Risky business: Why investors are back in love with crypto

That has generated a “risk-on” environment that has underpinned a return of flows of investment into all risk asset classes.

Crypto is arguably the riskiest of all assets classes, with its historical performance showing quite extreme movements in both directions. In effect, it has intrinsic leverage to the broader investing environment.

The past several years have demolished the conviction once held by crypto investors that digital assets provide a hedge against inflation and diversification from other assets classes.

It turns out that they are highly correlated with significant trends in equities, particularly the high-multiple equities, and are as sensitive to interest moves and expectations as other risk assets.

They plunged as inflation and interest rates began rising and have recovered significantly as the inflation rate has edged down and expectations of future interest rates have begun looking past their yet-to-be reached peak.

Should equity investors’ optimism about that rate trajectory prove wrong, of course, crypto investors would be very exposed, although the violent moves that have been a feature of their market don’t appear to have undermined the commitment of hardcore crypto investors have to the sector.

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The rollercoaster ride those investors have been on over the past 15 months, however, has demolished another strand to the conviction they once held that crypto assets could function as a realistic alternative to fiat currencies. The magnitude of the swings in their value makes it impossible for them to act as a medium of exchange.

Warren Buffett’s equally famous offsider, Charlie Munger, this week said on Wednesday that claims that cryptocurrencies could replace fiat currencies were the equivalent of saying that air can be replaced.

“It isn’t even slightly stupid, it’s massively stupid and, of course, it’s very dangerous and, of course, governments were totally wrong to permit it,” he said.

He described crypto assets as “crap,” having earlier this month said they aren’t a currency, commodity or a security but a “gambling contract with a nearly 100 per cent edge for the house.”

In a sense he’s right, at least about the pure cryptocurrencies and the trading in them. There are other digital assets particularly those with applications for decentralised finance and smart contracts, that could reshape financial sectors but there is a legitimate view that Bitcoin, for instance, is akin to an unhedged derivative position, a call option or, to borrow from Munger, a bet on equity markets rising.

As long as investors recognise that, and regulators protect them from fraud, ineptitude, recklessness and the intermingling of investors and promoter’s funds (revealed most graphically by the FTX collapse but present in many other crypto scandals) there’s no reason why Munger’s view that cryptos should simply be banned should be adopted by regulators and legislators.

What’s needed is sensible regulation. This week the US Securities and Exchange Commission tabled a proposal that would require more businesses that manage third-party funds to use custodians and expand the range of assets that investment advisers, fund managers, hedge funds and pension funds would have to hold with custodians.

The SEC, which has recently become more active in regulating crypto businesses, made it clear that crypto exchanges were a key target of the proposal.

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It’s also been cracking down of “staking,” where investors allow their crypto assets to be pooled and used to verify transitions in a blockchain in return for “yields,” as well as testing whether “stablecoins” – where the cryptocurrency is supposed to be pegged to the US dollar or a basket of conventional assets – are actually as stable as they represent and do hold the underlying assets they claim.

There is an obvious need, given the sector’s history, for more of the same.

Crypto investors are, however, consenting adults even if they might be, as Munger describes them, “idiots” and some of the assets they are trading “crap.” Provide some better regulatory protections, hoist the “caveat emptor” banner and then let them make their high-risk bets on the future risk environment rather than trying to protect them from themselves.

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