With digital assets, we are witnessing the emergence of a new and nascent asset class built on a technology that has the potential to revolutionize the global financial system. This year, both top-down macroeconomic and bottom-up crypto-specific headwinds have blown hard for digital assets, resulting in the biggest downturn ever in terms of the level of value destruction we’ve seen in the space.
Central banks
Since the initial announcement by the US Federal Reserve in November 2021 to scale back its asset purchases and tighten monetary policy, risk assets have suffered from strong selling pressure. As a high-volatility asset class, digital assets were not immune to this pivot away from risk assets, which eventually saw its total market capitalization fall by around two-thirds from its peak.
Therefore, during the first months of this year, top-down macroeconomic factors rather than token-specific factors were in the driver’s seat for crypto. Since the cross-crypto correlation has remained elevated since the initial tapering announcement, there was nowhere to hide as almost all tokens moved lower in lockstep. Furthermore, we believe that these elevated correlations among the leading tokens suggest a currently low level of sophistication and differentiation between the value propositions of different digital assets.
Stablecoin shakedown
Stablecoins first attracted investors with the touted benefits of decentralization and blockchain technology, while mitigating the notorious volatility of free-floating cryptos like Bitcoin and Ethereum. While there are many different types of stablecoins, one of the increasingly popular construction methods was algorithmic stablecoins. These instruments rely on complex automated mechanisms and incentive structures to maintain their 1:1 peg to the underlying fiat currency, without holding fiat-denominated cash or near-cash securities.
The DeFi Liquidity Crisis
The total value of crypto-assets locked into DeFi protocols, so-called TVL, is one of the main metrics that investors use to gauge the level of activity and the overall value of the DeFi ecosystem. In this regard, we have seen a dramatic decline in values since the beginning of the year, with aggregate TVL falling from over $250bn to well below the $100bn level currently. Lending protocols in particular saw a very large portion of their TVL decline as investors were spooked by the TerraUSD collapse, prompting them to exchange tokens held in their lending pools for stablecoins, with the ultimate intention of cashing out into safer fiat currencies.
Spillover on Wall Street
With digital assets increasingly accepted as a new asset class, recent months and years have seen an increasing number of institutional investors warming up to digital assets. This push from institutional investors such as hedge funds and other asset managers into digital assets has not gone unnoticed by Wall Street, with several high-profile banks rapidly building their digital asset expertise and capabilities.
Three Arrows Capital was the first high-profile name to report significant losses from their crypto trading activities. In mid-June, with significant exposure to the Terra/Luna ecosystem and other leading cryptoassets, reports began to emerge that the hedge fund had failed to meet a number of margin requirements. When the fund filed for bankruptcy, records indicated creditor claims of $3.5 billion, as well as estimated losses running into the billions of US dollars in the 2021-22 period, marking one of the largest hedge fund trading losses of all time.
Does it make sense to hold crypto in a portfolio?
When considering the recent crypto crisis and its many episodes, the question now arises: Is there still profit in 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 have based our analysis on Bitcoin, which is the largest, most established and most mature cryptocurrency.
Conclusion
All in all, we continue to see crypto primarily as a return enhancer in a portfolio. Historically, this assessment is supported by the fact that adding crypto to a portfolio beyond a small weight of 1 percent or less has caused an increase in realized returns as well as realized volatility. Allocations of up to 5 per cent may be appropriate for risk-seeking investors, while higher allocations will lead to a significant change in the portfolio’s characteristics and may ultimately produce a lower risk-adjusted return.
We thus maintain our view that crypto is only suitable for investors who have the ability and willingness to bear the related risks. However, these risks can be rewarded with very attractive returns due to the potential disruptive force that we primarily see in the world of decentralized finance. Risk seekers should also exercise caution as digital assets are still a highly unregulated area. Increasing regulation should instill confidence in the asset class and ultimately promote adoption. Due diligence is key: If something seems too good to be true, it probably is.
Sipho Arntzen is a next-generation research analyst at Julius Baer
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