Crypto Winter, or Crypto Spring?

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Hi, I'm Stacie Jacobsen. Thanks so much for joining us today on The Pulse, where we bring you insights on the economy, global markets, and discuss all the complexities of wealth management.

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Today on the show, we are talking about a popular word these days, Crypto. For about the past decade, Crypto assets have been an unmissable part of pop culture and financial news. Nearly fantastical wealth appeared from thin air, inspiring copycats, charlatans and disbelievers. As the market collapsed over the past year. Observers looked on with astonishment and, dare I say, a dash of pleasure. Well, crypto enthusiasts watched in horror and pain. More importantly, from where we stand today, will the crypto winter require a lengthy hibernation or is spring around the corner and another summer is still ahead?

01:00 - 01:38

During crypto skyrocketing phase, skeptics warned that it would all come crashing down. But even the skeptics had differing opinions. Some thought it was merely a matter of overvaluation above all, that needed to pop, while others thought the mere existence of crypto assets is just pointless. The complexity of crypto is a source of some of its appeal, but also much of its risk. And there's really just so much to know that learning about this space is like learning about markets all over again. So where do we begin? How do we get a handle on what's happening in the crypto world and how do we approach it intelligently? When we come back, we'll talk to two of my colleagues to help answer these questions.

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Hi, I'm James Seth Thompson.

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And I'm Maci Philitas.

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We're the hosts of Changing the Trajectory, a podcast that informs, engages people of color and wealth creators to change the course of their wealth, impact and influence.

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02:16 - 02:28

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Welcome back. Joining us today are my two colleagues, Sasan Doroudian, head of taxable bond trading and Chris Brigham senior research analyst. Thank you both for being here today.

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Thank you for having me. Thanks, Stacie.

02:43 - 03:00

Now, I know there's a lot to cover in this area. So before we jump right in, I just want to set the expectation that we are approaching this topic with two important Cs: curiosity and conservatism. Okay. So, Chris, I'm going to start with you. How are we thinking about crypto assets from an investing standpoint?

03:01 - 03:36

So inside of our private client division, we wrote a white paper on crypto assets about two years ago, back when they were booming and before the current crypto winter. And the most important takeaway from that is that investors should not be putting anything into crypto that they are not willing and able to lose entirely. Just to repeat that, anything that people are investing in crypto. You should be comfortable if that goes to zero. And in the latest crypto winter, I'd say that that approach has had its value really shared and shown.

03:37 - 04:34

The other big takeaway from our work on crypto a couple of years ago, and I'd say a guiding principle for us is that it's tech, not macro. So crypto at the end of the day is software. And if you think about it like technology, you think about it like software. It makes it a lot easier to get your head around what's going on in the future development. There's a lot of people think of it as money or digital gold or something along those lines, and it's harder to expand the analogy from there. So thinking of it as software and as technology helps ground you and also has a an impact on the way that you manage risk around it. There's also the fact that you can invest in stocks and tokens, but generally we've extracted venture capital like principles. So size that small is a portion of your overall portfolio. Diversify inside of that and have fundamental reasons for owning the things that you don't have some long-term vision and story that you think is going to play out, and that's why you want to own these things.

04:35 - 04:53

When you said the research from two years ago, I was going to ask you what updates we've had, but I think we've just seen that that has played out. So, look, Chris, one of the things that you said was that, you know, we almost think about crypto like tech, right? So a common criticism is that crypto doesn't actually really do anything useful. But what are some of the use cases that you've seen?

04:54 - 05:35

So there are a number of real use cases and each one is at a different phase of development. Let's say the one that gets the most attention immediately is payments. That was sort of the original vision of Bitcoin. Crypto hasn't necessarily proven itself that much in payments to this point, but there are interesting applications of whether it's central bank, digital currencies or what are called stablecoins, which are crypto tokens that are pegged to an asset like the US dollar. And so they're designed to be stable. You can use those to effectively move dollars around that crypto ecosystem, which is we think about what the future of the digital economy might look like that could have value.

05:35 - 06:00

If people want to spend what's basically a dollar online or on these other digital ecosystems, the payments are still a poor one, although it hasn't really played out to date the way that I think people thought it would a decade ago. Tokenization taking real world assets and basically securitizing them, splitting them up into fractional shares and then having them trade on the blockchain. That's a use case that we think has a lot of potential and we're very excited about.

06:00 - 06:24

Smart contracts and insurance are another one. Digital asset ownership and NFTs. When we think about the metaverse and things that you can own in the digital economy, the value add that you can create out of these digital assets and the ability to capture that value for creators, You think that has a lot of value? And then the last one where we're seeing some really cool use cases today is games. And so that's, I think, where we're going to see some cool development in the coming years.

06:25 - 06:28

Sasan, from your perspective, do you have anything to add to that?

06:29 - 07:05

And I would just add in fixed income. We had the European Investment Bank issue a digitally native bond, and it was about a disappointing year and a half two years ago. It was on the Ethereum blockchain. And then most recently out of Asia, there was an insurance using the stellar network. So we're seeing test cases use cases out there. Seven public seven private cloud versions of the public blockchains where we think there could be some interest from corporate issuers to use the technology just a more efficient way than the traditional APEC settlements process we have in place.

07:06 - 07:10

Right. So that that leads me where I want to go next. So where do we stand on institutional adoption?

07:11 - 08:02

So from the investment side, what we've what we've observed and has been some of the public information as well, is that there are pensions that have invested into the digital asset ecosystem. It seems to be majority of it has been initially kind of VC side as opposed to direct investment of the crypto assets. But in the last several months, what we've heard is that there are endowments as sovereign wealth funds, as the family offices that are allocating that percent to direct investments into the space. I would just say it still seems like it's very early innings and institutional adoption. A lot of people are waiting for more regulatory clarity. But about every week for the last three or four months, I've seen another really big headline about institutional adoption. So despite it being crypto winter, we're definitely seeing that fundamental progress playing out.

08:02 - 08:18

So even though it feels like we're in the depths of this crypto winter, Chris, it seems like you're alluding to a little bit of a light at the end of the tunnel. We know that 2022 was clearly a tough year and I talked about that early on. But what is your outlook for 2023 and even beyond?

08:19 - 08:56

I'm going to make a very bold statement that 2023, I think, will look a lot like 2022, at least on the technology side and on the fundamental side. In the last few months, like I said, there's been this steady progress with really, I'd say, probably one key milestone or one key headline week. And my suspicion is that that pace is going to be maintained or even accelerate over the course of 2023. For a little while at least we might see more of that fundamental progress than any kind of market progress. But from an investment standpoint, I guess there is probably something to be said for the extent to which fundamentals are progressing and the markets aren't.

08:57 - 09:08

So, look, we're in mid-January right now, and one of the headlines in the crypto space is Genesis. Can you shed some light on that and the custody issues there? And how should people really be thinking about this?

09:09 - 10:00

Absolutely. I guess I would just add really quickly, talking about FTX, that's going to be probably the milestone that people remember most about 2022 for crypto, even though there were some other really big ones like the Ethereum merge or they completely changed how that crypto protocol, how that software runs and how it's validated. That fundamentally was a really important milestone for the year, but FTX is the one that people will probably remember. It's along the lines of Enron or Lehman or Theranos. And in a similar way to at least Enron and Theranos, it really came down. At the end of the day, it sounds like, to just bad actions and to what the U.S. government is going to be making a pretty compelling case for fraud. From the sounds of it. So there were definitely some red flags there that people close to the situation might have been able to catch better and probably should have caught better.

10:00 - 10:39

But I would say that a lot of what went wrong there was just general finance problems and general corporate problems, less than a crypto specific problem, the same way that there are no Swiss fraud rather than a biotech related problem with Genesis, it's a slightly different situation in that the knock on effects from FTX blowing up have caused this contagion effect and actually FTX wasn't even the first domino to fall addressed originally back to the Tara and Luna blowup from earlier and in 2022. And that's just taken time to flow through the system as people have started to realize whose balance sheets were affected by it, and then his counterparties were affected by it. And so now it's taken down.

10:39 - 11:25

FTX and FTX in turn had a counterparty that was exposed to them across Genesis, another very large exchange in the crypto space. And Genesis is also particularly interesting because it's owned by Digital currency group, which is run by Barry Silbert, and that company is all over the crypto ecosystem. So Genesis was very connected throughout the crypto ecosystem and Genesis and Gemini had a product where you could earn yield on your crypto. The issue with that product and the SEC is now suing both of them for that because they are saying that it was basically security because it had this yield component, but because of it you basically were taking counterparty risk to Genesis.

