Why investors are in love with crypto again

This has created a ‘risk-on’ environment that has underpinned a return on investment flows into all risk asset classes.

Crypto is arguably the riskiest of all asset classes, with its historical performance showing fairly extreme moves in both directions. In fact, it has an intrinsic leverage effect on the broader investment environment.

Recent years have shattered crypto investors’ once-held belief that digital assets offer a hedge against inflation and diversification from other asset classes.

They turn out to be highly correlated to significant trends in stocks, particularly those with high multiples, and are just as sensitive to interest rate movements and expectations as other risky assets.

They collapsed as inflation and interest rates began to rise and have recovered sharply as inflation rates have eased somewhat and expectations for future interest rates have started to surpass their yet to be reached peaks.

Of course, should stock investors’ optimism about this price action prove wrong, crypto investors would be very exposed, although the violent moves that have been a feature of their market do not appear to have undermined the commitment of hardcore crypto investors to the sector.

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However, the roller coaster ride these investors have experienced over the past 15 months has shattered another strand of their once-held belief that crypto assets could act as a realistic alternative to fiat currencies. The degree of fluctuation in their value makes them impossible to function as a medium of exchange.

Warren Buffett’s equally famous maverick, Charlie Munger, said this week on Wednesday that claims that cryptocurrencies can replace fiat currencies are tantamount to saying that air can be substituted.

“It’s not even a little stupid, it’s massively stupid and of course very dangerous and of course governments were dead wrong in allowing it,” he said.

He described crypto assets as “crap” after earlier this month saying they are not a currency, commodity or security but a “gambling contract with an almost 100 percent house edge.”

In a way, he’s right, at least when it comes to pure cryptocurrencies and trading them. There are other digital assets, particularly those with decentralized finance and smart contract applications, that could transform the financial sector, but there is a valid view that bitcoin is similar to, say, an unhedged derivative position, a call option, or a loan from Munger, one Bet on rising stock markets.

As long as investors recognize this and regulators protect them from fraud, incompetence, recklessness, and the mixing of investor and sponsorship funds (most evident in the FTX collapse, but seen in many other crypto scandals), there is no reason why Munger’s view that cryptos should simply be banned should be embraced by regulators and lawmakers.

Reasonable regulation is needed. This week, the U.S. Securities and Exchange Commission unveiled a proposal that would require more companies 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 be required to hold with custodians.

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

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It has also cracked down on “staking,” whereby investors allow their crypto assets to be pooled and used to verify transitions on a blockchain against “returns,” as well as testing for “stablecoins” — where the cryptocurrency intended to be – are pegged to the US dollar or a basket of conventional assets – are in fact as stable as the underlying assets that claim them represent and maintain.

Given the history of the sector, there’s an obvious need for more of the same.

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

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