“Crypto winter”: Fear, Fad or Opportunity for Regrowth?

Are we really facing a so-called crypto winter? It’s certainly been the looming fear since USD 2.25 trillion drained out of the market in a few turbulent months and is an unavoidable talking point.

However, that widely expressed concern is not universal. A CapGemini report, published in June, found that around 70 percent of high-net-worth individuals remain invested in digital assets. That number rises to around 90 percent among millennials, i.e., those under 40. In fact, when it comes to digital assets, cryptocurrencies remain the preferred option above both exchange-traded funds (ETFs) and metaverse investments.

Of course, this is not the first time that crypto markets have seen spectacular swings. But, as the market evolves, each cycle tells us something different. This time, we can say with a strong degree of confidence that the increased interest of institutions in crypto will play a crucial role in lifting the market out of the downturn.

But, as the first shoots of recovery are observed and confidence is slowly coming back, we have to look at why predictions of a crypto winter persist, and what that tells us about the market and the opportunities it presents.

There are three obvious and interconnected ‘cold fronts’ that between them could kill off emerging re-growth.

1. The Fed lets fly its inner hawk

Crypto is not the only currency with challenges. Inflation in the US is running higher than most people have ever experienced, and a now hawkish Fed has had to abandon its previous super-soft monetary policy. May 2022 saw inflation reach 8.4 percent, leading the Fed to hike benchmark rates by 75 basis points (bps).

Thanks to the consequent rise in rates on deposits and loans, investors shifted money out of high-risk assets into protective deposits as they started to provide more attractive returns. Both traditional stocks and cryptocurrencies inevitably felt the impact of the move.

Of course, as deposit rates rise, so do rates on US government debt in order to remain attractive to investors. And, when the risk-free returns on T-bonds go up, so do the required returns for investments in riskier assets, leading investors to price them down. The companies most affected by this price correction are those not yet earning EBITDA or free cash flow (FCF), in other words, high-growth companies where the bet is on the company's long-term potential, often in the tech and biotech fields.

2. The consequences of correlation

Cryptocurrencies have moved beyond the ‘fad and fanatic’ stage of just a couple of years ago, to a point of almost mass adoption. Since 2020, cryptocurrencies, most famously Bitcoin, have become financial instruments like any other exchange-traded asset, albeit riskier than the average.

Crypto’s changing status has been helped by increased institutional adoption. The entry of such large investors led to soaring capital, the emergence of new investment opportunities and various patterns and strategies for trading appearing. This, in turn, has created a situation in which crypto assets are strongly correlated with the stock market. During the bull run of the past few years, that has been to crypto’s advantage. In the current crisis, it has been to its detriment.

3. Regulatory limbo remains

As crypto goes more mainstream, the regulators inevitably get involved. As a global market, crypto is under the scrutiny of numerous national governments, with diverse views on how best to regulate it in this still-evolving market. Where governments are in a position to create a regulatory framework, we see central banks actively developing their own digital currencies (CBDCs) and/or distributing stablecoins, and regulators reviewing licensing requirements. For new jurisdictions, a position on the Financial Action Task Force’s (FATF) gray list awaits.

The result is that, at present, crypto exists almost in limbo, where creating clear entry and action strategies is extremely difficult if not impossible. It is only when clear regulations on the reporting and trading of cryptocurrency assets come into force that we can expect crypto’s dramatic price curves to calm down.

This uncertainty is intolerable for most FIs, who may avoid speculating on assets that could seriously damage their capital availability and balance sheets. The adoption of crypto by intuitions is an important part of its trajectory, but it is still in the very early stages. The key to unlocking the next wave of financial capital, potentially enormous as it is, lies in the hands of regulators.

Hope springs

Despite all the headlines, the volatility, and the lingering uncertainty, investor interest has not gone away. It may not be as buoyant as it was at the back end of 2021, but mainstream adoption of digital assets still has momentum. Many investors are keeping their heads down to avoid further losses, but other institutional investors are actively taking profits to keep some part of their assets.

How severe and how long the downturn will be is not yet clear. But, winter ends eventually. Spring always arrives. And, the strongest life forms always regenerate and re-grow.

By Anton Chashchin, Managing Partner of Bitfrost.io