Opinion: What’s Driving ‘Crypto Winter’?

As record high temperatures have scorched the northern hemisphere, winter has hung over the crypto industry, with 2.25 trillion lost across the market in the last few months alone.

Nevertheless a report released in June by technology consultancy Capgemini found that approximately 71% of high net worth individuals (HNWI) have invested in digital assets – a figure that rises to 91% for those under 40. Cryptocurrencies were reported as the favorite digital asset investment, followed by exchange-traded funds (ETFs) and metaverse investments.

It is true that this time it is different, and the growing interest from institutions will undoubtedly lift us out of the slump eventually. But if this latest research paints such a rosy picture, what are the underlying reasons why we find ourselves in this crypto winter?

1. Hawkish Fed policy

In the context of the US suUS’ soft monetary policy in recent years, the debt burden to the markets has grown significantly, while borrowing has been carried out at historically minimal interest rates. As a result have Federal Reserve raised its benchmark interest rates by 75 basis points (bps) on June 15 to curb inflation that reached 8.4% in May.

This has inevitably seen a simultaneous increase in interest rates on deposits and loans, too, prompting people to move money out of high-risk assets – including stocks and cryptocurrencies – into protective deposits, as the latter begin to offer more attractive returns.

A rise in interest rates also affects the return on US bonds. When the deposit rate rises, in order to attract investors to buy US government debt, the government must offer a correspondingly higher interest rate. As the risk-free rate of return increases, so does the required rate of return on investments in risky assets, so that investors overprice them down. While this applies to all stocks, the companies most at risk are those not yet earning EBITDA or FCF – typically high-growth technologies and biotechs, where the bet is on the company’s corporate potential.

2. Correlation between crypto and stock market

Cryptocurrencies have gone through various stages in their lives. They were basically “fads” that “eeks” and fanatics invested in. Some were “digital gol” “investors” led to hedge against the risk of a falling stock market.

With the increase in mass adoption, cryptocurrencies began to take the position of a specific, risky, but in many ways common stock market asset – facilitated in part by the rapid growth of institutional adoption in recent years.

The influx of such large investors has seen capital increase and patterns and strategies for trading and investing emerge. This has led to cryptocurrencies – especially Bitcoin – since 2020 becoming financial instruments similar to other exchange-traded assets, only with increased risk. This has led to a high correlation with the stock market which in the current crisis has been to the detriment of the crypto market.

3. Regulatory challenges

2022 has been a roller coaster ride for cryptos. The global crypto market has been under scrutiny by many different authorities, with varying degrees of regulation popping up all over the place. Many are still studying cryptocurrency and trying to create appropriate regulatory frameworks for the ever-evolving space. Central banks are actively developing CBDC concepts that could affect the distribution of stablecoins, regulators are reviewing the conditions for obtaining licenses, and all new jurisdictions are on the FATF gray list.

All these regulatory changes clearly affect crypto companies and investors, creating the effect of a suspended state where it is extremely difficult to make clear entry and action strategies in the market. In fact, until there are regulations governing the reporting and trading of cryptocurrency assets, these price drops are unlikely to be the last.

For a large financial company, this kind of uncertainty is unsustainable. Because of their massive balance sheets, they can avoid speculating in assets that could lose them huge amounts of capital due to underlying fiscal problems. The monetary withdrawal and reduction of balances will have an effect on all assets. But with broader institutional adoption still in its early stages, the next wave of financial capital could be huge. The key to unlocking is in the hands of the regulators.

Waiting out the winter

Confidence seems to be resurging in the market, but these three factors represent significant “cold fronts” in the global crypto market.

Despite the volatility and fears surrounding the “crypto winter”, investor interest in the region has not stagnated – suggesting that the momentum for mainstream adoption of digital assets is likely to continue. Of course, we see some institutional investors actively taking profits in an attempt to retain at least some of their assets. But many other investors lay low, so as not to lose more from the market’s fall.

No one knows how long this crypto winter may last. What we do know is that winter always ends, and that the spring that follows can bring with it rich opportunities for growth.

Image source: Bitfrost