In 2021, Bitcoin, Ethereum, and multiple other cryptocurrencies were on their greatest run yet, setting all-time highs and being on the lips of mainstream media. In 2022, the industry has once again been on the lips of mainstream media, but due to more negative reasons due to tumbling prices and various collapses, such as FTX, Celsius, and Terra. Heading into 2023, the industry will hopefully be spared from similar and countless negative setbacks such as the ones it experienced this year. But, as the crypto market has stressed over and over again, there are no guarantees for a certain course, and every so often it may help to expect even the worst-case scenarios. In this piece, we look back at these epochal events of 2022 and dare to risk guessing what the worst-case scenarios are in 2023 and what the year could bring for crypto.
The contagion may continue where we left
The collapse of the $58bn stablecoin Terra in May initiated an avalanche of contagion throughout the crypto market as it triggered the bankruptcy of crypto hedge fund Three Arrows Capital and later the retail magnet Celsius, which was focused on borrowing and lending crypto assets, among other intermediaries. Yet, what the market was not aware of at that time was that both the major exchange FTX and its closely affiliated hedge fund Alameda Research were at best having liquidity issues or at worse were already insolvent at that time. Fast forward around 6 months to early November, at what point it became clear that FTX had for years commingled client funds to Alameda Research, according to the Commodity Futures Trading Commission of the US. On the 11th of November, co-founder and then CEO Sam Bankman-Fried (SBF) filed the exchange for bankruptcy, leaving a hole of up to $8bn in FTX’s balance sheet. Last week, SBF was then arrested by Bahamian authorities, facing extradition to the US these days.
Despite the fact that the contagion started in May this year upon the collapse of Terra, we are not yet over it. On the contrary, not one of these prominent cases has sufficiently come to an end and more cases have seen the light of day in recent weeks. For instance, the public first figured out that crypto trading firm Orthogonal Trading was “effectively insolvent” close to a month after the collapse of FTX, likely due to the loss the firm incurred because of FTX. Likewise, the prominent institutional-focused Genesis Trading has not yet reopened withdrawals for its lending division after having $175mn stuck on FTX and facing a liquidity crisis as investors withdrew funds from the firm. In addition, neither the bankruptcy of Celsius, Three Arrows Capital, BlockFi, and the other firms are nearly finalized. As we head into 2023, market participants in crypto should be aware of potential further contagion, potentially rocking the market once again as in 2022.
Binance is in the spotlight
Speaking of further contagion, all eyes have been on the world’s largest crypto exchange, Binance, in the past weeks. Binance has faced billions worth of outflow of client funds in the past weeks upon rumors that the exchange may face the same destiny as FTX. The fear was amplified last week as Binance’s auditor Mazars announced that it suspends all work related to its crypto clients, among these Binance. To make matters worse, Mazars was the auditor behind Binance’s November proof-of-reserve. Mazars stated that the reason for suspending work with crypto firms was “due to concerns regarding the way these reports are understood by the public”.
Until now, Binance has satisfied each withdrawal without issues and more points towards solvency than insolvency. Although the risk of Binance becoming insolvent is very small, the risk is nonnegligible, particularly considering the surprising insolvency of FTX. Despite the small risk, the potential consequences for the industry would be immense, simply considering the relatively greater size of Binance than FTX.
Grayscale goes head-to-head with the SEC
The largest crypto fund manager Grayscale has had a tough year. Not only is Grayscale owned by Digital Currency Group (DCG), which is also the owner of distressed Genesis Trading, but Grayscale has also seen its trusts trade at a substantial discount. How Grayscale has structured its funds does not enable the firm to redeem shares to keep them from trading at a discount to the underlying asset e.g., Bitcoin. So, holders can only sell shares on the open market with no counterpart to ensure a fair price. This has caused Grayscale’s Bitcoin and Ethereum trusts to trade at a discount of 47.5% and 56% relative to the underlying asset, respectively.
As a start, Grayscale has applied to convert its Bitcoin trust to an ETF to redeem shares. However, the US Securities and Exchange Commission (SEC) has so far rejected this conversion. This rejection made Grayscale sue the SEC earlier this year. This week, Grayscale once again battled the SEC publicly, as the firm stated that it is exploring the option to return up to 20% of the capital in its Bitcoin trust unless the SEC approves a Bitcoin ETF. This would likely be done through a tender, at which Grayscale appeals to shareholders to sell shares at a specific price during a definite time, credited by the selling of Bitcoins from Grayscale on the open spot market. As Grayscale manages Bitcoins worth over $10bn, the potential sell pressure from the potential tender can be as high as $2bn. Similarly, Grayscale manages Ethereum worth over $3.7bn, so if shareholders of this trust would be offered a tender, the selling pressure on the open market can be as high as $740mn. The tenders will not happen with certainty, as the SEC must approve them as well, however, if they happen, the market may be floated with fresh sell powder.
