How to weigh risk and reward in the midst of crypto's collapse

Watching dominos fall, one by one, in a painful chain reaction of de-leveraging in the crypto space has not been fun these past couple weeks.

As companies and investors prepare for the worst, jobs are getting cut seemingly everywhere, and contagion from Terra's $40 billion bust and the ensuing collapse of crypto trading fund Three Arrows Capital has spilled over from crypto lender to countless crypto lender.

Slowly but surely, news trickled out that things were going from bad to worse for the previously embattled crypto platform Voyager Digital. Not only was the emergency lifeline it received in funding from Sam Bankman-Fried not going to be enough to help in the short-term, it moved to file for Chapter 11 bankruptcy. Shortly after, we learned that famed crypto exchange Blockchain.com was also preparing to eat a $270 million loss on bad loan exposure to Three Arrows Capital.

So, in case it's still not obvious, crypto's 2008-moment is still unfolding. Even lenders who might appear to be safe may just be delaying the inevitable.

Part of the frustration stems from the fact that there isn't much transparency into how levered some of these crypto lenders may have been. That's ironically very anti-crypto, which is all supposed to be about open, public, and transparent ledgers. In the end, it's now the centralized quasi-shadow crypto banks that are currently brining crypto to its knees - and nobody knew how levered they were until it was too late.

Take Celsius, for example, which still has customer deposits frozen right now. Per a Wall Street Journal deep dive into their filings, it had an assets-to-equity ratio roughly double what the norm is in traditional banking:

Celsius had $19 billion of assets and roughly $1 billion of equity as of last summer, before it raised new funds, according to Celsius investor documents from 2021 reviewed by the Journal. The median assets-to-equity ratio for all the North American banks in the S&P 1500 Composite index was about 9:1, or about half that of Celsius, according to data from FactSet.

So, not a great position to be in as we wait to see who will join Celsius, Babel, Voyager, BlockFi and the other troubled crypto platforms in the washout. However, as messy as things appear and as messy as bankruptcies and hair cuts on deposits are likely to be, there is a silver lining here.

Mainly, crypto is repeating a lot of traditional finance's mistakes on an accelerated timeline. For crypto purists like me, it always seemed problematic that centralized lenders were effectively re-creating the same risks of the traditional banking system. Why people always wanted fully transparent lending protocols is being proven out right before our eyes. Sometimes it takes a meltdown to remind everyone what needs to be improved. And in the meantime, the bitcoin blockchain continues humming along as usual. The tech works, no matter how flawed the levered systems on top of it became.

Yes, Zack that all sounds great from a theoretical perspective, but bitcoin is down 69% from its all-time high. When is it coming back?

I think right now looks like a very interesting time for long-term investors - and not because I think bitcoin has bottomed (I don't think it has quite yet.) Rather, I think now is an interesting time because if now is crypto's 2008 moment, I'm reminded of what Warren Buffett said about stocks when all hope seemed lost and the global financial system was on the brink due to the same over-levered thinking going bust.

Back then, he urged for calm in a New York Times opinion piece:

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Like Warren Buffett, I can't predict whether bitcoin's price will be higher or lower in a month or a year from now. And like he said in 2008, I don't think that's really the question worth asking. Overall, this has become an intense gut check on a lot of why "crypto" and all its major pieces exist. But through it, I think we are reminded that a more perfect system can exist. And on the other side of the panic, we all know bitcoin blocks will still be getting added to the chain.

Now is a time to get back to focusing on the projects that are showing real adoption, and a time for me (more specifically) to highlight some of those projects to watch (I'll be doing that more often for paid subscribers.) In weighing out risk and reward, it's always important to consider time horizons. There certainly was a chance to be fearful when others in crypto were greedy. There might come a time soon to be greedy when others are fearful (there's no shortage of fear right now.)

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