In May 2022, cryptocurrency (or crypto) experienced a massive loss of value due to Terra’s crash. As a result, retail investors have exited their positions, and various jurisdictions are considering increasing regulation on the crypto industry.
Despite this, financial institutions have been increasing their investments into crypto.
The debacle surrounding the rapid and spectacular failure of FTX was, unfortunately, not isolated, and part of a series of failures which beset the cryptocurrency industry in 2022. Cryptocurrency’s rapid loss of value has been widely publicized: between November 2021 and June 2022, the value of Bitcoin fell by 70%, from approximately US$68,000 to US$20,000. This steep decline was largely due to a tightening monetary policy around the world, but was severely exacerbated by the failure of the Terra stablecoin, alternatively known as TerraUSD or UST.
A stablecoin is a digital cryptocurrency asset whose price is pegged to another financial instrument, typically a traditional asset class, such as a currency or a commodity. One of the most widely used stablecoin is Tether (also known as USDT), which is pegged to the US dollar.
Stablecoins are not issued by a cryptocurrency exchange, but they have to maintain reserve assets of the pegged currency as collateral, mitigating against the inherent volatility of conventional cryptocurrencies as a medium of exchange.
As a stablecoin, Terra took a different approach: it was pegged to the US dollar, but not backed by reserve assets of that currency. Instead, Terra was linked algorithmically to a sister token, Luna, whose price was set by the market. Luna served as the primary backing asset for Terra, and UST targeted a consistent value of US$1 by enabling users to exchange it for US$1 of Luna. Users could sell UST for Luna when UST prices rose above US$1, and could buy UST at a discount when prices fell below US$1.
In theory, Terra was supposed to remain stable, while Luna served as a volatility buffer. This approach also created arbitrage incentives for traders to maintain the value of UST at, or close to, US$1.
In May 2022, this Terra-Luna system was severely disrupted. It is still not fully known what precipitated the initial slump in UST demand, but in early May, a large amount of UST was withdrawn from a decentralized exchange.
In particular, an unknown user exchanged approximately US$84 million worth of UST for another cryptocurrency. These large movements set off a cascade of UST withdrawals, which eventually led to its depegging from the US dollar.
The UST-Luna linkage meant these large UST withdrawals led to a rapid increase in the supply of Luna, resulting in a parallel rapid drop in the latter’s price. Since cryptocurrency traders relied extensively on UST as a medium of exchange for other cryptocurrencies, Terra’s nosedive quickly accelerated into an outright market-wide crash.
Eventually, the collapse of Luna and UST led to cryptocurrency traders fielding a loss of approximately US$18 billion in May 2022 alone.
By July 2022, the global crypto assets industry had lost 70 percent of its value within 6 months, while the value of crypto assets had fallen from US$3 trillion (November 2021) to US$1.3 trillion (July 2022).
Since Q4 2020, the KPMG Financial Performance Index (FPI) has been tracking a steady decline in crypto firms: between Q4 2020 and Q4 2021 (from 94.3 out of 100 to 76.0) the falling FPI scores are consistent with the worsening debt position of the industry. Therefore, FPI analysis could potentially have served as a predictive indicator of the then-impending distress.
The severe loss registered in Q2 2022 has been heralded as a “crypto winter” and led crypto-based firms to hastily engage in restructuring and right-sizing, leading to significant selloffs and layoffs. Many crypto exchanges are lurching toward insolvency, with at least two major exchanges and one crypto-focused hedge fund having filed for Chapter 11 bankruptcy. As of August 2022, cryptocurrency companies have laid off more than 3,000 employees.
The industry’s FPI score witnessed a recovery in 3Q 2022 due to three factors. Firstly, there was improved liquidity (cash to total market assets ratio increased from 0.11 in 2Q 2022 to 0.15 in 3Q 2022). Reduced market volatility (standard deviation of stock prices reduced from 105% in 2Q 2022 to 91% in 3Q 2022) also allowed for a brief rebound. Thirdly, there has been an improved return against the market (excess return ratio experienced recovery from -0.17 in 2Q 2022 to -0.06 in 3Q 2022).
Taken in the larger historical context of the crypto industry, however, this recovery is of small comfort. Having grown at an average rate of 5.4% from 1Q 2017 to 3Q 2022, the market value of the industry increased by 14.2 percent in this period, followed by a major dip of 19.7 percent in 2Q 2021 to 3Q 2022. On the other hand, total liabilities of the industry increased by 6.7percent in 1Q 2017 to 2Q 2021, and further expanded by 12.6 percent in 2Q 2021 to 3Q 2022, widening to a staggering US$242.9 billion in 3Q22.
The Q4 2022 FPI numbers will surely take a hit again, given FTX’s failure and its outsized impact on the crypto industry. The knock-on effects of crypto’s volatility and turmoil on the global economy have compelled governments and monetary authorities to intervene and more rigorously regulate the crypto markets.
The EU has sought to increase their oversight of cryptocurrency trading with their Markets in Crypto-Assets (MiCA) regulation. Singapore, which has been hailed as a “crypto paradise” (Terraform Labs, creator of Terra stablecoin, was headquartered there), is now proposing restrictions and safeguards to reduce consumer risk in crypto trading.
As a result of all these developments, retail investors have continued to quickly divest themselves of their cryptocurrency holdings. Outflows due to decline in crypto value totaled US$423 million in June 2022, eclipsing the prior record of US$198 million outflow up till January 2022. This retail selloff has also been driven by a growing fear of a recession, as well as rising commodity prices due to supply chain issues and the Russo-Ukrainian conflict.
While the allure of unregulated currency has waned for retail investors, institutional investors are rapidly entering the crypto market. One major asset management firm has been raising capital to purchase distressed crypto assets, while another has been looking to expand crypto investment, particularly in firms with declining valuations. Other firms are also attempting to deepen their technical knowledge of the crypto industry.
Such institutional activity potentially points to a long-term optimism toward crypto; but whether or not institutional involvement manifests a market turnaround is dependent on three key factors.
Firstly, crypto-based companies have a set of unique challenges owing to the nature of digital assets. Crypto trading can be a highly complex trading process, undergirded by capital structures that are radically distinct from what the traditional financial system has been built on. Such companies are unlikely to have much funded debt, and what debt they have is likely to be secured by their main assets — cryptocurrency holdings.
Secondly, many crypto exchanges are currently unregulated, and potentially expose investors to unexpected risks without the thoroughness of regulation and the assurance provided by deposit guarantees. The forthcoming federal and governmental oversight mentioned earlier might assuage some of these concerns, but it is unlikely that there will be a rise in institutional lending options as compared to the past.
Thirdly, in the aftermath of the securing of crypto assets by an insolvency practitioner, there will arise the difficulty of how to accurately value and sell the assets. This is challenging as the market for crypto assets still remains highly volatile.
However, valuations for healthy crypto firms remain high relative to general technology and fintech sectors, due largely to their growth potential. Crypto exchange infrastructure, mining and data analytics are still rapidly maturing and likely will be active sub-sectors going into 2023. Despite the widely publicized crash, there still remains much potential for blockchain and digital asset applications.
KPMG FPI includes 40,000 listed companies across the 50 largest stock exchanges worldwide. The data set represents more than 99.9% of all public companies. Unlike similar rating methods which focus on credit worthiness, the custom FPI algorithm goes beyond by interlinking financial history, market performance, and micro trends into one practical output.
The KPMG Financial Performance Index is available now at fpi.kpmg.com.
