Crypto's Rocky Outlook

IT'S NOT VERY OFTEN you hear the legendary investor duo of Warren Buffett and Charlie Munger being critical and sarcastic about investment opportunities. But ever since crypto mania gripped Wall Street, at every annual meet of Berkshire Hathaway, the duo has made their derision quite explicit. From terming the hype around cryptos as "trading turds," "dementia" and "probably rat poison squared," this year, Munger went on to say: "In my life, I try and avoid things that are stupid and evil and make me look bad in comparison to somebody else — and Bitcoin does all three. In the first place, it’s stupid because it’s still likely to go to zero."

Though the poster boy of cryptos has not gone to zero — not yet — the meltdown over the past year has seen Bitcoin come off 65% to $16,841 (December 20). The risk-off trade, accentuated by the U.S. Fed rate hike that began at the end of 2021, has taken the wind off cryptos with the overall market cap collapsing from $3 trillion to $853 billion. The bubble burst in the 24/7 crypto bazaar has opened a can of worms with the shutdown of the BlackRock and Sequoia Capital-backed exchange FTX amid charges of fraud and corporate misgovernance. Even as the exchange went down, so did crypto hedge fund Three Arrows Capital and crypto broker, Voyager Digital.

The nonagenarian investor is not wrong in his assessment about cryptos, which was meant to be an antithesis of all things wrong about modern finance and Wall Street but ended up becoming a symptom of the greed culture that became all-pervasive with non-fungible tokens (NFTs) and meme coins making it to the list of cryptos as the universe expanded from 5,000 in 2019 to the current 22,000. Though most cryptos are at sub-decimal levels, the concentration of the current market cap is largely confined to the top 10 currencies. Of the overall crypto market cap, the top 100 coins amount to $827 billion (96.87%). Touted as a hedge against inflation, the near 40-year high price spike and a rising interest rate cycle in the U.S. have taken the sheen off Bitcoin and other currencies.

Edward Moya, senior market analyst, Oanda, a currency data and forex specialist firm, believes there is more pain left in the crypto market. "A lot of early investors raised exposure over the past year and some of them placed massive bets on blockchain technology. The crypto market could still lose over 70% of its value if a couple of parts of the crypto verse break down."

What makes cryptocurrencies a unique case is that it is an unregulated space that has found evangelists across the globe. The asset class is practically "nothing" as unlike equities where you own shares of a company which is in your name, held with a depository and the values get reflected based on genuine buy-sell trades on stock exchanges, cryptos don't have an underlying asset.

What investors have not been able to grasp is that unlike shares, it's the exchanges that own the cryptos and not the investor. In equities where exchanges are just intermediaries, in cryptos the exchanges open an account, do the e-KYC mandate, but the cryptos that investors trade in are vested with the exchange. The bitter reality came to light with the collapse of FTX where investors lost what they thought were "their digital assets". They were unable to withdraw funds and liquidate their positions, with reports suggesting that FTX clients lost $1 billion in funds. This has prompted some crypto exchanges to announce proof-of-reserves to assure customers that their trading platforms are backing crypto assets 1:1, every dollar of crypto is backed by a dollar in capital of the respective exchange. Though in a way it acts as capital adequacy ratio, but just like a bank will have no money if there is a run on deposits, there are fears that these exchanges will not be able to honour their clients' money if there are panic withdrawals. "In the absence of any regulatory regime, it's a Wild Wild West as crypto investors have no legal recourse if an exchange collapses," says Sidharth Sogani, founder of Mumbai-based CREBACO Global , which audits cryptocurrencies and blockchain technology.

Given the decentralised nature of cryptos that are built on the blockchain platform, an investor who opens an account with the exchange does not "own" the crypto which is linked to an alphanumeric "wallet" in the blockchain maze. What complicates this so-called alternative investment class is the convoluted value discovery mechanism itself.

It can be as complex as it can get and that was evident in the crash of Terra Luna (Luna) a regular crypto token, and Terra USD (UST), a stable coin whose value was not pegged to the U.S. dollar but to its sister crypto token, Luna. The prices of both the cryptos were maintained through an algo based on the burn-mint equation. If UST fell below $1, investors could swap it for Luna tokens. The idea was to lend stability to the value of both the tokens. Further, investors were enticed into believing that they could make more money (nearly 20% yield) by lending their UST holdings on Anchor, a decentralised money market built on the Terra blockchain. However, post a $2 billion sell-off in May, UST and Luna prices fell. In the absence of any regulatory framework, investors who lost their money have no legal recourse. No one knows till date what led to the sell-off. Some reports indicate hedge funds orchestrated the sell-off and that the subsequent panic sales by investors only accentuated the fall.

