Crypto Has Been Through the Wringer in 2022: Now What?

Cryptocurrencies, or digital assets, have gone through a lot of turmoil so far in 2022. Since their high-water mark in late 2021, major assets like Bitcoin and Ethereum have seen dramatic price pullbacks. These withdrawals created a chain reaction in other areas of the digital asset market, eventually leading to the bankruptcy of several crypto platforms – and a crash that wiped out the value of a few major cryptocurrencies.

Many coins have seen massive price drops since their all-time highs and have not recovered. As an investor, how should you approach crypto now?

Crypto basics and recent falls

First, a brief overview of crypto and recent major events:

The blockchain technology used to trade cryptocurrencies has been hailed as a game-changer for the future of currency. Users can “confirm transactions without the need for a central clearinghouse,” democratizing access to the economy, especially for those who have historically had no access to financial institutions. Cryptocurrencies like Bitcoin, Ethereum and other coins or tokens are simply an alternative form of payment known as digital currencies. While potential drives crypto’s allure, so does speculation. And while cryptos have been hailed as “inflation-proof,” the recent falls are quickly affecting their market value.

One of the most important events that happened recently was the dramatic collapse in value of TerraUSD, an algorithmically stable coin, which was supposed to behave like cash. TerraUSD’s algorithm was structured to keep it tightly linked to the US dollar, but the link failed, leading to panic selling and simultaneously crashing another popular token, LUNA, which was linked to TerraUSD. Both tokens have lost tens of billions of dollars in total market capitalization.

Another major event that rocked the digital asset world was the collapse of Three Arrows Capital (3AC), a cryptocurrency hedge fund. This had a knock-on effect as other crypto trading platforms that were counterparties to 3AC had to freeze withdrawals for their customers.

Basic value proposition versus “pump and dump”

I am not saying all this to scare you away from investing in cryptocurrency. But I think the sensible approach to this asset class is to focus on the fundamental value proposition of a digital asset – along with fully understanding its utility – before investing in it.

There are many websites that promote new and upcoming coins based on recent peaks in performance; rosy claims about these coins’ long-term potential are inevitable. Much of this is self-serving, as seed investors in digital assets will try to promote their projects to keep prices up, which in turn allows them to promote further price appreciation and momentum in the coin.

Just as we’ve seen with the swings in “meme” stocks, holders of some assets will use the internet and social media to market the assets they currently hold in the hopes that they can pump and dump them. I recommend avoiding the temptation to chase returns in the new and lesser known altcoins. Some investors have successfully made money with this strategy, but it carries a very high risk – and can be financially devastating for investors who are overconcentrated in this type of asset.

Bitcoin and Ethereum – the most established players

Federal regulation of digital assets is still pending – although it may receive a renewed priority after the recent fallout. Meanwhile, a more conservative strategy would be to invest in the most established digital assets, including Bitcoin and Ethereum. Both have started to increase in value since lows in mid-June, coinciding with positive returns in other risk assets over the same period.

Bitcoin is the largest digital asset by market capitalization and the most well-known. It is also the digital asset that enjoys the greatest adoption among institutional investors. BlackRock, one of the largest asset managers in the US, recently announced a partnership with Coinbase to offer digital asset trading to its clients. Institutional demand for Bitcoin can give a steady boost to the price given greater demand in portfolios. Bitcoin also continues to be used to send and receive global payments.

Ethereum is the second largest digital asset by market capitalization. What makes Ethereum’s value unique is the fact that it is used as a network for many, many other digital assets and projects – including “DeFi” or decentralized finance applications. As more projects are built on Ethereum’s network, the demand for its token, ether, increases. Ethereum is also working towards a major upgrade next quarter that will significantly reduce the energy use of the blockchain, in theory reducing its carbon footprint by 99%! Interest in ether, and its price, has increased since the beginning of July.

Considering crypto? Consider a conservative allocation

Given the above, it’s no surprise that I typically recommend a conservative allocation to digital assets. Digital assets, compared to stocks, are highly volatile – as we have already seen in 2022. The Nasdaq composite, which represents technology stocks, was down approx. 33% so far this year at its lowest point, while the better-known S&P 500 index (a barometer for US large cap stocks) was down around 24% at its lowest point for the year. Bitcoin, by comparison, fell more than 60% from its end-2021 low.

For a well-diversified portfolio, cryptocurrencies can provide an increase in potential returns and some diversification benefits when combined in the right way. Digital assets generally have a low degree of correlation to stocks. In modern portfolio construction, low-correlated assets tend to be desirable, as this means that when an asset rises or falls, the price of a low-correlated asset will not move in lockstep with it. In other words, if the market panics and assets sell off, you don’t want all assets in your portfolio to fall at the same time.

Digital assets can also provide some excess return potential during periods when stocks are flat or trading in a range.

With any investment portfolio, it is also important to periodically review the strategy and decide whether strategic or tactical changes are necessary.