What Traders Can Learn From Crypto Winter

At a time when the broader digital currency industry has been struggling with numerous headwinds, cryptocurrency traders have significant opportunities to learn from these changes. There are many valuable takeaways that can be gleaned from the difficulties this particular sector has faced following the sharp decline in asset values that took place in 2018.

Crypto Bear Market

One of the easiest data points to cite when making the case that digital currencies have entered a so-called "crypto winter" is the sharp declines that these assets have suffered since hitting a peak in early 2018.

The total market capitalisation of digital currencies fell to nearly US$100 billion in December 2018, which represented a downturn of more than 80% from the all-time high of more than US$835 billion it reached in January of that same year.^[1]

This coincided with a sharp decline in the value of many digital assets, including Bitcoin, whose price fell from more than US$20,000 in December 2017 to less than US$3,200 in December 2018.^[2] This drop represented a loss of approximately 84% of the cryptocurrency's value.

Please remember that Past Performance is not an indicator of future results.

Traders can benefit from keeping in mind just how volatile this space can be. In early 2017, Campbell Harvey, who teaches finance at Duke University's Fuqua School of Business, estimated that Bitcoin was five times more volatile than the benchmark S&P 500 index.^[3] At the time, he noted that the digital currency generated a return on investment greater than 100% in 2016.

Falling Trading Volume

Many digital currency exchanges have suffered low trading volume in the aftermath of the market's sharp crash. In January 2019, this measure of activity hit its lowest in two years, according to figures provided by research firm Diar.^[4]

The BTC/USD market for Binance, one of the world's largest cryptocurrency exchanges, fell 40% between December 2018 and January 2019.^[4] This fits into a broader, generalised trend where this trading volume declined in 2018.

In January of that year, investors traded more than US$8 billion worth of the currency pair through the exchange.^[4] By October, that figure had fallen close to US$1 billion.

Changing ICO Market

The market for initial coin offerings (ICOs) changed significantly between 2017 and 2018, with some going so far as to say that it was "dead."^[5] This is how Barry Silbert, CEO and founder of industry firm Digital Currency Group, described the market for ICOs during a CNBC interview.

Michael Novogratz, founder, CEO and chairman of merchant bank Galaxy Digital, offered a similar point of view. "The ICO market is pretty much dead right now," he said.^[6]

Despite these claims, entrepreneurs held more than 2,000 of these digital token sales in 2018.^[7] However, the 2,284 ICOs that took place that year raised close to US$11.4 billion, while the 966 of these sales that happened in 2017 generated US$10 billion.

In other words, the ICOs that entrepreneurs held in 2017 generated significantly more per sale, on average, than the sales taking place in 2018.^[7] When explaining the sharp differences in fundraising success between these two periods, some emphasized the significant volatility in the underlying cryptocurrencies that entrepreneurs accepted in exchange for newly created digital tokens.

The price of Ether, which was used in most ICOs, peaked at more than US$1,430 in January 2018 before falling to roughly US$83 in December of that year.^[1] This represents a roughly 94% decline.

Amid this change, ICOs raised far more at the start of 2018 than they did closer to the end of that year.^[1] In March 2018, for example, these sales brought in close to US$1.75 billion. However, they generated US$0.36 billion in November of that same year.

While some pointed to the sharp fluctuations in digital currency prices as contributing to the varying amounts generated by this fundraising, others cited different factors. "There was a lot of fraud, and there was a lot of hype, and people lost money," Novogratz said.^[6]

One thing that traders can learn from these developments is that conducting due diligence is crucial. Some ICOs were outright scams, and market research conducted by ICO advisory firm Statis Group revealed that roughly 80% of digital token sales fit this description.^[8]

Traders can benefit greatly from performing thorough research and asking many questions when considering digital currencies, especially if the tokens are being issued by startup companies. Investors who are looking at these digital assets may also keep in mind a warning issued by the Financial Industry Regulatory Authority, Inc.^[9]

"While ICOs, cryptocurrencies and the technologies that power them may hold great potential for legitimate innovations in capital raising and financial markets, it can be a challenge for investors to verify information about these products to make informed decisions," the investor alert stated.^[9] "The markets for digital assets continue to display high levels of volatility, involve speculative risk and the potential for fraud."

The Vulnerability Of Exchanges

One of the most basic tenets of digital currencies and blockchain technology is the benefits provided by decentralisation. Unfortunately, cryptocurrency exchanges manage to centralise significant resources, which can make them attractive targets for hackers.

In 2018, these marketplaces were a significant weak point for the broader market. Data provided by analytics firm CipherTrace reveals that hackers stole more than US$950 million from digital currency exchanges and infrastructure that year.^[10] This figure is more than three times the amount that hackers stole in 2017.

