Crypto meltdown rings alarm bells

The drivers of the implosion in risk asset values that began in the crypto market last November are obvious. It’s the outbreak of inflation at 40-year highs and the inevitable, if belated, response by the Federal Reserve Board in the form of higher interest rates and reduced liquidity.

The implications for the change in monetary policy for conventional assets is obvious. When the risk-free rate – the 10-year bond rate used to discount future corporate cash flows – rises, the net present values of those cash flows shrink.

Sharemarkets are also tumbling as investors face a number of headwinds but the crypto downturn started earlier.Credit:Bloomberg

Crypto assets generally don’t have cash flows so the destruction of value occurring presumably relates to the impact of the external settings on investor psychology and the increasing aversion to risk that has developed since late last year.

Diminishing liquidity in financial systems generally might also be playing a role as leveraged investors seek to cash out or cash up to meet commitments elsewhere.

The fact that the downturn in the crypto market started a little earlier than the broader sell-off in riskier stocks is interesting. The “mainstreaming” of crypto last year attracted institutional money and wider use of sophisticated trading strategies, including the use of leverage and derivatives.

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The exodus of those relatively new investors, and the unwinding of their positions, might be another strand in the explanation for the violence of the movements in the value of crypto assets.

The meltdown in cryptos is already producing casualties.

Algorithmic stablecoin TerraUSD – which is supposed to use financial engineering to peg its value perfectly to the US dollar, fell below US70 cents this week after experiencing something akin to a “run.”

Coincidentally, on Monday the Federal Reserve warned in its latest financial stability report that stablecoins were vulnerable to runs because they were backed by assets that might lose value or become illiquid during periods of stress.

It noted that stablecoins are increasingly used to meet margin requirements for leveraged trading in other cryptocurrencies, which could amplify volatility and increase redemption risks.

The dominant stablecoin, Tether, has so far held at, or fractionally below, $US1.

It’s not just the crypto assets getting smashed.

The largest US cryptocurrency exchange, Coinbase, listed on the Nasdaq exchange last year. Its share price peaked at $US357 last November. It’s now about $US73.

This week it announced a loss of $US430 million after a 35 per cent slump in revenue. It cited the fall in crypto asset prices and increased volatility for a 44 per cent decline in trading volumes – a decline which provides an insight into the extent to which crypto investors are fleeing the market.

Their extraordinarily volatility also makes them practically useless for the purposes originally envisaged for cryptocurrencies, mediums of exchange and an alternative to fiat currencies.

That exodus creates a form of network effects. When the crypto market was booming last year it drew in investors. That increased demand pushed up prices and increased liquidity in the markets for the assets.

The implosion from November left investors facing massive losses and triggered a reversal of those network effects. That explains why the declines in value have been so precipitous.

The true crypto believers will say they’ve seen this before. It was only three years ago that Bitcoin, for instance, was trading around only $US5000. What crashes down might eventually soar, given how leveraged crypto assets seem to be to the macro settings.

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The dive in their valuers has dispelled any notion that they aren’t correlated to other risk assets and therefore provide diversification. They don’t — they provide a more concentrated and leveraged exposure to the risk environment, which is great in a “risk-on” environment but disastrous when investors’ appetites for risk shrink materially.

Whatever might happen in the future – there are a lot of interesting and potentially important ideas being developed in the crypto space — at this point they are assets for speculation rather than investment.

Their extraordinarily volatility also makes them practically useless for the purposes originally envisaged for cryptocurrencies, mediums of exchange and an alternative to fiat currencies.

This news is republished from another source. You can check the original article here

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