11:25 - 11:48

And now that Genesis is on the brink of bankruptcy, that counterparty risk is really coming home to roost both for Gemini and for the people who, whether they were giving their money to Genesis directly or giving their money to Genesis via Gemini, they now thought that they had a safe asset, something like a bank account that was just yielding a lot of money. And it turns out that actually they just had a ton of counterparty risk.

11:48 - 12:23

So the takeaways for it are really that you have to think about the way that you hold crypto. That was essentially like having a checking or savings account, but with no government insurance. You could also have somebody custody it for you. And that's sort of like having a safe deposit in a bank. Or you can self custody, which is like having an online wallet or putting it in cold storage in a hardware wallet that's more akin to the safe in your home where you have to do the work and you have to protect it. But each one has costs and benefits, and people in the space are going to have to think a lot more clearly about how they actually have their assets.

12:23 - 12:45

And one thing we're already seeing is, especially amongst institutions, and it's actually surprising that people weren't paying as much attention to this upfront. People are now paying a lot more attention to making sure that their assets are custody, as that should be. Kind of that should have been square one for a lot of people. In this case, I think there were a lot of players who didn't really understand the custody situation and fine print there.

12:46 - 12:55

We were talking a little bit about the contagion of FTX and how that's impacting Genesis. How far reaching do you think the contagion effect is?

12:56 - 13:19

That's a really good question. I don't know how far it's going to stretch. I've actually been thinking about this one a lot lately. We've had clients who do have fairly large crypto holdings, some of whom have had money at exchanges that are either involved in this or are close to this. And so they've been curious about what they should do with their assets.

13:19 - 14:17

And that's made me think a little bit about, okay, how far does it go? How long does this daisy chain take to play out? And on the one hand, it does feel like we're getting a little bit close to the end. On the other hand, if you think back to the global financial crisis, Bear Stearns went under in March of 2008 and Lehman wasn't until September. The six months unfolded before that, and that was already six months after the first money market funds in fall 27 started to have issues. So there could be an extended period of time where this contagion effect plays out. If anything, the thing that might make it a little bit shorter is just that the ecosystem is still fairly small at the moment. So this could be really bad for certain entities. But the length of time that it takes to get from one point in the network to another point, that network is, I think, only so dense.

14:18 - 14:40

Chris, Earlier on you started to talk about some of the different ways that crypto can be held. One of the issues that many will state is that hacking and cybercrime have been sources of a lot of these negative headlines that we've seen, especially in the recent years. Either one of you, what do you think that means for the future of crypto? How do we want to be holding it? How is it going to transform?

14:41 - 15:38

I guess the saying is not your keys, not your coins, but you know, self-custody requires having like your own sort of security measures in place and using a third party custody alleviates that sort of immediate pressure to set up the infrastructure from a security standpoint. I think it depends on what your objectives are and what your comfort level is in terms of software sitting versus sort of outsourcing it. I suppose from the hacking perspective, I mean, corporations get half as well, so it's netting out. You've got somebody that's been around the space like the Snowden. And they're comfortable with their infrastructure and their protocols and how things are moved out. Some have validated you need like three out of five validators before you can move your digital assets from a cold wallet to heart if you're going to trade it. And just getting very familiar with the data with a team and the infrastructure they have in place. And I would echo that that I think hacking is just an inherent issue in the space.

15:38 - 16:01

If you think about it, software, right? So software, especially software that has economic value attached to it. There's always going to be incentive there for some bad actor to go and try to steal that or hack that. And so that's not going away. And the only way to protect against it is to have cybersecurity protocols in place to deal with it.

16:02 - 16:40

The one thing I would say there is that from a custody standpoint, I think that people have begun thinking more about lately and been more inclined to do in the last year or so is staking of your Crypto, which basically means that you are using your crypto that you hold and risking it to validate transactions on the network and essentially make that software run. You can sort of think of it like MasterCard is software and it's just processing transactions and the company MasterCard takes accountability for that as a centralized actor.

16:40 - 17:15

Crypto does that same type of thing and has that computing process, that computing power to enable that data validation and that transaction processing. It's just decentralized. And when you're staking your assets, you have to have them connected to the Internet to allow it to do that processing and to be part of that network that is processing it, which means that you are potentially hackable. And so for people going forward with staking as a possible thing, if you do want to stake your assets and you do want to earn that yield, that means putting them at more risk of hacking.

