Will Rising Interest Rates Sink the Crypto Ecosystem?
Interest rates across the U.S. economy are beginning to tick up – and in some cases surge.
These rates obviously affect borrowers, but they also provide higher returns for lenders, including in some relatively safe assets. That competition for capital, among other factors, has already brought doom to speculative assets including stocks in "growth" technology firms. While crypto has held up surprisingly well by some metrics, it is stalked by the same dark horse.
The most sensational spike in interest rates has come in the mortgage market, with 30-year, fixed-rate mortgages reaching an average of 5.3% on April 19, a 12-year high. On the same day, the yield on the 10-year Treasury bill hit 2.94%, still historically low but the highest rate seen since 2018. Most incredible – and for those holding speculative investments, perhaps most symbolically terrifying – the return on risk-free, inflation-adjusted U.S. savings bonds is expected to reach nearly 10% in May. Obviously, all of those rates are offset by current high inflation – but so is every other investment.
These are still somewhat tentative signs of the rising cost of capital. Broadly, that's because changes to the U.S. Federal Reserve's lending rate to banks spread into the wider economy according to complex human judgment calls about the future. For instance, a bank that thinks the interest rate spike is temporary might continue lending at a lower rate to steal volume from competitors that raise rates first. So changes starting to appear now, one month after the Fed began a series of planned rate hikes, could be just the beginning.
Rising rates are already changing the risk-reward calculation for investors, particularly larger investors like hedge funds. It's a complex calculus, because a "safe" investment like a bond can easily attract money that otherwise would have gone to a higher-return but also higher-risk asset. Those higher-risk assets definitely include most if not all cryptocurrencies and other token assets.
There are already strong signs of a gradual but steady transition to lower-risk assets (though those impacts are hard to entirely untangle from an ongoing reversion for so-called stay at home stocks). The Nasdaq 100 is a basket of stocks topped by the likes of Amazon (AMZN) and Nvidia (NVDA), stocks that still have at least a bit of "growth" expectation built in – or, put another way, their price before the current slump implied significant future growth. The Nasdaq 100 is down more than 12% since January, compared to a 4.4% drop in the Dow Jones Industrial Average, which is relatively heavier in slower-growing banking, retail and manufacturing stocks.
Once you start looking at even more speculative groupings, the carnage gets much worse.
Risk on
The poster child here is ARK Innovation, the aggressively future-forward fund managed by Cathie Wood. Wood has bet heavily on truly speculative tech, fintech and biotech growth firms including Robinhood (HOOD); Shopify; Unity; Block (SQ), the former Squarew; Tesla (TSLA), ARK Innovation's biggest holding; and Zoom. These are firms that either aren't profitable yet (most of the biotechs), were expected to become much more profitable (Zoom) or are only profitable thanks to aggressive accounting (Tesla).
Wood's basket of long shots has dropped a walloping 60% from its 2021 peak. Notably, that's significantly worse than the performance of bitcoin (BTC), which is currently off about 38% from its 2021 peak. Ether (ETH) is off even less at 35%, while the total market cap of all cryptos is off close to 36%, according to data from CoinGecko.
It's really stunning to see crypto hold up better than a more conventional technology growth fund. Certainly part of that is continuing investor optimism about crypto and blockchain, which can, to be clear, still trump granular considerations of risk and return.
But there are also significant structural and transparency differences in crypto that make an impact. Most of all, a conventional startup with high spending in excess of income, or "burn rate," will see its equity value drop faster in a higher interest rate environment because "burn" implies future borrowing. But in crypto, the "burn rate" of a blockchain is not collated in a single place – arguably, it is instead spread out among the various maintainers and contributors in a way that's hard to read. In other words, it's more difficult to figure out the real financial picture of a blockchain ecosystem, particularly whether it's somehow reliant on outside financing, than when it comes to equities.
However, there are specific situations where protocols are clearly dependent on external funding. Some of these are acute events, such as when the hacked Wormhole bridge was bailed out by Jump Trading. Much more worrisome are the obvious and ongoing deficits run by various staking or lending pools.
For instance, the yield on Terra's Anchor protocol is heavily subsidized, with about half of returns to lenders coming from outside capital rather than borrowers. For now, the funders regard that as a worthwhile marketing expenditure, but rising rates elsewhere will almost inevitably have some crowding-out effect.
Buckle up
For now optimism may be supporting crypto through the big interest rate transition. But hopium has its limits, and crypto has significant tail risks that could make future drawdowns much more violent. In particular, those staking and yield pools often support other products that would become less stable if competition drew away capital.
Anchor ranks high among those risks: It forms a major pillar of the ecosystem supporting the fast-growing UST stablecoin. There is already near-frantic discussion of the internal fragility of UST's "algorithmic" model.
Add external pressure from safer high returns elsewhere, and it's not hard to imagine a perfect storm just over the horizon.
–David Z. Morris
