What A Difference A Year Makes In Crypto Markets – Top Performer In 2023

I’ve been a fan of Michael Lewis ever since I read his first book, “Liars Poker,” which gave an insider’s view of bond trading at Salomon Brothers when they dominated the mortgage-backed securities (MBS) market. It was of particular interest to me because, at that time, I was the MBS Portfolio Manager at Fidelity Investments and one of Salomon Brother’s biggest clients. It is not often one gets such insight into the personalities they do business with each and every day.

Lewis is gifted in being able to explain sophisticated financial concepts and complex investment instruments in an understandable way. He is also the rare author who can make the serial numbers on a dollar bill seem exciting. His other financial books, “The Big Short” and “Flash Boys,” were equally compelling.

It was with this enthusiasm that I was eager to read his latest book, “Going Infinite,” which not so coincidentally, was released in October 2023, just as the main subject of the book, Sam Bankman-Fried (SBF,) was going on trial for fraud.

Sam Bankman-Fried founded Alameda Research, a crypto currency trading firm, in 2017 at the age of 25. Having zero experience in the crypto market, SBF decided he could apply some of the quantitative strategies he learned trading international ETFs at Jane Street Capital, to the inefficient crypto market. Two years later, in 2019 he founded FTX, a crypto currency exchange, in part to facilitate trading at Alameda Research.

Within two years FTX became the second largest crypto trading exchange in the world, and on paper was valued at $40 billion. SBF, as the largest shareholder of FTX, was worth $23 billion. He became the cover boy on numerous magazines, including Fortune, and in October 2021 posed for Forbes when he was placed on their list of the 400 richest Americans. SBF was profiled as the World’s Richest 29-year-old.

What the trial, and the book, highlighted was that FTX emphasized growth to generate trading profits, without any oversight. There were no internal controls, there was no risk management, there was no Chief Financial Officer and there was no Board of Directors.

The accounting system seemed to be not much more sophisticated than that of a lemonade stand.

As CEO, SBF didn’t believe in titles, job descriptions, or even an organizational chart. He just kept everything in his head.

Customer funds for the FTX trading exchange were comingled with Alameda Research’s trading positions, which in the world of finance is a no-no, and when the crypto markets tanked in 2022, it all blew up.

SBF was convicted of seven counts of fraud.

FTX was not the only crypto bankruptcy in 2022, just the most prominent. Altogether, there were nine crypto bankruptcies during the year, with a cumulative loss of $18 billion.

Bankruptcy has been common in the crypto space almost since its inception in 2009. Perhaps the most well-known was the Mt. Gox bankruptcy of 2014. At the time, Mt. Gox was a crypto exchange that handled over 70% of all Bitcoin transactions. They had to file for bankruptcy when they were hacked and 850,000 Bitcoins were stolen.

As the market evolved rapidly, players tried to evolve with it, with little regard for the rules.

In the most recent action, Binance, the world’s largest crypto exchange, pled guilty to violating anti-money laundering regulations. They agreed to pay a $4.3 billion fine and their Chairman, Changpeng Zhao (CZ,) perhaps the most famous player in the crypto field next to SBF, agreed to resign. Their settlement was with the US Justice Department and the CFTC, following an investigation of their failure to comply with laws including the Bank Secrecy Act, obligating lenders to verify customer’s identity and to flag suspicious money transfers.

Observations

Although the crypto market is 15 years old, it is still the wild west, with little regulation or oversight.

The original crypto asset, Bitcoin, was designed as a digital currency, to be used as a peer-to-peer medium of exchange that circumvented the central banking systems of the world, which were the creators of fiat currency.

The concept was that Bitcoin would be easy to transact, have low transaction costs, and all transactions would be immortalized on the blockchain ledger. Additionally, Bitcoin enabled transactions using only digital identities, thereby granting users some degree of anonymity.

Reality, however, proved to be different. It was not simple to acquire Bitcoin, as one had to go through an exchange. But how do you choose between the dozens of exchanges? Plus, the exchanges were unregulated and risky for investors due to the prevalence of scams and security risks.

Then Bitcoin owners had to decide how to store their cryptocurrency. It could be stored on-line in the exchange’s e-wallet, or off-line in a cold wallet. Neither was ideal.

