the billions of US dollars over the period 2021-22, marking one of the largest losses hedge fund trading of all time.
Does it make sense to hold crypto in a wallet?
When considering the recent crypto crisis and its multiple episodes, the question now arises: is it still worth holding crypto and, if so, what proportion of a portfolio should be allocated to digital assets? Due to the nascent nature of the asset class, we based our analysis on Bitcoin, which is the largest, most established and mature crypto coin.
Overall, we continue to view crypto primarily as a yield enhancer in a portfolio. Historically, this assessment is supported by the fact that adding cryptos to a portfolio beyond a small weight of 1% or less has resulted in increased realized returns as well as realized volatility. Allocations of up to 5% may be appropriate for risk-seeking investors, while higher allocations would cause a significant change in portfolio characteristics and could ultimately lead to lower risk-adjusted returns.
We therefore maintain our view that cryptos are only suitable for investors who are able and willing to assume the associated risks. However, these risks could be rewarded with very attractive returns due to the potential disruptive power that we mainly see in the world of decentralized finance. Risk-seekers should also exercise caution, as digital assets are still a very loosely regulated area. The increasing regulation should build trust in the asset class and ultimately drive adoption. Due diligence is essential: if something seems too good to be true, it probably is.
Sipho Arntzen is the Next Generation Research Analyst at Julius Baer
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