Cryptocurrency is a risky business

The almost deafening buzz around cryptocurrency had even the most amateur investors prepared to dabble. But the collapse last year of the $32 billion FTX crypto exchange – and subsequent arrest of eccentric founder Sam Bankman-Fried – served to highlight the risks of investing in this highly volatile asset class.

After a slow but steady start, the crypto market exploded during the pandemic, as novice investors found themselves trading from home during the widespread lockdown, explains Maria Flannery, financial services audit partner with KPMG. This surge in activity pushed up the price of cryptocurrencies such as Bitcoin, given that its value is driven by supply and demand, and also meant crypto investing became far more mainstream.

“Investor demand and hyperinflation fears drove those even with the most traditional investment strategies to consider alternative investments such as Bitcoin and other digital assets,” she says. “But as an asset class that is very high on the risk scale, cryptocurrencies are particularly vulnerable to interest rate hikes – and this was one of the factors that resulted in price drops and the beginning of the current ‘crypto winter’.”

This view is shared by Colum Lyons, chief executive and founder of ID-Pal, which offers online verification solutions for industry. “Investing in cryptocurrencies and non-fungible tokens (NFTs) is complex and highly speculative. As with any investment, there is potential for upside and downside,” he says, pointing out that the nature of cryptocurrencies means the less savvy investor may struggle.

“Investing in this sector requires a strong understanding of blockchain, market dynamics and digital assets. Inexperienced investors could struggle, especially with the volatility seen over the past 12 months. As with anything, assessing and understanding the risks is key.”

Flannery says there is widespread acceptance that the collapse of FTX was primarily a result of significant corporate failings, as opposed to a failing of crypto itself. “The vulnerabilities in FTX’s business model were simply exposed when the price of cryptocurrencies crashed. The European Authorities, including ESMA [European Securities and Markets Authority], have indicated their view that the FTX case is not specific to digital assets, but rather to the unregulated ecosystem in which they operate, with a lack of mandated governance and regulation,” she explains.

Industry tolerance for the ‘crypto bro’ is dead and I expect to see buyers’ excitement to be replaced with rigorous good old-fashioned due diligence

—  James McKnight, Simmons & Simmons

“The fallout from FTX has resulted in crypto being pushed higher up the agenda of regulators, which is a positive thing. Regulation is being welcomed by many in the crypto industry, as it will result in wider adoption, which is key to the success of the asset class.”

The EU’s forthcoming Markets in Crypto Assets regulation (MiCA) framework – due to come into force at the end of this year – for regulating crypto assets will prevent a replay of the FTX disaster. Flannery says it would have gone some way to preventing some of the issues that arose with FTX – “in particular around internal controls, custody and the segregation of firm and client assets”.

James McKnight, partner in the investment funds practice at Simmons & Simmons, echoes this, saying the lack of experience with these relatively new assets was to blame for many of the failings during the first wave of crypto funds. “You saw early adopters and miners who thought that because they made a lot of money themselves, that this meant they could manage others’ money. Obviously some could and some couldn’t, but what is evident is that the profile of crypto managers since that first wave has changed significantly, with many household names at least looking at crypto as an asset class, almost certainly driven by client demand,” McKnight says. “The crypto industry was rapidly institutionalising prior to FTX and this will continue apace.”

McKnight sees the recent scandals as not the end of the crypto industry, but rather a “watershed” moment. The “crypto bro”, epitomised by Bankman-Fried’s sloppy appearance – and clearly sloppy management – is no more, he says. “As an asset class, crypto has been around for nearly 15 years – it is not going away and is not a flash in the pan. What has happened and what will continue to happen is that the suits and ties will take over from the shorts and T-shirts. Industry tolerance for the ‘crypto bro’ is dead and I expect to see buyers’ excitement to be replaced with rigorous good old-fashioned due diligence – this will weed out players without the proper infrastructure in place to manage money in an appropriate manner.” He also believes that cryptocurrencies will move from being domiciled “offshore” to “onshore” as they become increasingly legitimised and investors seek the additional protection of an onshore jurisdiction.

Despite the challenges of 2022, there’s certainly nothing to indicate that this asset class isn’t here to stay

—  Maria Flannery, KPMG

According to Lyons, “all the signs are there” that the move towards a digital asset ecosystem is happening regardless. “The UK treasury just released a report on regulating crypto and digital assets and confirmed that current legislation will be adapted to apply to players in the crypto space,” he notes. “This means in the UK, rules and regulatory requirements for crypto will look like those applied to traditional finance institutions so these digital assets and currencies can work together, move between blockchains and between countries.”

Flannery also echoes this, noting that bitcoin has started to rebound, with a 40 per cent rise in value since the start of 2023. “While that has been driven primarily by retail rather than institutional investors, there’s still a considerable level of interest in digital assets from institutional investors; however, a robust regulatory framework and the existence of reputable, trusted service providers in the ecosystem are crucial to restore investor confidence,” she says. “Despite the challenges of 2022, there’s certainly nothing to indicate that this asset class isn’t here to stay.”

She has also observed a “significant amount of activity” in the traditional finance world with large banks now embracing blockchain technology, if not necessarily cryptocurrency itself. Tokenisation – not to be confused with non-fungible tokens – is something that will become increasingly commonplace.

“We are seeing a lot of the big players take a real interest in this – it presents an opportunity to remove some of the obstacles of asset illiquidity and settlement delays, and to open investment opportunities to a wider market. I believe tokenisation has the potential to be the next big thing within the asset management industry.”