Crypto markets – connectivity and contagion, with carnage to follow?

Resilience in financial systems gets developed and honed over time, Bitcoin (BTC) and the wider crypto universe are still very young. Conceived and developed post the global financial crisis in 2008, BTC has only ever existed in a low rate and low inflation environment. 

BTC is now down 70% from its recent peak. It has seen weakness before but this time it is seeing a different type of test. There will be further challenges ahead but we believe BTC will survive and be stronger for it.

BTC is often likened to being digital gold and a possible inflation hedge. It’s strictly limited supply was supposed to ensure stability. BTC, recently anyway, is far from the uncorrelated and stable asset it is supposed to be. Since the start of the year price action has seen trading in line with equities but with a much higher volatility. To be fair, a perfect storm of events has built up to overwhelm all financial markets with significant weakness across all asset classes. Gold has not provided any haven either, not helped by a stronger USD and in keeping with all liquid assets it has likely seen selling to meet margin calls on other positions.  

In crypto, this weakness has been compounded after this month’s serious and potentially permanent service suspensions and liquidity access restrictions at Celsius, a major player in offering digital yield products. At the same time, there was also a temporary activity restriction at Binance, a major crypto exchange. Both issues were likely caused by the magnitude and speed of falls in crypto prices and, perhaps, also with a wary eye on the recent collapse of the Lunar/Terra stable coin.  At the heart of these issues is connectivity within a young crypto system and arguably a lack of transparency. Let’s explore this in more detail.

An industry in development

Over the last few years, the crypto ecosystem has been developing at pace. Much of what you can do in traditional finance you can now do in crypto.  Secure hot and cold wallets for storage and access, custody, exchanges, and brokerages have evolved as centralized (CeFI) and decentralized (DeFi) models. No longer solely a static buy and hold position, crypto holdings can generate a yield return much like a normal currency position. Yield can come from, loans, lending to liquidity pools for market making and running staking nodes for token ecosystems. Transaction activity is executed and managed via smart contracts. These are, blockchain specific, computer programs written to automatically execute when certain conditions are met. Their purpose is to enforce the legal rights and obligations within a transaction or contract activity. The automatic and very precise nature of the contract execution is key benefit of the whole blockchain technology. That said this is still a developing environment and smart contacts cannot ,yet, work efficiently across different blockchains opening up connectivity risks as we outline below.

The various developments of market venues, products including derivatives, and infrastructure have opened a multitude of trading opportunities, many based on arbitrage, that can all be used to generate returns that do not always rely wholly on direction. Much activity has been developed outside of regulations, crypto currencies fall outside the regulations completely just as traditional currencies do, but regulators have certainly been slow to define what is a currency and what is a security requiring regulation.  More recently in their search for institutional capital many groups have recognised the benefit of being regulated.

Over the last few years, the crypto ecosystem has been developing at pace. Much of what you can do in traditional finance you can now do in crypto.  Secure hot and cold wallets for storage and access, custody, exchanges, and brokerages have evolved as centralized (CeFI) and decentralized (DeFi) models. No longer solely a static buy and hold position, crypto holdings can generate a yield return much like a normal currency position. Yield can come from, loans, lending to liquidity pools for market making and running staking nodes for token ecosystems. Transaction activity is executed and managed via smart contracts. These are, blockchain specific, computer programs written to automatically execute when certain conditions are met. Their purpose is to enforce the legal rights and obligations within a transaction or contract activity. The automatic and very precise nature of the contract execution is key benefit of the whole blockchain technology. That said this is still a developing environment and smart contacts cannot ,yet, work efficiently across different blockchains opening up connectivity risks as we outline below.

The various developments of market venues, products including derivatives, and infrastructure have opened a multitude of trading opportunities, many based on arbitrage, that can all be used to generate returns that do not always rely wholly on direction. Much activity has been developed outside of regulations, crypto currencies fall outside the regulations completely just as traditional currencies do, but regulators have certainly been slow to define what is a currency and what is a security requiring regulation.  More recently in their search for institutional capital many groups have recognised the benefit of being regulated.

Many of the techniques used to trade and produce returns are straight out of the capital markets playbook. Much of the trading is a function of the high volatility and the disperse nature of independent market venues, meaning price differences on the same or similar underlying’s across different venues. Many of the strategies, on paper anyway, are hedged for market risk but there are often real risks in the connectivity between these offsetting positions. Different venues with products on different blockchains may reveal connectivity and settlement gaps that increase risk because they do not all interface with each other exactly.

Leverage can cause problems in crypto just like in traditional markets

Naturally with limited market risk, leverage is used to pump up returns and this is why yield returns can be high but, classically, also where problems lie when issues occur. Asset and liability matching is a mastered skill within traditional finance but perhaps one still being learnt by the crypto industry.  And, just as in the traditional financial system when there is a rush to the exit for whatever reason, tensions emerge, and failures can occur. With no regulation of course there is less forced transparency or controls which can compound fears and volatility.

Let’s consider the detail of the Celsius business which is a key driver of current fears. Celsius, originally a UK business but now based in the US, offers its clients the ability to lend their crypto currency and earn a yield in return. In some cases, these yields can be as high as 18%. Celsius, which is a CeFi business, generates returns using the capital from client loans by re-lending to crypto traders and market makers involved in Defi and Cefi activity.  Overall, mechanically, it works in a very similar way to someone lending securities to a prime broker which then lends those same securities to hedge funds in exchange for a fee.  Of course, in traditional finance only institutions within an industry can access these type of returns ,whereas with Celsuis, everyone gets to play. This is democratisation of financial markets in action.

Now the problem. Unlike the securities lending market where lending agreements usually have defined time periods Celsius clients can redeem at any time. At least they could until this week when Celsius announced it was halting all flows in and out. It was quite within its right to do this, all set out clearly with their T&C’s for those who actually read them.

A pivotal price point

It is not known if the situation at Celsius is a short term liquidity issue or a fundamental long term insolvency but as the business seeks to meet its obligations the fear is that other parts of the crypto ecosystem may be impacted, in particular in any major liquidation event, the effect on stable coins which have little transparency and no regulation today. It may be an existential moment for crypto with real possibility of real carnage still to come. BTC is at an interesting and pivotal level right now, trading just below it’s realisation value which is the average price paid for BTC by holders. It has not often stayed below this level for very long but of course if holders decide to stop out given the wider economic concerns and the potential failure of market platforms the gap down could be significant and material.   

Many coins may fail but those that survive will emerge stronger. The blockchain technology, potential efficiencies from smart contracts, and opportunities for new digital business models are substantial and a game changer for financial services and other industries. Existing digital business models may need to evolve, with improved transparency and better controls, but the core layer 1 technologies like BTC, ETH and no doubt some of the second generation, proof of stake, chains such as Cosmos, Avalanche, Polkadot and Zilliqa amongst others have strong foundations to build on for the future.

Transformative technologies always see booms and busts

In any new and transformative industry there have been booms and busts, canals and railways in the nineteenth century and the developing internet in the dotcom bubble. Blockchain and crypto will be no different. Fortunes will be made and lost as the best ideas and businesses filter through over time to become dominant in their field. 

For the investor, just as with traditional markets, building wealth is requires patience and some risk management. Two things stand out as drivers for investment success over the long term. Diversification (build your exposure across between 10 and 30 underlying’s) and pound cost averaging (stagger your entry and exit points over a few days, weeks or months). Don’t be afraid of market weakness, it can be an opportunity too. Further learning and information about crypto markets will be available via future blogs and coming articles.

Stephen Ashworth

Investment Director – Digital assets and cryptocurrency