Bitcoin and Ethereum prices fell more than 50% since the beginning of the year, as rising inflation and interest rates sent investors seeking safe-haven asset classes. CoinMarketCap reckons that cryptocurrencies have lost more than $2 trillion in value since their highs in 2021 – and not everyone believes the bear market is over.
Let's look at the crypto winter and its potential effect on the crypto markets over the coming quarters and years.
The crypto winter could have long-term effects on retail investors, institutional investors, and other market participants.
What Caused the Crash?
The crypto market's crash began earlier this year when rampant inflation caused the Federal Reserve to hike interest rates and cool off the economy. Despite their reputation as an inflation hedge, cryptocurrencies turned out to be more correlated with tech stocks than gold prices. And the tech industry's swift decline precipitated the crypto crash.
Algorithmic stablecoins were the next casualty. As investors began selling TerraUSD (UST), the stablecoin de-pegged from the dollar, and its sister coin, Luna, fell to zero. While Terra-based DeFi protocols, like Anchor and Astroport, experienced an immediate decline, over-leveraged hedge funds holding Luna were the most significant casualties.
For example, Three Arrows Capital (3AC) experienced a $600 million loss from the UST/Luna's collapse. The hedge fund also had a highly leveraged $1.2 billion position in the Grayscale Bitcoin Trust that fell to $550 million in value. Not surprisingly, it defaulted on a $650 million loan from Voyager Digital and went into bankruptcy.
3AC's bankruptcy had a domino effect across the industry. In addition to throwing Voyager Digital into bankruptcy, the hedge fund's creditor list includes Genesis Trading, CoinList, DeFiance Capital, and FalconX. These companies remain solvent, but the steep losses could force them to scale back growth plans and ambitions.
The collapse of UST and 3AC's bankruptcy led many investors to pull capital out of the crypto ecosystem. Unfortunately, many DeFi protocols rely on two-sided liquidity to operate, and they ran into problems. In particular, Celsius' stETH began trading at a discount, making it hard for the organization to raise money for redemptions.
Meanwhile, several high-profile hacks accelerated these losses and eroded customer trust. For example, the crypto startup Nomad lost an estimated $200 million and didn’t disclose if customers would be reimbursed if the funds weren’t recovered. The heist came just a month after Harmon Horizon lost about $100 million from a similar bridge attack.
Potential Long-term Effects
The crypto winter has led to a confidence crisis among retail and institutional investors. For instance, Coinbase has seen a dramatic decrease in trading volume, forcing it to lay off 18% of its employees to cut down on costs. Meanwhile, many crypto miners have run into profitability challenges given the lower prices for many tokens.
The good news is that FTX's Sam Bankman-Fried has become a JP Morgan-like figure, bailing out cryptocurrency projects and helping the market stabilize in the near term. For instance, he provided a $250 million loan to bail out crypto lender BlockFi and gave Voyager Digital a $200 million line of credit through his Alameda Research.
The bad news is that the crash has left a bad taste in many mouths. For example, Morgan Stanley predicts that venture capital funding to crypto companies could drop by 50% due to the poor macroeconomic outlook and the crypto winter. And the lack of new capital could force many non-profitable projects to slim down or close completely.
Financial investors may also have less interest in crypto assets. Not surprisingly, retail interest in crypto assets fell alongside the price and could take some time to recover. As a result, demand for crypto exchange-traded funds and other financial assets could decrease, while the asset class' diversification merits have become questionable.
And finally, the crypto industry may also need to grapple with structural changes. For example, algorithmic stablecoins may need to rethink the need for tangible reserves to back their value. Meanwhile, regulators will likely use the crypto winter as justification for regulations on bank-like decentralized finance (DeFi) apps or currency-like stablecoins.
Winterizing Your Portfolio
Crypto traders and investors have several options when it comes to hedging their portfolio to weather the crypto winter. While some have completely exited the market, there’s always the risk that they could miss an opportune time to re-enter the market. After all, numerous market timing studies have shown that investors tend to sell after a drop and miss buying at the bottom.
Some strategies and best practices to consider include:
- Dollar-Cost Averaging – Investors may want to continue buying small amounts of cryptocurrencies over time, thereby lowering their cost basis as the price of crypto declines. In the event of a recovery, they can then experience more profit.
- Tax-Loss Harvesting – Investors can sell losing positions to realize the loss in the current tax period and offset their ordinary income and capital gains. Since cryptocurrencies aren’t subject to the Wash Sale Rule, investors may be able to quickly repurchase them and maintain their asset allocations.
- Diversification – Investors may want to consider holding a broader range of assets rather than a handful of risky projects to mitigate the risk of any single project derailing their entire portfolio.
Before implementing these strategies, it’s a good idea to consult your financial and/or tax advisor to discuss how they might impact your overall portfolio. For example, the timing of certain sales could impact your marginal tax rate or diversification into certain crypto assets might shift the overall portfolio’s risk levels.
The Bottom Line
Bitcoin, Ethereum, and many other prominent cryptocurrencies have been trading significantly lower since the beginning of the year. As a result, retail investors have scaled back their trading activity, miners are struggling to turn a profit, and institutional investors are hesitant to back any new projects or add crypto assets to their portfolios.
While the crypto winter won't end the industry, it could take time for the market to recover and confidence to rebuild. As a result, some cryptocurrencies and projects could offer discounts at their current valuations. However, conservative investors may want to wait on the sidelines for more clarity since the ripple effects may persist.
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