2023 Crypto Outlook
by Ryan Shea
- 2022 started with much promise. Cryptocurrencies were riding high, with prices having hit all-time highs just a month or so prior and the sector was attracting considerable interest from both Wall Street and Main Street.
- Then along came the Fed in penitential mood for having mischaracterized the surge in inflation as “transitory”. Redemption came in the form of much more aggressive monetary policy – tightening that proved very deleterious to financial assets both crypto and tradfi.
- Relatively speaking crypto was hit harder because the initial down-draft in prices revealed a lot of hidden leverage in the ecosytem. The failure of the algorithmic stablecoin Terra set off a deleveraging cycle that has spread like a virus throughout the crypto ecosystem killing off numerous crypto lenders, hedge funds and even taken down one of the world’s largest centralized crypto exchanges, FTX.
- 2022 will undoubtedly go down in history as one of the most turbulent years in crypto, but what does next year hold for the world’s newest asset class?
There are three key “macro” trends that will, in our view, impact the crypto industry during 2023. First and foremost will be increased government involvement in the sector.
Bitcoin - the seminal cryptocurrency - was designed to return money to the people, taking it out of the hands of government because of their unenviable track record of currency debasement as Satoshi Nakamoto noted in the original Bitcoin white paper. Reflecting the sector’s anarchistic roots, the empowerment of individuals not institutions remains a powerful ethos and opposition to government encroachment is considerable. However, with cryptocurrency adoption having risen consistently over the past several years – surveys conducted in 56 of the world’s leading countries suggest that, on average, 15% of respondents have owned or used them (see chart) - they are no longer dismissed by governments as financial curiosities and this is being reflected in their policies.
Estimated Crypto Adoption Rates
The initial thrust of government involvement in crypto is via regulation. In the US, several bipartisan crypto bills are making their way through Congress, in the EU the MiCA bill was recently approved by the European Council with implementation expected in 2023 and in the UK the Treasury has confirmed that stablecoin legislation will be part of the new Financial Services and Markets Bill, which is currently making its way through parliament.
Due to the high profile failures of several crypto firms during 2022, which were entirely attributable to the dubious practices and behaviours of individuals not the technology, governments not only feel compelled to act to protect and safeguard consumers, but they feel qualified to act because they have witnessed numerous similar events in tradfi over the preceding decades. Consequently, this regulatory push is being both strengthened and accelerated.
As alluded to above, not everyone in crypto likes regulation. Nevertheless, it could turn out to be a positive because, in our view, it is a necessary condition for broader public adoption of cryptocurrencies.
One noteworthy development that has largely gone under the radar during the cryptowinter is institutional investors have been steadily building out crypto infrastructure. Obviously rising crypto prices will be an important catalyst to bring institutional money into the sector, but the other crucial element will be regulation because it brings with it the perception of legitimacy. Moreover, these entities are used to operating in a regulated landscape so as legal frameworks get developed and implemented, it will become easier for them to embrace crypto. Given the potential size of capital inflows, it would have a profoundly bullish impact on crypto prices.
Government involvement in crypto will not, however, be limited to regulation. Central banks are clearly crypto-curious with around 90% investigating and researching CBDCs – a digital version of central bank money. In part, this interest stems from the need to respond to the increasingly digital nature of our lives and the growing irrelevance of cash within the economy, which is the only form of central bank money available to the non-bank private sector at present. It is also a reflection of the fact that CDBCs constitute programmable money – a feature that makes them inherently attractive to policymakers. For example, CBDCs would give governments the ability to directly influence spending patterns by setting restrictions on what goods and services can be bought with them, tax collection could be automated via smart contracts and, if required, interest rates on CBDCs could be set substantially below zero providing much greater macro policy control. They are, in short, a central planners dream (and a crypto-anarchists nightmare). Given this, we expect to see additional trails and new pilot schemes for CBDCs during 2023, in anticipation of their eventual and widespread introduction.
