iCapital Market Pulse: Five crypto questions as stablecoins prove not so stable

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Last Thursday, as the price of stablecoin Terra dropped to near $0, Tether “broke the buck” and traded at $0.9964, and cryptocurrencies fell more than 10% or more across the board, we hosted our Cryptocurrency Education webinar.¹ Bitcoin has since rebounded somewhat to around $30,000², but several questions raised during the webinar continue to bear examination. In this week’s commentary we take the opportunity to answer the five crypto questions top of mind for investors right now.
 
1. Do the current market conditions change any aspects of this asset class?
 
This was the number one question that was asked. And the answer is yes. As with many other assets, the pivot by the U. S. Federal Reserve (the Fed) from November was a turning point. With the Fed no longer willing to sit idly by in the face of sky-high inflation, and with cash yields bound to move, the inflation protection argument for Bitcoin weakened as the dollar strengthened.
 
Over time, Bitcoin and other cryptocurrencies have also become much more highly correlated with equities³—which is warranted since the crypto ecosystem is innovative technology above all else. Like equities, cryptocurrencies have suffered because for the first time in two years cash and parts of fixed income started to become viable alternatives. The effective fed funds rate is now at 1.00% and the three-year AAA municipal bond yield-to-maturity is 2.46%, while growth stocks yield 0.9% and bitcoin yields nothing.⁴ You’d have to lend it out to earn a yield but would be taking credit risk to do so. Additionally, unlike tech companies, cryptocurrencies do not have readily available projected cash flows that could be discounted back to present value. Of course, miners do earn revenue for validating transactions, but that accrues to the miners and not the bitcoin asset holders. In this absence, cryptocurrencies are likely to trade as unprofitable tech and indeed, their correlation with that index has risen over the past year from +0.22 to +0.72.⁵ Longer term, cryptocurrencies should derive value from their use cases and adoption, but that takes time. Near term, like for stocks, it would take a stabilization of growth expectations and/or a Fed pivot to justify a move higher in crypto assets.

2. What can we learn from the Terra/Luna collapse and the Tether jitters?

For anyone who lived through the Global Financial Crisis (GFC), the notion of “breaking the buck” is a big deal. But as the chart below illustrates, the losses that investors suffered from so-called stablecoins—which are supposed to be pegged 1 to 1 to the dollar—were far more catastrophic than the money market experience during the GFC.⁶

This highlights a bigger issue—certain parts of the crypto ecosystem potentially pose a risk to the traditional financial system via stablecoin linkages and this should sharpen regulators’ focus on this issue. In light of Terra’s collapse, other algorithmic stablecoins like Dai and Fei could attract regulatory attention. Unlike Terra, which relied on a software algorithm to engineer a “peg”, coins like Tether are backed by financial assets, but this could need regulation too. Similar to a money market, in the event of a mass liquidation, Tether providers have to liquidate reserve assets sufficient to redeem each unit of Tether for $1, which are comprised of Treasury bills, commercial paper and certificates of deposit and other cash and cash equivalents, which together account for 84% of overall reserves.⁷ This could adversely impact money markets holding similar assets.

The bottom line is that recent developments in crypto highlight that decentralized finance (DeFi) and traditional finance (TradFi) remain inherently linked and excess volatility in crypto can find its way back to more broadly held assets. Consider that stablecoins’ collective market cap already grew from $5.8 billion at the start of 2020 to $180 billion at the start of May 2022.⁸ Today, it is roughly $160 billion, which is still only 3.55% of the overall size of U.S. money markets (estimated at roughly $4 trillion), but if their size and significance continues to grow they could have systemic consequences.⁹ This is something that regulators will want to (and should) address, especially given risks to the broader markets.

