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Testing times for crypto

A hostile economic climate tests the mettle of cryptocurrencies
Testing times for crypto
  • Since the market boomed during the pandemic, millions of Brits hold some cryptocurrency
  • But a more difficult economic climate is presenting a whole host of challenges for crypto

According to research from the Financial Conduct Authority (FCA), around 2.3mn Brits hold some type of crypto. Although Bitcoin is the best known, there are over 18,000 other cryptocurrencies to choose from. It is no longer a niche market. And it is no longer a buoyant market. As my chart shows, after topping $64,000 in November 2021, the value of Bitcoin has tumbled below $20,000. This is a drop of almost 70 per cent. 

The pandemic proved a boom time for crypto. As savings accounts offered meagre returns, the chance to make a capital gain on Bitcoin’s run-away growth looked increasingly attractive. Investors looked for more creative ways of chasing returns: the FCA found that coronavirus was far more likely to have encouraged respondents to buy cryptocurrencies than to have discouraged them.

High levels of economic stimulus also ramped up demand. AJ Bell investment director Russ Mould argues that “cryptos gathered more buyers and believers when central banks (and governments) were spraying money around like confetti, especially during the pandemic, and some investors were understandably looking for stores of value or havens”.

But times are changing. Governments in advanced economies are unwinding quantitative easing, interest rate rises are on the horizon in the US, UK and eurozone, and inflation in OECD economies is averaging 9.2 per cent. The trouble is that cryptocurrencies have only been around for 13 years – we have little idea how they are going to fare in a more forbidding economic climate. 

We can, however, make an educated guess. Rate hikes are crypto’s first problem, raising the ‘risk-free’ rate of return: a three-month Treasury Bill now offers a 1.6 per cent return, up from 0.05 per cent a year ago. This increases the opportunity cost of risky investments and makes the gamble of a capital gain on a cryptocurrency less attractive.

This is all compounded by the fact that a significant proportion of crypto market activity is fuelled by borrowing. According to research by the FCA’s Michael Karim and Gergana Tomova, 14 per cent of UK crypto investors bought on credit. Research from AJ Bell has found that according to data from American market regulator FINRA, margin debt (the amount borrowed by professional or private investors in the US) has fallen for the seventh time in 10 months. Mould points out that even the pandemic could not force such a retrenchment. Is this a sign that appetite for risk is fading? 

It is worth pointing out that some of the problems facing crypto are not new. Equities markets have also been hit by the gloomier economic climate. Since Bitcoin’s November peak, meme-stock AMC (US:AMC) has dropped by 67 per cent and the better-established pandemic darling Zoom (US:ZM) has dipped 61 per cent. The FTSE 100 is down just 1 per cent over the period but the S&P 500 has lost over 16 per cent as recession fears hit equity markets. 



But some of crypto’s problems are very new indeed. There are no established valuation metrics for many cryptocurrencies, meaning that their values can fall steeply and unpredictably. Some stablecoins are trying to build solid reserves that tether them to the US dollar. Yet the recent unmooring of the largest stablecoin, Tether, highlighted the fragile nature of private stablecoins, argue Monsur Hussain and Alastair Sewell from Fitch Ratings

Crypto has also never had to prove itself as an inflation defence in advanced economies – since its inception in 2009, the average OECD inflation rate ranged between 0.3 and 3.4 per cent. There was once hope that it would act as a hedge in the same way that alternative investments such as art, wines and stamps historically have. The evidence so far is not promising. As we enter an economic climate of rising interest rates, recession fears and high inflation, cryptocurrencies are going to see their mettle tested.