The next key trend is increased transparency on the part of centralized crypto entities. In the face of heightened risk aversion and fears of contagion in the aftermath of FTX’s bankruptcy the number of cryptocurrencies coming off centralized exchanges surged as users took back direct ownership of their tokens via self-custody. In order to assuage concerns, centralized exchanges have started to publish their wallet addresses thereby allowing external parties to independently verify the extent of their cryptocurrency holdings. This is unquestionably a good start but more needs to be done. Proof-of-reserves is meaningless without proof-of-liabilities ie. customer deposits. What is really needed is proof-of-solvency - the difference between assets and liabilities - but this is not as easy to provide in an independently verifiable way as may first appear.
Proving ownership of digital assets by providing wallet addresses is trivial, but how can one independently validate if an entity has non-digital assets, or more importantly, liabilities, such as loans outstanding in fiat currency because these are not recorded on a blockchain? In addition, periodic proof of reserves are also vulnerable to the same window-dressing risk that occurs in tradfi, whereby assets are brought “on-balance-sheet” (or on-chain in crypto) just ahead of any attestation or audit and then subsequently returned whence they came. Indeed, this is exactly the sort of behaviour that brought Lehman down1, a much used analogy for FTX’s failure.
Ultimately, proof-of-reserves (meaning solvency) is going to require the involvement of external auditors to verify the financial soundness of the entity. Some of the larger audit firms are upscaling their knowledge of the crypto ecosystem and developing crypto audit software and analytic tools but there is still a great deal to do, especially given the lack of universal guidance. In short, this area is very much a work-in-progress but, given earning and maintaining user trust is business critical for any firm, there are strong financial incentives for centralized exchanges to make robust progress in this area. So expect to see a lot more progress on this front in 2023.
The final key trend I would describe as the greening of crypto. The asset class has been widely denigrated for its perceived negative environmental impact. However, following last September’s Merge when Ethereum transitioned to Proof-of-Stake, the majority of cryptocurrencies when measured by market cap now run much less energy-intensive consensus algorithms, making them more environmentally friendly.
Even Bitcoin, which is the cryptocurrency most heavily criticized for its environmental impact because it continues to run an energy-intensive Proof-of-Work consensus algorithm, is becoming greener. Bitcoin miners are strongly incentivized to find the cheapest sources of electricity as it forms the bulk of their operating costs. Because mining rigs are mobile they can relocate easily to exploit stranded energy sources such as excess hydro or flared gas, which other industries find hard to use and hence are available at a much lower cost. Given how fossil fuel prices in particular have been trending higher, cost incentives will push Bitcoin miners to becoming more environmentally friendly over time without the need for government green subsidies, something not many other industries can claim.
Not only that, but Bitcoin mining can actually facilitate national energy grids in transitioning from fossil fuels to renewables. Wind and solar are renowned for being intermittent, making them unsuitable for providing baseload electricity. Utilizing Bitcoin mining rigs, which can be quickly turned on or off, provides a way for energy companies to smooth out fluctuations in renewable electricity generation. Combined with the fact that the profits from Bitcoin mining can be used to invest in excess solar and wind capacity, there is a clear mechanism for making renewables a more stable, baseload-like, electricity generating source – see chart.
Renewables Generation Mix vs. Capacity
In my view, this is represents an important shift in the narrative because it challenges the prevailing public perception and makes cryptocurrencies much less problematic for global policymakers intent on achieving their net zero goals. In recognition of this emergent trend Trakx last year launched an ESG Crypto Traded Index for investors wishing to gain exposure to the most environmentally-friendly cryptocurrencies.
Finally, I think it is important to reiterate that while 2022 was a difficult year for the crypto industry the underlying technology was not at fault. The problem lies firmly at the door of some key crypto players misbehaving and these people have been – or are getting - exposed and ejected for the industry. For the long-run health of the crypto sector this cathartic cleansing, painful as it may be in short-term, is unambiguously good for the sector’s long-term health.
The stage is being set for the next bull cycle.
1Repo 105 was an accounting loophole (now closed) that allowed Lehman Brothers to borrow short-term liquidity by pledging less liquid collateral, in order to flatter the firm’s liquidity ratios – see: