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The recent failure of crypto-related business such as FTX has highlighted a void in regulatory oversight in the digital currency world. Read more about why a back to basics approach may serve investors best in our latest Markets in a Minute.
Markets in a Minute: Crypto vs. Back to Basics?
Conversations and news stories about cryptocurrencies and Bitcoin have been hard to avoid over the past two years. You’ve probably heard it all from someone telling you that Bitcoin will eventually replace traditional reserve currencies, that a new meme coin is going to the moon, or that crypto is just another form of gambling. But how has the recent rise and fall of crypto-related companies and exchanges shifted the outlook on crypto? Let’s find out in this week’s Markets in a Minute.
While bitcoin and other cryptocurrencies were rising rapidly, it was tempting to ignore the challenges and unknowns of these assets to get in on the quick returns. But now that prices are falling and companies are imploding, those challenges are becoming impossible to ignore. We’ve published several pieces on the many challenges and associated investor risks.
Since those reports were published, crypto-related companies such as FTX and BlockFi have begun winding their ways through bankruptcy court. With that journey, crypto’s lack of regulatory oversight is now front and center.
It has been widely reported, for instance, that FTX didn’t have the most basic corporate governance or controls in place, no functioning board of directors, and no audited financials. In a matter of days, the value of FTX went from an astonishing $32 billion to nothing. While some of these lapses are likely particular to FTX, that company’s experience does highlight some broader risks associated with digital assets that investors would do well to learn from.
Segregation and Lending of Client Assets In traditional banking and asset management, segregating a client’s assets from another client’s and from the financial institution itself is paramount. If a client, for instance, deposits $10,000 into a traditional brokerage account, custodians and broker-dealers have extensive accounting controls to ensure a client will have access to those funds.
Many financial institutions have programs to use customer funds for commercial purposes, including lending and trading, meaning that they often hold only a fraction of their customer assets at any given time and allow clients to earn incremental income. These programs require clients to opt in and sign additional disclosure agreements. Regulators also maintain a keen eye to ensure companies follow those procedures, undergo regulatory examinations, and produce audited financial statements.
In contrast with these traditional methods of oversight, the crypto world has no governing body to oversee the many intermediaries who facilitate investment in cryptocurrencies, and it is left to individual companies to police themselves.
JurisdictionWhile regulators and lawmakers in the US have been slow to draft regulations surrounding the digital world, given that cryptocurrencies are not tied to a particular country, it’s not always clear who has authority. FTX, for instance, was based in the Bahamas, and now Bahamian officials are battling with US-based bankruptcy courts for jurisdiction and what few assets remain. BlockFi based its non-US operations in Bermuda, where a bankruptcy process is running in parallel to the one in the US.
Heightened VolatilityThese recent experiences have highlighted another challenge with cryptos: volatility. FTX had a sister company Alameda Research. While FTX ran an exchange where individuals could buy and sell digital assets, Alameda would invest in and trade those currencies. Recent reports have revealed that about half of the $16 billion in assets that Alameda had access to was invested in smaller cryptocurrencies, crypto-related startup businesses, and venture capital funds (some of which even had investments in FTX), while the other half of those assets was in a single cryptocurrency, or token, that FTX had itself created, FTT. Let’s leave aside, for a moment, that many of those FTT tokens actually belonged to end customers.
When Bitcoin and other cryptocurrencies, such as FTT, started to fall earlier this year, Alameda’s assets fell in tandem. Then a few weeks ago, as some of FTX’s issues came to light, investors who owned FTT started selling, driving the price even lower, and Alameda’s value began to evaporate in spectacular fashion.
This dramatic decline in value highlights the challenge of being able to determine the value of a cryptocurrency. A stock, for instance, will be valued on the company’s ability to earn money over the long haul. A bond on its ability to deliver income. A country’s currency will rise and fall based on things like the long-term economic growth of the country and interest rates. By contrast, cryptos are heavily based on sentiment, which works great when sentiment is improving, but terrible when opinions have turned negative.
What Will Likely Happen Next with Crypto? With the fallout of FTX and other crypto exchanges, we will likely see a push for more regulations and oversight of these companies. What those regulations might be remains unclear. The US government has yet to even determine how to classify cryptocurrency—whether it’s a security, commodity, or something else entirely. While a broader regulatory regime will take time, policymakers are taking some steps. The Biden Administration has been developing new laws and regulations to crack down on crypto-enabled cybercrimes and block transactions on, for instance, Russian exchanges associated with criminal activity.
As technology advances, Central Banks around the globe, including the Federal Reserve, have begun exploring, researching, and developing Central Bank Digital Currencies (CBDCs) that would ideally offer some of the benefits of cryptocurrencies. Benefits could include faster transactions, broader access to financial instruments and verification of transactions through blockchain technology. Unlike cryptos, CBDCs would likely offer the consistency and oversight of more traditional financial products.
Some countries are much further along in the process than others. This month, India is introducing a pilot program of a digital rupee that will have the same value and legitimacy as a banknote or coin. Switzerland began testing its own CBDC late last year.
What’s an Investor to Do? Most investors have little to no direct exposure to digital currencies. As such, these headlines around FTX and others will have little impact on their portfolios and investors would be well served to take what we like to call a “back to basics” approach to investing.
Further insights:Markets in a Minute: Cryptocurrencyhttps://www.mundifinancial.com/cryptocurrency
Notes from bankruptcy filing:https://twitter.com/GRDecter/status/1593272102047580161?s=20&t=8Ofpg6AE0HtB7CHaLtbvzQ
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Investment Services, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by any entity for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Investment Services, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. Does not offer tax or legal advice.