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The case for a multi-year digital currency bear market

As the digital currency markets implode in real-time, with hedge funds like Three Arrows Capital (3AC) entering liquidation and lenders like Celsius and BlockFi facing possible insolvency, it appears that another digital currency bear market has arrived.

In this piece, I’ll argue that conditions are ripe for a long, drawn-out ‘crypto winter’ from which many coins will never recover. As you’ll see, it’s a multi-faceted problem with no easy solutions in sight.

Recklessness and the inevitable regulatory response

To say that the actions of the likes of Three Arrows Capital were reckless would be an understatement. This one hedge fund seems to have borrowed from every digital currency lending platform in the industry and leveraged long on everything it could get its hands on. Founders Kyle Davies and Su Zhu are paying the price now, and they’re blowing holes in the balance sheets of some of the biggest lending platforms in the industry as they hurdle rapidly towards the end.

Yet, Three Arrows Capital isn’t the only guilty party here. As we’ve learned in the last few weeks, infamous figures like Roger Ver were also (allegedly) irresponsibly long, and Michael Saylor’s MicroStrategy (NASDAQ: MSTR) came dangerously close to margin calls on some of its loans. Even the President of a sovereign nation, El Salvador, has plundered his nation’s treasury to buy into the world’s largest pyramid scheme and is now down tens of millions of dollars.

All of this madness has led to a series of events that will almost certainly cause regulators to step in and stop it from ever happening again. While the industry isn’t yet big enough to pose systemic risk in large economies, innocent consumers find their funds locked up in platforms like Celsius, BlockFi, and Voyager as these platforms desperately attempt to stay afloat. Sadly, most will never see their hard-earned funds again. The backlash will be severe.

When regulators step in and pen new laws to prevent a repeat of the 2022 digital currency crash, it will mean that the leveraged long positions and laissez-faire lending/borrowing that enabled the runup in 2020-2021 will not be possible again. Honestly, I’ll be surprised if a few people don’t serve time for what has happened and what has yet to occur.

Inflation and the response of central banks

It was probably apparent that inflation would become a major problem when central banks turned on the turbo printer while global supply chains simultaneously ground to a halt during the pandemic. Hindsight is 2020, as they say, and regardless of who was right or who saw it coming, here we are.

In response to the worst inflation in decades, central banks such as the Federal Reserve have made it clear that they plan to raise interest rates aggressively. They have to, but it’s putting intense pressure on everyday people, and if it’s not dealt with swiftly, political discontent will likely turn into civil unrest.

What happens to risk assets when central banks raise rates? We’re watching it play out in real-time. BTC has tanked from a peak of over $60,000 in November 2021 to barely holding $20,000 in June 2022. So much for the ‘hedge against inflation’ narrative. Meme stocks like Tesla have cratered, and the S&P 500 has entered bear market territory. Some other digital currencies have tanked even harder than BTC, and as happened in 2017, many of them will never rise again.

Yet, this is only the beginning. The Federal Reserve has made it clear that it will continue to raise rates aggressively until inflation is under control. As the yield available on Uncle Sam’s bonds increases, they will continue to get more attractive. Institutional investors who may have been thinking of allocating funds to risk assets like BTC will be parking it where they know the return on investment is getting better and the return of investment is 100% guaranteed.

Expect the vast majority of institutional capital to leave the digital currency space until this trend reverses, or at the very least, expect no more to enter.

A brief word about the boomers

Demographics play a huge role in every economy, and the Western world is about to experience a tectonic demographic shift. The largest generation in history, the baby boomers, is set to retire en masse in the coming two to three years. When they do, their economic behavior will change drastically. Retirees are, as a rule, risk averse. Boomers will be taking their capital off the table and will be putting it into the aforementioned bonds and perhaps safe blue-chip stocks.

As this capital essentially vanishes, things will get even tighter, and what’s left will mostly be allocated to real, productive companies and not to digital pet rocks. The era of easy money and plentiful capital is over in more ways than one.

Rising energy costs—we ain’t seen nothin’ yet

Rising energy costs are one of the sad consequences of a combination of current factors; inflation, war, ill-preparedness, and some opportunistic profiteering. We can argue all day long about which factors play the biggest role, but truthfully, it doesn’t matter. The prices at the pump keep rising, and so do the costs associated with heating or cooling our homes.

Yet, it’s entirely possible that energy prices are going to keep rising and could double again by the end of the year. Geopolitical consultant and best-selling author Peter Ziehan explains why in this video.

In short, Russian oil pipelines won’t maintain themselves, and with the mass exodus of oil service companies like Halliburton, Schlumberger, and others, coupled with potential damage to the pipelines from the ongoing conflict, the lines that transport between 4-5 million barrels of Russian crude oil per day will slowly break and fall into disrepair, and it will take a very long time before they come back online. The last time this happened was when the Soviet Union collapsed, and it took 30 years to get back to peak production only recently.

Contrary to popular belief, oil-rich countries like Saudi Arabia, Venezuela, Iran, and the United States can’t magically bring millions of barrels per day to replace Russian crude. It can take years to go from drilling a well to production, so oil prices will likely go a lot higher in the short to intermediate term.

This will have all sorts of implications. Directly, it will impact prices at the pump even further and massively increase the costs of transporting goods and services from around the world, causing the prices of everything to slowly creep up as companies try to cover the difference. Ordinary citizens won’t be speculating on digital currencies like BTC, ETH, or other altcoins because they’ll be trying to put fuel in their cars to get to and from work while paying for more expensive groceries.

Of course, Bitcoin doesn’t run on thin air, either. The global mining industry depends on the same supply chains, transportation systems, and energy as everyone else. We’re already seeing miners under pressure as many dump the coins they were holding to pay the bills. Any further increase in energy prices, transportation costs, etc., will only exacerbate the situation. It’s also possible that when energy prices really begin to bite, digital currency mining will be either banned or severely restricted in many different places.

How could I be wrong about all of this?

It’s important to remember that this is merely a thesis, my thinking on how things will go in the next couple of years. I don’t have a crystal ball, and I could well be wrong.

It’s possible, although in my opinion not likely, that inflation is quickly curbed and the Federal Reserve and other central banks loosen monetary policy, lower rates, and begin the easy money carnival ride once again. 

It’s also possible that the Russia-Ukraine conflict will come to a quick end, and some compromise will be struck to keep the Russian crude flowing so that energy prices don’t skyrocket further.

Likewise, regulators could decide that light-touch rules are the way to go, leaving Tether to print tens of billions more with little oversight, causing digital currencies to pump once again.

In my opinion, none of this is likely. Back in the real world, inflation is not transitory, the sad war in Ukraine will not end anytime soon, and regulators will stomp the digital currency industry. 

Winter is here, and it’s going to get a lot colder in the coming months and years. Only utility blockchains will survive.

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