3. What is the likelihood of the U.S. government affecting the market for crypto currencies? How might they do this?

We do not believe that the U.S. government will want to regulate cryptocurrencies out of existence or ban their trading altogether. The White House admitted this much in a recent executive order which called for ensuring responsible development of digital assets.¹⁰ The order acknowledged an interest in financial innovation, expanding access to affordable financial services, and reducing the cost of domestic and cross-border transfers and payments, all of which bitcoin can help deliver. We do believe regulators will want to increase the transparency and resilience of the system, and the protection offered to consumers. We expect the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), U.S. Treasury Department, and Congress to be much more focused on this after the Terra collapse. What exactly will they be focused on? Here some of the focus areas from that same executive order: “protection of consumers, investors, and businesses, including data privacy and security; financial stability and systemic risk; crime”.¹¹

As a result, there have been proposals to report tax information about crypto trades to the IRS. SEC Chair Gary Gensler proposed plans to register and regulate crypto exchanges and potentially separate asset custody to better manage investor risk. The Senate Banking Committee is now focused on stablecoin regulation, including clarity on the assets backing stablecoins. Certain stablecoin issuers might look to acquire a bank charter to help comply with any new regulations. Finally, preventing cryptocurrency crime is of course top of mind. The details are unclear, but whether it is this year or not, tighter crypto regulation may be on the way.

4. What is the risk of losing crypto assets that are maintained with an exchange provider that becomes insolvent? How do exchanges secure these assets?

As with custody of traditional assets, crypto custody is aimed at ensuring the availability, confidentiality, and integrity of a client’s assets. In fact, crypto custody goes a step further than the traditional holding and servicing aspect of custody by including safeguarding the private keys of a client’s underlying assets—an integral part of cryptocurrency security, as private keys are the sole identifier of ownership. As a result, an exchange like Coinbase—because it controls access to private keys—ultimately controls customers’ access to their assets.

Last week, Coinbase’s quarterly filing highlighted a growing concern that users could potentially risk losing assets if the crypto custodian or exchange becomes insolvent.¹² While the company is not currently at risk of bankruptcy, its CEO admitted that, “it is possible, however unlikely, that a court would decide to consider customer assets as a part of the company in bankruptcy proceedings”.¹³

Unlike traditional assets, crypto assets are not federally protected by agencies like the Securities Investor Protection Corporation (SIPC) or Federal Deposit Insurance Corporation (FDIC), because regulatory bodies do not—as yet at least—define cryptocurrencies as securities. This lack of protection is one more risk highlighted last week and calls for vigilance. In the meantime, the best way to manage this risk is to either self-custody your crypto assets via an offline wallet (cold storage) or opt for a self-custody wallet from an exchange.

5. How soon do you see broad institutional adoption of crypto for real world use cases, like with Cardano’s partnership with Dish Network?

The tie-up between Cardano and Dish—announced in September 2021—is intended to integrate the Cardano blockchain into Dish’s telecom business and help provide digital identity services to Dish customers.¹⁴

Further partnerships of this type are likely, but it will take time. The main obstacles to broader adoption of cryptocurrencies as a means of payment are the logistical hurdles of using it in both a bricks-and-mortar and e-commerce setting. While there are now nearly 30,000 physical locations globally at which consumers can pay for goods and services using Bitcoin, a 1,200% increase from 2013, this is still just a fraction of businesses.¹⁵ At the same time, transaction costs in the ballpark of 30%¹⁶ mean a $4 coffee purchase could cost you an extra $1.25—something we suspect most people would not easily entertain.

However, the payments company Strike, working with Blackhawk and NCR, recently proposed a payment system that uses Bitcoin’s Lightning Network—or “layer 2” as it is sometimes called—which could help solve these problems.¹⁷ By allowing transactions to occur off-chain—between parties not on the blockchain network—this protocol can facilitate instant payments and micropayments with transaction fees close to zero, therefore making crypto much more practical.¹⁸ With transaction fees moving lower, businesses will likely be more inclined to take on bitcoin as a payment option, though mass adoption may take time as the Lightning Network continues to scale and prove its reliability.

While it is hard to put a definitive timeline on the mainstream adoption of crypto payments, it is likely to increase. Businesses such as Starbucks, Whole Foods, Home Depot, Microsoft, Expedia, and Shopify now provide consumers the ability to transact in crypto.¹⁹ Globally, payment with crypto is expected to total over $10 billion in 2022, up 70% year-over-year.²⁰

Clearly, lots of question remain about the future of cryptocurrencies. But we do believe investors could potentially benefit from incorporating crypto into a diversified portfolio given its long-term growth and innovation potential. Importantly, we would consider sizing the allocation as with any other highly volatile security with potential but plenty of idiosyncratic risk, perhaps starting at 1% to 3% in an all-equity portfolio, and less than that in a balanced one. Given cryptocurrencies’ correlation with equities and their high volatility profile, a commitment may best be made from the equity sleeve of a portfolio.