Are we heading for a ‘Crypto winter'?
The recent market uncertainty has brought about another seasonal change in the Crypto currency world, with many bracing for another ‘Crypto winter’. So, what does this all mean and what do Crypto-investors need to think about? Let’s start from the beginning.
What is a Crypto winter?
A ‘Crypto winter ‘is a prolonged bearish crypto market: in short, Crypto currencies’ prices fall significantly, and then a flat trading period follows.
You have probably stumbled across this term quite a lot in the past few weeks, but it’s not a new concept. Just like any type of investment, Crypto currencies go through market cycles. But unlike other lower-risk investments, Crypto is an extremely volatile asset, which means it regularly makes extremely large moves in either direction (big ups and big downs).
Each time this happens, many commentators are quick to declare crypto dead and buried, only to watch it “rise from the ashes” again sometime later. If recent history is anything to go by, our view is that this crypto winter is neither the first, nor the last, that Crypto investors will likely ride out.
What happened in 2018
The first Crypto winter happened in 2014, when Bitcoin dropped by 87% before shooting up again in 2015.
But when talking about ‘Crypto winters’, most people remember the market drawdown of 2018, when Bitcoin rallied to about $20,000 before a two-year slide that saw it plunge below $5,000. By the end of 2018, the price of Bitcoin had dropped by 84% from its peak. It wasn’t until mid-2019 that the Crypto markets started showing signs of recovery.
Statistica 2022 | Bitcoin (BTC) price per day from Jan 2018 to May 2022 (in U.S. Dollars)
So, what can we learn from that market cycle? All we can do is put things into context.
The Crypto crash of 2018 happened for a number of reasons, with regulatory uncertainty probably being the main one. Investors were increasingly concerned that regulators around the world would look to shut down crypto currencies in response to concerns about money laundering.
But a lot has been happening since then. Crypto currency is no longer just a niche product. Far from being a short-term fad, it has received more and more institutional support, and whilst Governments are still nervous the conversation has shifted from avoidance to addressing key concerns.
In other words, while still highly volatile and unpredictable, it’s a more mature market. Whether this maturity will translate in a shorter ‘winter’, only time will tell. In the meantime, let’s focus on what’s happening now.
What happened over the past few weeks?
According to market experts, two key factors are at work in this current Crypto crash.
First: macroeconomics (This is the branch of economics that deals national or regional economy as a whole. It is concerned with understanding economy-wide events such as the total amount of goods and services produced, the level of unemployment, and the general behaviour of prices.)
To manage the economic cost of the pandemic, central banks have been reducing interest rates. This had the effect of encouraging borrowing and increasing money supply. The abundant liquidity also pushed up prices across traditional share markets and Crypto markets, contributing to the inflationary pressure.
Now, inflation is at its highest level in four decades, and central banks only have one tool to bring it down: rising interest rates. This usually makes investors nervous, as rising rates can slow down company earnings and consumer-spending power. The result is broad market volatility.
The second factor comes from within the Crypto world, and that’s the sudden crash of stablecoins TerraUSD (also known as UST) and Luna. Crypto currency values were already dropping before the crash (mostly due to macroeconomics), but Luna/UST crash accelerated the whole thing.
A stable coin is a crypto currency coin that is meant to match the value of an underlying currency. In this case, a UST was always meant to be worth $1 USD. Unfortunately, unlike other assets that are meant to be backed by something real, UST was backed by another token called Luna. Investors could always switch a UST for $1 of Luna, the amount of Luna you receive would be determined by the value of Luna at the time of issuance.
In May, within just days, UST was completely wiped out due to significant selling pressure from a number of hedge funds who had bet against UST. This caused other panicked investors to pull their money out of UST and also sell Luna as quickly as they could pushing down the value of the collateral, effectively pushing the Luna token into a death spiral. The one event caused the destruction of c. US$50billion of value through the destruction of the UST and Luna networks.
Shortly after, the ripple effect was felt throughout the Crypto ecosystem. Terra had purchased billions worth of Bitcoin and other crypto currency assets as a safeguard for UST. And when US$3 billion in Bitcoin and other currencies were sold in a vain attempt to save UST from collapse, it caused other large investors to sell off their Bitcoin.
You might think this is something exclusive to crypto currencies, but it is actually a pretty standard bank run. When investors become nervous, and look for an exit prices fall through the floor. The closest precedent to this is what happened in the late 1990’s when a number of hedge funds took on the Bank of England and pushed it out of the Euro mechanism (set up in order to stabilise exchange rates and help Europe to become an area of monetary stability before the introduction of the single currency, the euro), or arguably with mortgage backed securities in 2008 - when they all of a sudden became toxic assets with no buyers willing to touch them (a big part of what caused the Great Financial Crisis).
What’s next?
No one really knows. Crypto could fall further, it could rise, it could stay the same: all bets are off. But the long term story has not changed, the potential for crypto currencies to transform finance and monetary systems still exists and this short term dip does not change that.
When we launched our new Carbon Neutral Crypto Fund, we knew exactly how volatile Crypto currencies could be. And our view hasn’t changed: Crypto is not for everyone. It’s for long-term investors who have the capacity and appetite to take on more volatility.
That is why, when we talk with our clients, we say that we expect Bitcoin to drop by more than 50% at least once every two years. It gives investors an idea of the level of risk they are exposed to. That’s also why we only allow to allocate up to 10% of their KiwiSaver plan toward Crypto.
Like to learn more or find out if Crypto may be for you? Get in touch or use our portfolio generator to get started.
