Bitcoin prices have tumbled in 2022, (see chart) but investors seem to continue to have trust in cryptocurrencies. One reason is that the software behind most cryptocurrencies promises a revolution in finance through a decentralized mechanism that provides efficient and secure transactions. Generating a way to make the financial transaction less expensive and quicker helps create an environment for the unbanked to have a payment mechanism that is a cash alternative. A peer-to-peer money transfer process that eventually has reduced fees will be a game changer for less affluent countries, especially when a family member moves to another country and sends money home.
Bitcoin Has Collapsed
The bitcoin exchange rate versus the dollar collapsed in 2022, declining by about 66%, after hitting a high early in the year near 48K and testing the 16K level in November 2022. The exchange rate has faced many headwinds, including a stronger U.S. dollar, higher U.S. interest rates, and a decline in riskier assets which has weighed on bitcoin. Bitcoin broke through the 200-week moving average, which is now strong resistance and is forming a bear flag pattern, a pause that generally refreshes lower. Despite the decline in the exchange rate versus the dollar, many investors continue to have faith in bitcoin as they believe that the cryptocurrency will usher in a new way of making payments and moving money around the globe.
Trust Despite Continued Issues for the Cryptocurrency Industry
There continues to trust that bitcoin will perpetuate despite several issues faced by the digital coin industry in 2022. At the same time, bitcoin lost two-thirds of its value in 2022, and another digital coin called TerraUSD, which was supposed to act like a money market fund and hold $1 in value, collapsed in 2022 with another stable coin called Luna.
TerraUSD was marketed as a stablecoin holding reserves and acting like a money market fund. TerraUSD had an algorithm that relied on traders to act as a liquidity provider to maintain the value of the stablecoin. If the liquidity providers decided to step away could be a deviation from the value, which is exactly what occurred. Following a series of withdrawals from Anchor Protocol, similar to a cryptocurrency bank, traders stepped away, creating a tidal wave of selling.
The selling and crypto trading continued, pushing TerraUSD through the $1 level and dragging lower Luna, another stablecoin. The collapse of TerraUSD led to the massive selling of bitcoin reserves to help stabilize TerraUSD. What is clear is that the stablecoin concept based on liquidity providers that held bitcoin did not work. A similar scenario occurred in 2008/2009 during the great financial crisis. Money market funds expected to hold the $1 level collapsed as liquidity providers refused to hold the line.
Then Came FTX and a Massive Decline in an Exchange
The drop in digital stablecoins such as TerraUSD was not the biggest headline in the cryptocurrency space in 2022. In November, cryptocurrency exchange FTX collapsed following a report that it exceeded the leverage it offered and was brought down by a hedge fund Alameda Research owned by the company CEO Sam Bankman-Fried. The markets had seen this story before, where leverage created untenable trades, eventually destroying the entity. The book When Genius Failed describes some of the most prominent traders on Wall Street who owned long-term Capital Management hedge funds. Their premise was that they could trade illiquid off-the-run treasury bonds versus on-the-run treasury bonds and continue to benefit from the convergence of prices over time. The theory was sound, but markets can push investors to maximum pain before a trade might work out. In the case of Long-term Capital Management, their leverage was massive, and the losses piled up to the point where the hedge fund needed rescuing from the Federal Reserve.
In the case of FTX, Alameda Research used a token created by FTX to borrow money from investors and then used that borrowed capital to invest in cryptocurrencies. When the losses became unwieldy, Alameda decided to use customer funds, which is against the law in the United States, to post as a margin for the borrowed capital they were using for their trading. On November 11, 2022, FTX CEO stepped down, and the company filed for Bankruptcy.
The unwinding of the exchange will take months or even years. Customers do not have money in their accounts and are looking for a remedy to become whole. In cryptocurrency, no overseeing body like SIPC or the FDIC will insure customer deposits. On November 10, the Bahamas securities regulators froze the assets of FTX Digital Markets and FTX’s subsidiaries as rumors floated that Bankman-Fried was looking for eight billion in capital to bail out the exchange. In the wake of the Bankruptcy, the Securities Commission of the Bahamas demanded control of the assets held by FTX and moved them to a protected wallet.
Bitcoin Takes Another Leg Lower
The news that FTX was bankrupt spurred another leg lower for the cryptocurrency under pressure for 2022. Despite the cryptocurrency decline, some continue to believe that a decentralized currency will be the future wave. You might think you can move money digitally via products such as Venmo and Zelle. Behind the scenes, some magic makes this all happen. Bankers still need to advance the money to you, and it still takes a day or two for the fiat currency to be authorized and for a financial institution to create the transfer. Your money is eventually moved but does not move instantly when you make a Zelle or Venmo transfer.
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