Perhaps the two biggest drawbacks to Bitcoin as a currency were, first, not many products would accept payment in Bitcoin and second, its value was too volatile. The simplicity of payment that was originally envisioned never materialized and very few vendors accepted the digital currency. Usage never became widespread.

As for the volatility in its value, no one could figure out the actual price they would be paying for a good, because it changed too frequently. Daily value fluctuations of 5%-15% were simply unacceptable. This volatility actually increased the transaction costs to accommodate the risk.

Daily Volatility of Bitcoin Source: Highcharts.com

These levels of volatility over short periods of time are not the characteristics of a stable currency. It is more indicative of a speculative investment or trading instrument. Consequently, usage of Bitcoin as a medium of exchange never took off.

No one was sure how to treat it. Among the regulators, the SEC thought it should be a security and regulated by them, while the CFTC thought it was a commodity and should come under their purview.

Gary Gensler, Chairman of the SEC, was quoted on CNBC saying “there’s been far too much fraud and bad actors in the crypto field. There’s a lot of non-compliance, not only with securities laws, but other laws around any money laundering and protecting the public against bad actors there. And so, I would note, this is a field where you still don’t have the fundamental information on many of these projects. And the intermediary of the so-called crypto exchanges are commingling and doing things that we do not allow anywhere else in our financial system.”

Growth of the Cryptocurrency Market

It did grow, however, as a speculative investment.

The argument against Bitcoin as an investment is that it has no intrinsic value. Unlike a stock, there is no ownership of an ongoing business, and unlike a bond there is no annual interest payment then you get your money back at maturity. Some may view it as a commodity, like gold, where its value is a function of demand relative to its limited supply.

While Bitcoin is the original cryptocurrency, it is by no means the only one. Since Bitcoin was introduced, there has been an explosion of crypto coins, as there are limited barriers to entry. There are currently 8,866 cryptocurrencies in circulation, down from the high of 10,397 in February 2022.

What a Difference A year Makes in Bitcoin

The year 2022 was a disaster in the cryptocurrency market. High inflation and aggressive Fed tightening led to a collapse in the price of Bitcoin.

From 12/31/21 to 12/31/22 Bitcoin fell from $46,333 to $16,539, a -64% decline. As described above, in addition to the failure of FTX, the drop in value caused massive losses at several other large crypto players, including Three Arrows Capital, a hedge fund, as well as crypto lenders BlockFi, Voyager, Celsius, Genesis and Gemini.

Meanwhile, as the year turned to 2023, while much focus was on an analysis of what went wrong the prior year, the price of Bitcoin began climbing. In part it was due to the improvement in inflation, and an expectation of a Fed pivot to looser monetary policy. Bitcoin climbed back to $43,000, a 160% gain on the year.

In fact, Bitcoin became the top performing asset for the year, outstripping stocks, gold, bonds and other commodities!

SEC Poised To Approve Bitcoin ETF

Another factor driving the price of Bitcoin has been the expectation that the SEC will soon approve the introduction of a spot Bitcoin ETF.

The SEC has been reviewing the application from Grayscale Bitcoin Trust, a $24 billion Investment Trust, to convert to an ETF.

In addition, 12 other investment firms have submitted applications to form a spot Bitcoin ETF, and have had meetings with the SEC to work out the kinks.

The other applicants include BlackRock, Fidelity, ARK 21, Bitwise, VanEck, WisdomTree, Invesco, and Franklin.

The expectation is that a decision will be made by January 10, 2024.

The long-awaited Bitcoin Spot ETF will invest directly in Bitcoin. An approved ETF will address many of the problems outlined previously with investing in Bitcoin, and will make the asset class more accessible to the masses.

Market Depth

While the price of Bitcoin has jumped, the crypto market as a whole still shows the effects of the collapse of FTX last year. By removing Alameda, a major investor, and FTX from the marketplace, liquidity has declined, making Bitcoin harder to trade.

The daily value of trades on centralized exchanges has dropped -55%, to about $675 million, from a peak of $1.5 billion before FTX collapsed.

Conclusion

Bitcoin will remain a volatile asset. The problems that have plagued it will remain. Yet, with the approval of the SEC to form Spot Bitcoin ETF’s, the market will open up as Bitcoin becomes more accessible to the masses.