Is the crypto market bubble bursting?

Current issues related to economy, (responsible) investing, pension and income: every week an APG expert gives a clear answer to the question of the week. This time: Portfolio Manager Jean-Paul Koopmans on whether the collapse of cryptocurrency exchange FTX is the beginning of the end for the crypto currency. “The system behind crypto currency is very robust.”

Last week, FTX went under. The fact that this so-called crypto exchange had to file for bankruptcy rocked the crypto world. What does this debacle say about the reliability of crypto currency as an investment asset for (big) investors? And about the future of crypto in general?

Although institutional asset administrators such as Fidelity and BlackRock see opportunities in the use of blockchain, APG remains adamant in rejecting it. Reasons are that crypto currencies do not provide cash flow, unlike equities, for example, or protection against inflation, like gold. Another factor for APG is that crypto currencies are not supported by central banks, regulators are not in favor of them and the reliability of non-blockchain counterparties is a concern. Will the fall of FTX prove pension investors right or is it more complicated?

Jean-Paul: “Currently, investing in crypto currencies is still fairly ‘wild west’. This is because investor protection is not well anchored in regulations and there is little oversight from regulators. Therefore, there are too many players in this market whose only goal is to get rich quick without adhering to traditional rules. In my view, it is currently not responsible for a pension investor to invest in this market.”

Investment vehicle
Back to FTX for a moment. What exactly happened there? The crypto exchange was using its customers’ crypto currencies as FTX’s investment vehicle, Alameda Research, Koopmans explains. That was not in line with the promise crypto exchanges make that for every coin a customer deposits, they actually hold one and have it audited by accountants. “At FTX, it turned out there was fraud, because they didn’t also hold one coin for every coin deposited. Instead, they offset the losses they suffered with Alameda Research with money from customers on their crypto exchange. That went well as long as those customers didn’t demand their money.”

On top of that, another problem arose. FTX created its own currency, the FTT, and sold some of it to third-parties. Things went wrong when Binance, the world’s biggest crypto exchange and holder of much of the FTT stock, decided to sell its share. “What happened then was something you can call an exchange run. Everyone quickly tried to get their crypto coins out of FTX. But because FTX didn’t have enough crypto coins in stock - after all, they had lent them to their investment vehicle - they stopped letting customers withdraw their crypto coins. What good is your savings if a bank says, ‘you can’t withdraw it.’ Then that bank is basically bankrupt. And that is the case with FTX.”

Back to basics

According to Koopmans, the cause of FTX’s downfall was the reliance on a centralized exchange. “Such an exchange is very user-friendly, because you can buy bitcoins or Ethereum there with your credit card. But actually this is not really working with the blockchain. In fact, it is the opposite of what was once the purpose of crypto currencies. Namely, that was a completely transparent system where everyone only has access to their own crypto coins, you can see exactly how many coins are being made and there is no bank that can print extra money and spend more money than it actually owns. Because that is what happened here.”  

Aside from the fact that it is an unpleasant event for everyone who lost their money, the debacle at FTX may also lead to a cleansing. “Where the fall of Lehman Brothers resulted in a whole range of strange financial structures and products not returning after the 2007-2008 financial crisis, the fall of FTX may result in the cryptocurrency system going back to basics.” That includes trading through a decentralized exchange, such as Uniswap. That is basically nothing more than bringing supply and demand of cryptocurrencies together on the blockchain, without a crypto exchange as an intermediary.”  

Robust
Koopmans welcomes more oversight of cryptocurrency trading, especially for that part that goes through centralized exchanges. “That is the playground for beginners in crypto. The fact that people run price risk there is normal, but now we know that there is also the risk that such a playground is managed by a fraudster. Then it is better to have a government agency on hand to check whether such an exchange has all the coins in stock in case people want to withdraw their credit en masse.”

Cryptocurrencies will become less popular because of the affair at FTX, Koopmans expects. Still, he believes concerns about the future of cryptocurrencies are unwarranted. “This is absolutely not the death knell; the system behind it will continue to work. Nor can bitcoin or Ethereum go bankrupt because they are not companies. All it takes is one server in the entire world to facilitate the use of crypto currencies and everyone will be able to use it.”

He points out that cryptocurrencies have already weathered several crises. For example, cryptocurrency prices went down 80 to 90 percent in a straight line in 2018. “But I think the system is inherently very robust,” Koopmans says. “There are also good reasons that big investors like BlackRock and Fidelity want to start offering it to their clients. I do hope they do it in a decentralized way. That might be a little unusual for a bank, but that way they guarantee that their clients only run exchange rate risks and there is no chance of fraud such as happened at FTX.”