Crypto at the Crossroads – A Look Back and What Lies Ahead

By John Ragozzino, Jr.

The beginning of 2022 marked an unparalleled level of enthusiasm in the crypto space as industry participants, investors, media and even large segments of the general public were beginning to truly catch on, learn about and believe in the potential of this new technology, once reserved strictly for obscure illicit Dark Web transactions.  A look back over the past four years provides some hindsight perspective to contextualize the current state of affairs and allows us to better anticipate the key drivers for the sector moving forward.

Over the past four years we watched as a credible thesis for real world cases of utility in blockchain and crypto gradually gained momentum. The emergence of decentralized finance (Defi), exchange platforms for trading, investing and lending, Web3, NFT markets, DAOs and the Metaverse/Gaming provided some real business models for early stage investors to sink their teeth into.  This set off a mad dash to raise as much capital as possible in both the public and private markets as investors scrambled to catch a piece of the tremendous growth exploding across each of these sub-sectors.

As we entered the summer of 2021, crypto mania was in full swing.  It became readily apparent that crypto and blockchain was here to stay and the range of applications in real world business models seemed endless.  Some of the most significant high-water marks reached across the space include companies like Axie Infinity taking in a massive $275 million per week on its Play to Earn (P2E) gaming platforms in August 2021.  The amount of capital locked up on various Defi protocols reached a peak of $200 billion by October of 2021, and by November, as investors and businesses alike remained blinded by their astonishing success and growth, peaks in BTC and ETH occurred almost simultaneously over November 8th and 9th at over $67,000 and $4,800, respectively.  That same month, the aggregate market capitalization of crypto currencies topped the $3.0 trillion mark, and as if another datapoint illustrating the extent of the froth across the crypto market was needed, a record $133 million in transactions for virtual real estate in the metaverse were recorded.

While hindsight is always 20/20, it is difficult to think that the doctrine of irrational exuberance was not waving a bright red flag as the words “Virtual” & “Real” Estate were regularly being married in an oxymoron of epic proportions used to describe a $133 million per month marketplace.

By January 2022, markets had cooled significantly, Bitcoin was down approximately 31% by January 1, 2022, however its flat performance through 1Q22 suggested it was simply a much-needed correction and respite before the next leg up.  During 1Q22 what would be perhaps the last of the notable highwater marks took place in January, with a record $17.2 billion of NFTs sold to investors.

Such a meteoric ascent leading up to the peak in November 2021, can only be matched in magnificence by the perfect storm of events over the next 12 months which would bring us to where we are today.

Following a relatively quiet 1Q22, the second quarter marked the true unravelling of the crypto markets in early May 2022 as the algorithmic stablecoin, “Terra Luna,” fell below its $1 peg for the first time, before subsequently cratering to less than $0.10 in the following days.  This likely marked the beginning of the “Crypto Winter” as we call it, as some $600 million in market value was vaporized in a single week following this event. The decline in BTC and ETH subsequently resumed, with the two largest coins by market cap closing out the month of May 2021 +/- 50% below the all-time highs reached in 4Q21. Not six weeks later, a highly frazzled broader crypto market got another dose of shocking news which rippled widely throughout the sector. The collapse of Three Arrows Capital (3AC), a crypto hedge fund which boasted some $18 billion in AUM at its peak and was considered by many to be one of the most successful and influential hedge funds within the crypto space.  Hedge fund failures are not altogether uncommon as we all know, but the eerie level of irony embedded in the collapse of 3AC was not just the collapse of a levered hedge fund  managed using the increasingly popular HODL strategy, which refers to an aversion to selling in the crypto space and encourages investors to “Hold On for Dear Life” through the massive bouts of volatility.

In hindsight, what stands out in the immediate aftermath of the 3AC collapse was a crystal-clear demonstration of yet another word that would rapidly become commonplace in discussions around the crypto sector in the coming months and would eventually haunt investors to a degree no one could fathom at the time, “contagion.”

3AC’s massive exposure to one token in particular, the aforementioned algorithmic stablecoin, Terra Luna, appears to have been the match that ignited the 3AC fuse, leading to its remarkable collapse.  The massive losses incurred following Luna’s implosion the month prior, left 3AC scrambling to plug holes in a rapidly sinking ship, an effort which in a very short time, resulted in the fund defaulting on $665 million in under-collateralized loans from Galaxy Digital, and the subsequent fund liquidation.