Traders should keep in mind that many of these exchanges have been hacked. For example, Japanese exchange Coincheck lost more than US$500 million worth of digital currency in 2018 because of hackers.^[11]

Hackers used many different methods to steal during 2018, combining old techniques with new ones.^[10] They used ponzi schemes, ICO exit scams and phony exchange hacks, among other methods, to achieve their objectives of misappropriating funds.

Traders should know that while some exchanges have a reputation for being very secure, it's important to know that, again, many of them have been hacked. As a result, investors can benefit from conducting thorough due diligence on any exchange they're considering.

Booms And Busts Are Inevitable

Individual sectors always experience periods of expansion and contraction.

In writing about cryptocurrency specifically, one author wrote, "If 2017 was the year of irrational exuberance, 2018 became the year of reality checks when the market sputtered and crashed."^[12] The author pointed out that by creating environments with certain incentives, entrepreneurs can leverage digital currencies to get varying stakeholders, including investors and users, to work toward common goals.

While ICOs can hold great potential, the problem with the 2017-2018 era was that many entrepreneurs used these offerings as a means of quickly generating funds, instead of stressing the benefits provided by decentralisation.^[12]

Investors flocked to the digital currency market, which caused the price of cryptocurrencies to climb significantly.^[13] Some critics stated that this created artificially inflated asset values, which would eventually come down.

"The last year has seen once again a massive growth and hype cycle (like it did already several times before) which needs to go back to normal after the current hype has reached its peak," said Thomas Bertani, CEO of Switzerland-based multicurrency wallet and hybrid exchange Eidoo, in early 2018.^[13] He described the then-recent losses that the crypto space had suffered as "mostly likely" the entire market retracing to normal values.

"It was just for too long going up and up and up," said Pawel Kuskowski, CEO and cofounder of Coinfirm, at around the same time.^[13] He described the pullback as "a correction, a long-expected correction."

While the cryptocurrency market lost significant value in 2018, this could create opportunities for savvy traders. Investors who are able to pinpoint digital currencies with long-term potential may be able to buy them at appealing values.

However, traders should keep in mind that risk is inherent to investment. Also, the entire digital currency space is very new, and the value of its assets is based largely on speculation, making it beneficial to perform due diligence.

Crypto is Making Progress

The entire digital currency and blockchain space has made significant progress since 2017. One example of this maturation is the growing number of digital token types.^[14] At the time of this writing (February 2019), the broader cryptocurrency space has grown to include security tokens, equity tokens, non-fungible tokens and stablecoins.

Also, companies of all sizes have been investing into building out the infrastructure of the cryptocurrency industry by creating new exchanges, wallets and methods of custodying digital assets.^[14]

The digital currency space has also made headway in terms of regulations. More specifically, government officials and lawmakers around the world have put effort toward creating a more effective and mature regulatory framework.

The U.S. Securities and Exchange Commission (SEC) has provided some guidance on digital tokens, stating in July 2017 that digital assets issued by "virtual" organisations are subject to federal securities laws.^[15] SEC Chairman Jay Clayton provided more guidance in December of that year and issuing a statement in which he emphasized the various questions that are raised by the existence of ICOs.^[16]

Clayton later spoke to some of the larger digital currencies and told CNBC in June 2018 that Bitcoin is not a security.^[17] He elaborated by saying that some digital currencies are securities and clarified the conditions under which a digital token would be considered as such. The SEC will consider to use the Howey Test to determine whether a digital currency is a security, he stated.

Under this test, putting money toward a venture where the investor expects some kind of return generated primarily by the efforts of others amounts to investing in a security.^[18] Shares of stock in a company, for example, are securities.

William Hinman, director of the SEC's Division of Corporation Finance, revealed that the SEC does not consider Ether a security either.^[19]

"Putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions," he said in June 2018.^[19] "As with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value."

Summary

While the so-called crypto winter has created challenges for investors, industry firms and other market participants, traders can learn quite a bit from this period. For starters, they can benefit from being aware of the sharp price fluctuations that digital assets experienced.

Traders can also benefit from knowing the key details of the ICO market, including the changes it experienced in 2017-18. One key takeaway is that many analysts have cited hype as a major factor that helped drive the success of these digital token sales. Unfortunately, some of these offerings were frauds.

Another major takeaway is the risks that come with using digital currency exchanges. Many of these organisations have suffered hacks. In 2018 alone, hackers stole upwards of US$1 billion from cryptocurrency exchanges and infrastructure.

The broader digital currency space has already suffered booms and busts, with the market for these cryptocurrencies enjoying sharp increases in value in 2017 and substantial declines the following year. This development could create opportunities for savvy traders. However, investors should remember that risk is inherent to investment, and that many consider digital currencies to be largely speculative assets.

Traders should also keep in mind that while digital currencies have experienced their ups and downs, the broader space has been making progress as new token types develop and the regulatory environment matures.

Past Performance is not an indicator of future results.