Investors must continue to avoid high-risk crypto

by | Nov 22, 2022

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Written by Taimur Hyat, chief operating officer, PGIM

The collapse of FTX, one of the world’s largest crypto exchanges, has rippled through the world of digital currencies. Once valued at $32 billion, FTX filed for bankruptcy protection and founder Sam Bankman-Fried resigned as its CEO last Friday, after reports alleged that the company had loaned billions of dollars in customer funds to his own trading firm, Alameda Research. This has fuelled a flurry of withdrawal requests across platforms as investors braced for possible contagion. 

With more than $2 trillion in cryptocurrency value wiped out since the 2021 high-water mark, cryptocurrencies are suffering from a spectacular fall from grace and are now drawing increasing regulatory scrutiny and investigations around the globe. Michael Barr, the Fed’s vice chair for supervision, said recent events in crypto markets “have highlighted the risks to investors and consumers associated with new and novel asset classes and activities when not accompanied by strong guardrails.” 

This is in stark contrast to just a few months ago when crypto enthusiasts were advocating for, and in some cases implementing, cryptocurrency’s inclusion in institutional portfolios and retirement accounts. 

If anyone out there is still tempted to enter the cryptocurrency orbit at a potentially attractive, lower price point, consider this: the most profound risks to cryptocurrency investing may still lie ahead, rather than in the rear-view mirror. This is something we have highlighted in our conversations with clients for some time, but it bears repeating. Investors contemplating a long-term allocation to cryptocurrencies should remain wary for three primary reasons.

First, a lack of clear and uniform cryptocurrency regulation – both within and across countries – creates tremendous uncertainty for long-term investors. It is still unclear in the US, for example, when a cryptocurrency falls under the regulatory framework of a security subject to SEC regulations and when it is deemed to be an asset or commodity like bitcoin and Ethereum have claimed. Indeed, in some countries, cryptocurrencies are facing outright prohibition; China’s abrupt banning of all cryptocurrency trading and mining in 2021 is a prominent example, but by no means the only one. Regulators have also been concerned with the notable and repeated breakdowns in the infrastructure supporting cryptocurrency mining and trading – another area where there remains significant regulatory uncertainty. And the fallout from the FTX collapse makes one thing clear, self-regulation and transparency are illusive.

Second, despite all the hype as digital gold, cryptocurrencies have failed to demonstrate either “safe haven” or inflation fighting properties when faced with actual market volatility or the first real bout of serious inflation in developed markets. Between 2010 and 2022, bitcoin recorded 29 episodes of drawdowns of 25% or more. By comparison, equities and commodities recorded just one each. Even in the pandemic-related market selloff of March 2020, bitcoin suffered significantly deeper drawdowns than conventional asset classes like equities or bonds. Similarly, while the fixed supply of bitcoin – set forth in its source code – might imply a resistance to monetary debasement, in the recent episodes of elevated global inflation, bitcoin has provided limited inflation protection with prices tumbling even as inflation spikes in the US, UK and Europe. 

Lastly, cryptocurrencies remain deeply problematic from an environmental, social and governance perspective. Most troublingly are the governance issues that have been highlighted by the FTX implosion. Too often non-existent control systems and decision-making limited to a small inner circle create a black box with no concerns for investors and their holdings. Additionally, cryptocurrencies decentralized frameworks and anonymity make them especially attractive for illicit activity, money laundering and sanction evasion. From an environmental perspective, even if the transition from proof-of-work to proof-of-stake that Ethereum is spearheading reduces the massive energy consumption underpinning crypto mining and validation. Environmentally, bitcoin – which represents about 40% of current cryptocurrency market cap – will continue to use a validation process where a single transaction requires enough energy to power the average American home for two months. And socially, cryptocurrencies’ promise of financial inclusiveness also appears overblown, with crypto wealth as unequally distributed as conventional wealth, and with simple phone-based payment services such as M-Pesa in Kenya or Grameen Bank’s international remittance pilots in Bangladesh already providing a digital platform for underbanked households – without the need for a new currency or payment infrastructure. 

The FTX collapse has turned another bright spotlight on to cryptocurrencies, and only time will tell whether the remaining players will have what it takes to survive. There continues to be dark clouds on the cryptocurrency horizon that long-term investors should observe carefully from the side-lines to better understand true value vs. hype before deciding to invest in the cryptocurrencies.

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