It is not entirely clear what the impact on Grayscale may be due to its indirect relationship with Genesis Trading through its shared parent company DCG. However, in case it does not continue as it is today, a possible outcome is that DCG sells Grayscale to raise fresh cash, but other than that does not change anything to Grayscale’s business model.
The regulation may become less than ideal as quickly enforced
After a decade of refusing to properly regulate the crypto market, regulators around the world are finally acknowledging that regulation is imperative following one collapse after the other in 2022 due to at best poor business ethics within crypto. However, this wake-up call for regulators may come with an ambition to regulate the industry in a flash. If regulation is quickly enforced, it may lead to a less-than-ideal regulatory framework for the crypto industry or a downright damaging framework. The latter can vastly impact the industry negatively for years to come, as it is easier to ensure appropriate regulation from the start rather than changing damaging regulations later on.
Luckily for the industry, the European Union (EU) had largely finalized its comprehensive regulatory framework known as the EU Market in Crypto-assets Regulation (MiCA) before the collapse of FTX. Following the collapse of FTX, member of the European Parliament Stefan Berger stated on Twitter that: “Governments shouldn't overregulate excessively now, but follow MiCA”, as MiCA by itself is anticipated to prevent cases such as FTX. This is a much positive statement and MiCA will hopefully serve as an inspiration for the rest of the world. If this is the case, it may impact the crypto market positively, as a proper regulatory framework ensures a fair and transparent market with less risk of cases like FTX. If done correctly, regulation may restore trust in the industry. The MiCA framework is set to take effect in 2024.
Withdrawable Ether staking
One of the most anticipated events of this year was the Ethereum merge in September, at which point Ethereum switched from a proof-of-work to a proof-of-stake framework. Since the staking contract went live over 2 years ago on the 1st of December 2020, holders verifying transactions or so-called stakers have not been able to stop staking and thus making their Ether accessible again, not even following the merge. At present, around 16.7mn Ether of a total supply of 120.5mn is in the staking contract, of which some have been staked since the 1st of December 2020.
Heading into 2023, these Ether may become withdrawable, as it is expected that a hard fork as early as March 2023 will allow folks to unstake Ether. On the day of the hard fork, the total staking rewards of the past 2 years equal to 900,000 ETH will instantly be withdrawable, however, only 43,200 ETH can be unstaked per day of the remaining 15.7mn Ether in the staking contract. As soon as the floodgates have opened, we expect some stakers to go on to sell their Ether, so some selling pressure should be expected. Yet, as stakers have been aware of this multiple-year lock-up of their Ether, they are largely long-term holders, so the selling pressure from unstaked Ether should be manageable. Importantly, though, it greatly depends on the sentiment around the hard fork, as a bad sentiment will surely amplify selling pressure from staking.
If successful, then withdrawable staking will be a risk-off event for Ethereum, as it is the last factor to come into effect for the merge to be fully finalized. In such a manner, it may contribute to short-term selling, but the aspect that holders can then stake and unstake as they see fit is positive long-term.
The participation of large corporations
Although the crypto market has largely been a mess in 2022, considering the various collapses and bankruptcies, it has not stopped the inflow of large corporations into crypto. As late as this week, VISA published a research paper on automatic payments based on crypto. In October, BNY Mellon launched its custody platform for cryptocurrencies. In the same month, Fidelity Digital Assets launched custody and trading of Ethereum for institutional clients, while opening up for retail trading of Bitcoin and Ethereum the following month.
The inflow of large corporations drives adoption, accessibility, and innovation, so it is crucial for the industry going forward. There is not much that points towards this trend slowing down, so various large corporations are likely to be introduced to crypto in 2023.
All eyes on the risk sentiment in the equity market
Other than the above factors, the equity market can greatly impact crypto in terms of prices in 2023. In 2022, the crypto market has been highly correlated to specifically riskier equities, including technology stocks. As the equity market is sensitive toward the macro environment, it is clear that this environment plays a major role in crypto as well. In our view, the sentiment in the equity market is likely to continue to impact the risk appetite in crypto in 2023, unless more negative crypto-specific contagion appears.
In conclusion, while 2023 may not become as eventful as 2022 for crypto, there are many potential factors market participants should be aware of, such as further contagion, hostile regulation, the risk sentiment in the equity market, the participation of large corporations, and selling pressure from Grayscale as well as unstaked Ether.