Traditionally decoupled from wider market movements, we are now seeing closer correlation between the crypto market and the macroeconomy, with many cryptocurrencies behaving like other risk assets such as stocks.
Summary
The role of crypto in the macroeconomy
With no indications that global macro pressures will ease off, along with an expected correction of at least 10-20% in stock prices, we perhaps shouldn’t expect to see a significant recovery in crypto prices by the year-end. On the flip-side, we have seen central banks tightening monetary policy more rapidly than we have seen in recent years, so it will be interesting to see what effect this may (or may not) have on crypto prices.
The influence of wider market conditions on crypto were perhaps best observed in The Merge. Despite the best efforts to drive prices up through the promise of less energy consumption, lower operational costs and the “airdrop” of the ETHPOW token, this event had much more success technically rather than driving positive price momentum. While it could be argued that some initial selling pressure in the price of ETH was fuelled by PoW miners selling off inventory, the finger still points firmly at the uncertainty of the macro economy. As long as interest rates and inflation continue to rise, risk assets such as cryptocurrencies will have a difficulty decoupling from the market in a sustainable way.
Decoupling crypto and the macroeconomy
Recent volatility in crypto markets was fuelled by large institutions going insolvent, many protocols being hacked and catastrophic events such as the Terra-Luna collapse. As a result, many investors have become much more cautious and aware of the risks in crypto. While we can expect this sentiment to continue for some time, once there is more clarity on regulation, as well as further development of use cases and utility for different crypto assets we should expect to see a substantial increase in crypto being included as part of investment portfolios for both retail and institutional investors.
When crypto as an industry matures further, and the number of active users inside the crypto economy continues to rise, we do expect there to be an opportunity for crypto to decouple from the wider risk asset market. Of course, this still relies on the macro environment improving significantly; as long as there is uncertainty over the future of the wider economy, it will be difficult for sentiment around crypto, and other risk assets, to improve too.
The crypto lending market
The high-profile collapses of Voyager, Three Arrows, and Celsius in 2022 certainly sent shockwaves through the crypto community, however they may be the catalysts needed to better align the crypto markets with traditional finance (TradFi).
Regulation will most certainly tighten up, pushing crypto market operators closer to TradFi operators. We should start to see more comprehensive in-house risk management functions from crypto providers, and investors are now much more likely to demand transparency over where, and how, their allocations are being stored and used. We believe that all successful players in the market will have these considerations at the core of their business going forward.
That being said, unsecured lending will most definitely still continue to be a part of the crypto industry in the future, just as it is in TradiFi today; without this accelerated activity we would see a slow-down in innovation. What will change, however, is a ramp up of risk management and the appropriate pricing of risk in unsecured lending. We already see this in the market today, with many crypto providers hiring risk management teams from the TradFi industry to be more compliant.
While it’s tempting to view secure lending as the watertight option in ensuring confidence and security in the market, this still relies on a better level of transparency from crypto operators and improved regulation in the industry. You only need to look at recent exploits in DeFi to see that secured lending can’t rely on the value of crypto alone; collateral may be manipulated if the token is illiquid, and events like a complete market crash can erase any value entirely. It would be positive to see a move towards the standardisation of loan agreements that we see in TradFi; the inclusion of loan covenants would be just one move that would create products that can easily be compared to each other. Again, operators can also help boost confidence in the industry by publishing financials and giving guidance on future business expectations.
The lending and earning of interest on excess assets, and the borrowing of scarce assets, are key pillars of any functioning market; they optimise the economy by ensuring assets are directed to where they are most useful. Borrowing provides a cost-effective way for the market operators engaging in different activities in the market to do those activities, while lending provides a way for other market operators to make use of their excess assets and earn an interest on them rather than letting them sit at their wallet doing nothing.
In the current crypto market, we are seeing the market makers and market-neutral hedge funds generate the best returns in the lending ecosystem, and so most lending activities are centred around these players. Market operators with excess capital are also earning the best risk-adjusted returns from directing their capital into crypto. In the future, it may be Decentralised Autonomous Organisations (DAOs) looking to invest into building crypto infrastructure, or a new product used by billions of people or investment managers, that will generate best risk-adjusted returns, at which point most of the money will be directed here.
The outlook for 2023
A potential recovery of the crypto market depends on a number of macro driven metrics that are still very much uncertain. However, we see that most of these are already priced in, and many of our used indicators suggest the market bottom could be near. For example, the Bitcoin supply in profit as of 13 Oct 2022 is on the same levels as it was during the Covid crash and the 2018-2019 bear market bottom. We expect a recovery of some sort during the next year, but it remains to be seen how strong the drivers are to sustain any positive momentum. This again depends a lot on the macro environment as prices of risk assets are not able to sustain a long rally if rate hikes continue or we move into a recession.
The crypto industry has a history of hostility towards regulation but, when done right in a collaborative manner, regulation helps to create a more secure and more reliable market with better standardised practices. This also advances market efficiency, which is needed if the industry truly wishes to challenge the banks, asset managers and other industry players of the TradFi world.
The crypto industry as a whole is currently at a tipping point: what we as an industry decide to do next is what determines the success or failure of our industry and crypto as a whole. Only by welcoming regulation, offering transparency to customers, regulators and other stakeholders, and ensuring appropriate risk management, can the crypto industry look to change current sentiment and better align itself with the demands of traditional finance.
Additional contributors to this article were from the DeFi team at Tesseract. Tesseract is an institutional digital asset lending company in Europe and emerging markets which provides digital asset lending solutions to institutional clients, such as hedge funds and retail trading platforms, globally.
By Daniel Staford and Lauri Marekwia, DeFi Team at Tesseract
