Crypto - The Good, The Bad, and The Ugly!

08.02.23 03:19 AM

Digital HUB is an open online community of financial and data science professionals pursuing practical applications of AI in their everyday functions.  Digital HUB community provides expert, curated insights into financial applications of Generative AI, Large Language Models, Machine Learning, Data Science, Crypto Assets and Blockchain.

A key focus for The Digital HUB publication is to provide best practices for the safe deployment of AI at scale such as: assessing the ability to execute, determining an organization’s digital DNA, fostering skill development, and encouraging responsible AI.

The Good, the Bad, and The Ugly!

It was just a year ago (November 2021) when crypto prices were at an all-time high and the industry seemingly couldn’t have been hotter. It was all going great until it wasn’t…

Starting with the implosion of FTX exchange, today, investors are wondering if this is the tip of the iceberg? 

There are two scenarios.  One would suggest that recent meltdowns is the tip of the iceberg, and we are witnessing the collapse of the crypto industry.  You could be in this camp and would have lots of evidence to point to.  Another viewpoint would be that the crypto ecosystem ismuch more complex than what we see in the form of this year’s meltdown and that this is part of the evolution of the industry.  There is evidence for this scenario as well. 

The title of the article is a telltale of how we can arrive at an answer to this question:

The Good…  Crypto market is burgeoning with innovations that can impact multiple industries from pharma to supply chain to cyber security to next generation of internet (web3.0) and to the next generation of financial systems.  So, from this vantage point, the crypto technology stack and may of its applications (like DeFi, Supply chain, cyber identity, etc.) will stay and grow albeit, at slower pace due to the recent market meltdowns.  After all, the internet didn’t go away when the dotcom bubble burst and the likes of Amazon emerged as killer apps.

The Bad…A sector of the crypto market represents crypto lending and borrowing firms (like a shadow bank for crypto).  These firms were very attractive to investors since they paid anywhere from ~8% to triple digit interest rates on the deposits!  It all works well in the booming crypto market with astronomical valuations…until it is not.  As it turns out, collateral for the interest payouts were composed of other made up cryptos!  So, once there is a sign of market weakness and a run on the bank, there is no money for the lenders and so a death spiral. This type of chain reaction, not unique to the crypto market, affected several crypto lenders like BlockFi, Voyager Digital, Celsius Network and others.  These companies were the market darlings with billion-dollar valuations, thanks to the venture firm’s FOMO.  For example, in March 2021, BlockFi raised $350 million at a valuation of $3 billion co-led by Bain Capital Ventures, partners of DST GlobalPomp Investments and Tiger Global. The bankruptcies rattled the market. However, crypto was able to find its equilibrium again — in part thanks to the centralized currency exchange FTX which pledged to make further investments in infrastructure, including to buy the assets of Voyager Digital for $1.4 billion.

The UIgly… Highlighted by the spectacular collapse of the centralized crypto currency exchange, FTX — $32B valuation just days before the bankruptcy — appear to have [mis]used client’s funds to prop up its highly speculative venture fund, Alameda Research, and other embattled crypto firms mentioned above.  When the house of cards collapsed, the company’s balance sheet appeared to show $9B of liability against $900MM of assets as reported by the Financial Times.  Many of financial media (Bloomberg, Matt Levine; FT, Antoine Gara in New York and Kadhim Shubber and Joshua Oliver in London) have laid out the sequence of events in detail.  To make matters worse, FTX seem to have suffered a cyberattack and $370MM of assets appear to be lost!  

So, if we weigh the good, the bad and the ugly; a few points become clear. 

First point, in a hyped and un-regulated market, such as crypto, investor knowledge and education are key.  In this article, I focus on closing the knowledge gap – far from exhaustive – in the crypto market by examining the technology stack, the ecosystem and the risks.   

Second observation…is that for now, the crypto market and traditional financial markets are reasonably separated (Annie Lowrey, The Atlantic) limiting the risks to traditional financial markets.  However, as investment portfolios are diversified into the crypto world, the line between crypto and traditional finance will blur and the separation will evaporate. 

…And the third key point is the failure of big-time investors in doing proper due diligence in their crypto investments, with a few notable exceptions that saw FTX as a complete risk and didn’t participate in the investment frenzy.  According to the MarketWatch, in the 2021 high, the crypto market valuation was ~$3T (yes, with a T!).  As of this writing, valuation is at $850B, a historical loss of capital, and it is not over yet.  Regular investors – individuals, participants in funds, pension fund contributors, etc. – however, relied on the big-time investors.  This is a major lesson for doing your own due diligence.

mehrzad mahdavi