To top it all, these cryptos were being promoted by celebs who understood little about what they were even endorsing. In fact, the Securities and Exchange Commission of the U.S. had fined TV reality star Kim Kardashian $1.26 million for not disclosing that she was paid to promote a crypto token, EMAX, on Instagram. Even in India, celebs such as Ranveer Singh, Ayushmann Khurrana, Dinesh Karthik and the likes have endorsed cryptos, terming them as safe and high-yielding alternative investments. In fact, over the past 12 months, some suicides in India have been linked to people who lost their money in crypto trading, including a recent case where a jobless techie killed his young daughter and tried to commit suicide after losses in cryptos, in which he had been dabbling since 2016. In May this year, though cryptos are not legally banned in India, the markets regulator urged the Parliamentary Standing Committee on Finance to restrict celebrities from endorsing cryptos. The Advertising Standards Council of India, too, had stated that celebs would be held accountable for misleading ads and commercials.

While there are no official estimates of how much Indians have invested and lost in cryptos, an advertisement put out by the IAMAI and Blockchain and Crypto Assets Council (BACC) in November 2021 stated that crores of Indians have invested over ₹6 lakh crore ($75 billion) in crypto assets! It was a bold and sensational claim which got the attention of the government and the central bank. The advertisement, however, did not mention how the figure was arrived at. Sogani believes the number is a complete hogwash. "It is unbelievable that Indians would have invested such a huge sum given cryptos remain a relatively unknown concept for the masses," says Sogani. However, a Knight Frank report had revealed that 20% of 13,637 ultra high-net worth individuals (UHNWIs) in India had invested in crypto assets in 2021 amid rising popularity of cryptocurrencies and NFTs. The consultancy firm defines UHNWIs as those above a net worth of $30 million (₹226 crore).

Wealth manager Rajesh Saluja, CEO and MD, ASK Wealth Advisors, feels some clients would have dabbled in cryptos on their accord. "Crypto being unregulated is more speculative. It's very tough to advise clients on it. I'm sure there must be some experts, but we haven’t been able to figure it out," says Saluja. Another leading wealth advisor, Ashish Gumashta, executive chairman, Julius Baer India, says, "Our clients are allowed to trade in cryptos overseas, but we don’t advise them in India."

Even as cryptos are in a free-fall zone, the ecosystem back home is unravelling as well with the IAMAI, early this year, dismantling the BACC even as the regulator and government authorities turned the heat on leading crypto platforms. "We thought of helping the players in creating a dialogue with the government and regulators and, in fact, had taken on the RBI as well. But we realised that these folks were more interested in hard selling the investment proposition rather than letting authorities know how they plan to build the cryptos and blockchain ecosystem," says a senior executive of the IAMAI. With the Enforcement Directorate opening investigations into the operations of 10 crypto exchanges, including the likes of WazirX, CoinDCX and CoinSwitch Kuber, the new-age investment class is losing steam. In the past eight months, India's Financial Intelligence Unit (FIU) has blocked 3,300 cryptocurrency accounts for money laundering, drug trafficking, and other illegal activities. While Fortune India reached out directly to the founders of WazirX, CoinSwtich and CoinDCX, for comments, some chose to direct the questions to their PR team.

For now, Bitcoin remains the poster boy of cryptos, accounting for a chunk of the overall market cap and remains the only currency that saw substantial institutional flows year to date at $332 million (See: The Last Crypto Standing?). "Bitcoin will likely consolidate below the $20,000 level for the foreseeable future, but a downside momentum could see an easy run towards the $13,900 level. If that breaks, it could get ugly fast. Until a better regulatory framework is put in place, cryptos will be shunned upon by most of Wall Street," says Moya. Not surprising that inflows into "Short Bitcoin" are quite substantial at $115 million during the year. True to its nature of being encrypted, the ownership of cryptos is not clear. For instance, while the market cap of Bitcoin stands at $326 billion with over 19 million units in circulation, institutional AUM just stands at around $14 billion, which means the remainder is held by a diverse set of investors, which might include institutional investors who are not willing to reveal their exposure, or even unlawful elements. Since cryptos are held in alphanumeric digital wallets across a decentralised blockchain network, it is nearly impossible for agencies and regulators to establish the identity of the owners as these wallets can disappear without a trace a.k.a cold storage, wherein digital wallets are stored on a platform not connected to the Internet.

Even as the law is playing catch-up, the coming year could also see the tide turning for the worst as the Fed's unrelenting rate hike spree is weakening the case for diversification, especially cryptos. "Interest in Bitcoin will wane in 2023 as cryptos are likely to trade in a tight range as investors lose interest," feels Moya.

For those looking for a "juicy" entry level, it's better to heed the advice of the Sage of Omaha who said thus: "Whether it goes up or down in the next year, or five or 10 years, I don't know. But the one thing I'm pretty sure of is that it doesn't produce anything. It's got a magic to it and people have attached magic to lots of things."