As if the sector needed even more pressure, the Crypto Winter of 2022 effectively culminated shortly after in one of the most spectacular displays of fiduciary negligence, financial recklessness, and widespread investor losses ever witnessed, when the ongoing saga of FTX and its founder and CEO Sam Bankman-Fried or “SBF” began to unfold on November 2, 2022.  If you are reading this, and have gotten this far, we likely do not need to go into the subsequent details of this still-unfolding story about a 30-year-old worth an estimated $18 billion who managed to “lose track” of billions of dollars worth of client assets and sink one of the largest, most well-respected crypto exchanges in the world, shaking investor confidence in the crypto space to its ultimate core.

It is at this point where our prior mention of the word contagion comes back into play.  Here in mid-December, headlines such as the Bankruptcy of BlockFi and “paused” redemptions at Binance, continue to cross the tape, plaguing investors with increasingly rattled nerves.  As investigators continue to peel back the layers of this onion, it is becoming increasingly apparent that we will likely not know the full extent of investor losses and other problems triggered by this event, nor the degree of fear and contagion that continues to run wild among investors, for many years.

So, What Now?

For better or for worse however, Wall Street can be incredibly near-sighted, and some would argue it will not be long before investors pile into the next hot thing, be it in crypto or elsewhere – overlooking the cyclical lessons presented by the market over time.  Will this be the end of crypto entirely?  Not a chance.  The potential applications of blockchain technology are far too revolutionary and present so many potential opportunities for businesses and society as a whole, that it will without a doubt continue to advance and make its mark on the world.  We know a clear pattern when we see one.  In that sense, all we need to do to get a glimpse into the crypto crystal ball, is turn back the clock about 22 years to the implosion of the bubble.

Everything about crypto looks, smells and feels almost identical to the emergence of the internet in the early 90s.  There are the hardcore purist believers, the naysayers, the opportunists, and most importantly, the rock-solid assurance that human nature will continue to exemplify herd mentality as long as somebody is making an easy buck.  This will continue right up until the laws of basic economics kick in and that opportunity is squeezed from existence, and everyone stampedes for the door, hoping they don’t get crushed on the way out in the mass exodus.

  • First, and almost certainly, we will see a bit of rational thought return to those bold enough to dip a toe back into this space in the future. Selectivity is a virtue in investing, unfortunately it is also a lesson typically learned very late, and at significant cost.  So those still standing will indeed continue to finance the development of this revolutionary technology, searching for real world use cases, actual utility and perhaps even a means of monetization to justify a business model, and actually invest in it.  Exactly as we saw following the crash, real internet companies emerged, and they have formed a multi-trillion-dollar sector now that is in many ways the centerpiece of the U.S. economy. However, the number of sham companies that debuted in the late 1990s is countless, while the true leaders can be counted on a few fingers.
  • Second, the silver lining in all of this will likely be the significant acceleration in the development of a true regulatory framework, as investors will demand it before returning to the sector after such a severe burn (remember the Global Settlement, anyone?). We have long believed that this was perhaps the single largest limiting factor in the adoption and broader development of the blockchain and crypto industry — the lack of a reliable, level playing field and a set of enforceable rules to govern the game. These are absolutely critical criteria of any market in which true institutional adoption and participation is expected.  Indeed, regulation in some ways goes against the purist views of the decentralized nature of blockchain, and that’s all well and good, right up until it’s your pile of cash that disappears.

The same will be the case for crypto. While it is incredibly challenging to see through the smoke and debris left from the market crash experienced over the prior 12 months, one only need look to the trends in early stage capital raises to gain confidence that selective crypto investors remain, alive and well. Their enthusiasm is clearly demonstrated by the fact that despite the market peaking in November 2021, and following an absolutely incredible crash course this year, 2022 was already a record year for VC raises by 2Q22 with a total of 415 VC funds launched and an aggregate $121 billion in capital raised.  More telling of the general sentiment, however, is the fact that just $32 billion of that, or 26%, has actually been deployed, as investors wisely sit in waiting, ready to pounce at a glimmer of opportunity. Beginning in 2Q22 and subsequently accelerating in 3Q22, a sharp decline in capital raising in the private / VC market has continued with the amount of capital fundraised dropping by 80%.  The wild events of May and June, appear to have put the bulls on hold for a moment as funds are likely pushing their fundraising plans out significantly to allow markets to fully flush out all the remaining unforeseen impacts, digest a new norm, and begin to stabilize.

Companies brave enough to continue their pursuit of this incredible technology will be under more scrutiny from investors than ever before.  Their challenge will be to prove their worth in an unproven industry of pioneering technology.  In this regard, it is critical to closely monitor every move happening in the space, because increased selectivity on the part of investors means the strategies and business plans presented to them must be bulletproof and communicated in an air-tight fashion, anticipating in advance a greatly enhanced degree of skepticism and caution.

Follow the entire ICR 2023 trends series on the ICR Insights blog.