17:16 - 17:49

So one thing that I think a lot of people have been working out, especially at some of the leading crypto exchanges, is how can you do that in a in as secure a way as possible? Because the safest thing you could do is basically put your crypto on to a USB drive, stick that in a safe and then bury that safe in the ground. But your crypto wouldn't be very useful for you then. So how can you bridge that gap to that user crypto? They can either spend that crypto or that you can stake it and earn some return on it without subjecting yourself to hacking risk. And there's a lot of good work in the space being done on that.

17:50 - 18:37

Then the other thing from a cybercrime standpoint is just that crypto has never been really good for cybercrime. These are publicly permanently available ledgers. You can see every transaction on them. You can see where the money is going, which is why it's been possible for some of these really bad hacking and ransomware attacks. We've been able to get the money back because at some point somebody put it in an account where they shouldn't have put it and U.S. Treasury was able to go in conjunction with the FBI and say, Hey, so-and-so company, this money there, we can show you it came from this crime and you are going to open that account and you're going to spend however many billion dollars or $100 million in it. You're going to send that to U.S. Treasury and are going to give it back to the people who it came from. And that, I think, just naturally makes crypto not actually that good for cybercrime.

18:38 - 18:49

It's very likely that in the next few years crypto will become much more closely supervised and regulated. Do you think that should ease some of our fears that we've discussed thus far?

18:50 - 19:34

Yeah, I believe, you know, touching back what we discussed earlier is that for many citizens who are doing the work, for some of them that will be the linchpin as having a regulatory framework, especially if you're considering setting up instead might take extra money that you want to make sure that you're advocating within a framework that you know what you're allowed to do, what you're not allowed to do, how are you able to market it? And I think we definitely want to see more regulation. It just makes it easier to plan what you're doing and figure out how you can utilize this. And it also will just make more people more comfortable, which expands the user base to really see that exponential growth that people are waiting for. You need regulation there to get more people comfortable and get them using it.

19:35 - 20:12

And where I personally am most excited to see regulation is in the area of tokenization. A lot of that is going to look like securities laws, but having a really clear regulatory framework in place I think will allow that use case to really get built out. And I'm excited to see with the right regulatory framework what that can mean for investment markets going forward. The other side of it is outside of regulation. You also need more financial disclosures and just more financial data to evaluate these assets that are now being invested in and being traded. That's the other leg that needs to come along with the regulation there.

20:13 - 20:22

Chris, I'm going to direct this one to you. There's been some discussion that crypto may start to act like an inflation hedge. Where do you stand on that?

20:23 - 21:09

So that's a good question. Overall, I would say we treated that with a little bit of skepticism before the fact. Partly because there's a question of whether or not crypto and when people talk about this, it's really Bitcoin. I mean, they don't mean crypto writ large. The question was whether Bitcoin would act as an inflation hedge. Would it be digital gold? I think we've had issues with that for two reasons. One of them is that the premise that Bitcoin is digital gold is still really more of a VC narrative to be proven out than an actual fact. And so we haven't really seen Bitcoin move like gold or move for the reasons why gold moves to date. That could still happen, but we haven't seen that and that was our issue there.

21:09 - 21:57

And the other part of it is gold itself, even a good inflation hedge. We've written a lot about inflation and we're actually recommending inflation protection to our clients before this inflationary breakout. And in the analysis that we had there, part of that inflation protection was to take a balanced approach across a range of asset classes. Not to make gold your only inflation hedge. And there have been many inflationary periods included, and I would argue this most recent inflationary if ever, gold did not actually serve its purpose as a hedge. So I think the idea of crypto or Bitcoin itself as an inflation hedge has been pretty well put to bed by what we saw this year. There will still, I'm sure, be people who make that case going forward, but the data just don't really support it at this time.

21:58 - 22:09

All right. Well, as I started, I said we are going to approach this with those two CS curiosity and conservatism. Sasan and Chris, thank you so much for joining us today. I really appreciated the time that you gave us today.

22:09 - 22:12

Thank you for having us. Thanks for having us, Stacie.

22:13 - 22:33

And thanks to everyone for tuning in. And you'll hear from us again on February 14th when we'll start our two part series where we discuss managing risk using alternative assets. You won't want to miss it. Don't forget to subscribe to the Post by Bernstein wherever you get your podcasts to ensure you never miss a beat. I'm your host. Stacie Jacobsen. Wish you a great rest of the week.