Boonchai Wedmakawand | time | Getty Images
The collapse of FTX, one of the largest crypto exchanges in the world, has rippled through the world of digital currencies.
Once valued at $32 billion, FTX filed for bankruptcy protection and founder Sam Bankman-Fried resigned as CEO after reports alleged the company lent billions of dollars in client funds to its own commercial company, Alameda Research. This fueled a flurry of withdrawal requests across all platforms as investors braced for possible contagion.
With over $2 trillion in cryptocurrency value wiped out since the high point of 2021, cryptocurrencies are suffering a dramatic fall from grace and are now the subject of regulatory scrutiny and investigations from increasingly important all over the world.
Michael Barr, Vice President for Oversight of the Federal Reserve, said recent events in crypto markets “have highlighted the risks to investors and consumers associated with new and emerging asset classes and activities when they are not accompanied by strong safeguards”.
This is in stark contrast to just a few months ago when crypto enthusiasts were advocating and in some cases implementing the inclusion of cryptocurrency in institutional wallets and 401(k) plan accounts.
If investors are still tempted to enter the cryptocurrency orbit at a potentially attractive, lower price, consider this: the deepest risks to cryptocurrency investing may yet lie ahead, rather only in the rearview mirror. This is something we’ve highlighted in our conversations with customers for some time, but it bears repeating. Investors considering a long-term allocation to cryptocurrencies should remain cautious for three main reasons.
First, the lack of clear and uniform regulations on cryptocurrencies – both within and between countries – creates enormous uncertainty for long-term investors. It is still unclear in the United States, for example, when a cryptocurrency falls within the regulatory framework of a security subject to the regulations of the Securities and Exchange Commission and when it is considered an asset or a commodity as have claimed supporters of bitcoin and ethereum.
Indeed, in some countries, cryptocurrencies face an outright ban; China’s abrupt ban on all cryptocurrency trading and mining in 2021 is a stark example, but by no means the only one. Regulators have also expressed concern about notable and repeated outages of infrastructure supporting cryptocurrency mining and trading – another area where significant regulatory uncertainty remains. And the fallout from the FTX collapse makes one thing clear: self-regulation and transparency are illusory.
Second, despite all the hype surrounding their status as digital gold, cryptocurrencies have failed to demonstrate either “safe haven” or inflation-fighting properties in the face of actual market volatility or the first real episode of severe inflation in developed markets.
Between 2010 and 2022, bitcoin had 29 episodes of drawdowns of 25% or more. In comparison, equities and commodities recorded only one each. Even during the pandemic-related market sell-off in March 2020, bitcoin suffered far greater losses than conventional asset classes such as stocks or bonds.
Similarly, while bitcoin’s fixed supply—stated in its source code—could imply resistance to currency debasement, during recent episodes of high global inflation, bitcoin has provided limited inflation protection, prices falling even as inflation spikes in the US, UK and Europe.
Finally, cryptocurrencies remain deeply problematic from an environmental, social and governance perspective. The governance issues that have been highlighted by the FTX implosion are most troubling.
Too often, non-existent control systems and decision-making confined to a small inner circle create a worry-free black box for investors and their holdings. Additionally, the decentralized frameworks and anonymity of cryptocurrencies make them particularly attractive for illicit activities, money laundering, and sanction evasion.
Environmentally, even though the transition from proof-of-work to proof-of-stake that ethereum is spearheading reduces the massive energy consumption that underpins crypto mining and validation, bitcoin — which accounts for about 40% of the cryptocurrency’s current market capitalization — will continue to use a validation process where a single transaction requires enough energy to power the average American home for two months.
And socially, the promise of financial inclusion of cryptocurrencies also seems exaggerated, with crypto wealth as unevenly distributed as conventional wealth, and with simple mobile payment services such as M-Pesa in Kenya or transfer pilots. international funds from Grameen Bank in Bangladesh already providing a digital platform for underbanked households – without the need for a new currency or payment infrastructure.
The collapse of FTX has shone a spotlight on cryptocurrencies, and only time will tell if the remaining players will have what it takes to survive. Dark clouds remain over the cryptocurrency horizon that long-term investors should watch carefully from the sidelines to better understand the true value versus hype before deciding to invest in cryptocurrencies .
— By Taimur Hyat, Chief Operating Officer, PGIM