Crypto Failures Fueled Better Due Diligence

How do investors in traditional risk assets stay safe in rough markets? They flee to fundamentals, value, income or quality – some expression of factors that lead to a traditional security having less volatility and more advantageous returns in periods of turbulence and down markets.

But what should digital-asset investors do? The fundamentals of digital assets aren't as easily discerned, and it’s not always clear which cryptocurrency is going to be more or less volatile than its peers.

Recent events have caused participants in the crypto sector to not only recognize the value of due diligence, but also to revisit how they perform due diligence on digital assets, said panelists in the “Importance of Institutional Due Diligence for Digital Asset and Crypto Investors,” a Digital Asset Research webinar.

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“I’d be dishonest if I didn’t say the market looked a little beaten up,” said Marc Nichols, partner and product director at Arbor Digital, a digital asset manager that targets registered investment advisors.

“It’s beaten up for a good reason. We’ve had some bad actors, some players in the space who weren’t acting with good intentions, and we saw that with what happened to Three Arrows Capital and what happened behind the scenes with the Luna protocol network," Nichols said.

The collapse of crypto hedge fund Three Arrows Capital created a cascade effect where investors suddenly heightened their scrutiny of cryptocurrencies and decentralized-finance projects and began to abandon the ones where developers and sponsors weren't acting in good faith or where there was no clear value being added or issue being solved, according to Nichols.

Nichols said that reports from the executive order signed by President Joe Biden in March are being released and the wealth-management industry is finally gleaning some regulatory clarity around the digital-assets market.

Doug Schwenk, CEO of Digital Assets Research, noted that in times of exuberance, investors often abandon the risk-management tools they once embraced in choppier markets, leaving them prone to drawdowns.

Nichols echoed Schwenk’s remarks, saying that all the signs of underlying vulnerability were present but that people weren't paying attention.

“We saw that in the space with people who were thought to be trusted players,” Nichols said. “Three Arrows Capital was a darling of the hedge fund space ... though we saw things happening that were cause for question, a lot of people chose to ignore them. So if you did due diligence and took a responsible approach, you could have seen the issues bubbling up – but because prices were going up, people wanted in.”

Read more: An Advisor’s Guide to Altcoin Investing

In a particularly obvious sign of market froth, the zeal for digital assets spread to the NFT market. As noise around the NFT sector increased in 2021, one non-fungible token sold for $69 million.

And then, last fall, the rally was over. After peaking at close to $69,000, the price of bitcoin (BTC) fell by more than 67% over a period of several months. Altcoin prices followed suit, often exceeding bitcoin’s losses.

The collapse wasn’t caused by macro issues, according Nichols, but by overleverage by investors like Three Arrows Capital. Digital brokerages were offering too much leverage to traders and investors, and firms like Three Arrows took on too much debt and counterparty risk.

“It wasn’t decentralized finance or the technology that actually broke. It was just human behavior and taking actions that they probably knew were a little outside the spectrum,” Nichols said. “With prices going up and dollars flooding into the space, it’s hard not to have the human reaction that we need to try to grow this exponentially.”

Luna was an experiment that used rich incentives to bootstrap the growth of its underlying network – including promises of fixed yields in the neighborhood of 20%.

But Luna’s failure was one of “economic theory gone awry,” Nichols said. While due diligence showed weakness in the Luna network, asset prices soared and investors bought into the hype. “It’s the same thing we’ve seen play out in traditional markets for hundreds of years,” he said.

Read more: The Fall of Terra: A Timeline of the Meteoric Rise and Crash of UST and LUNA

Another spectacular collapse in the last 12 months involved the staked ethereum trade, where big investors took large positions in staked ethereum and then leveraged other positions on top of those positions.

Many of those investors failed to account for the volatility of cryptocurrencies and didn't employ risk-management techniques to deal with a steep decline in ether's (ETH) price, according to Nichols.

Nichols uses Digital Asset Research to get clean, real-time pricing and asset data on cryptocurrencies and to vet digital assets on the strength and growth of their underlying network.

Arbor Digital, Nichols’ firm, identifies opportunities based on the network effect – the idea that the more valid, active participants a network has, the more powerful and valuable that network becomes.

“It’s almost like you have to throw away your old thinking, like the value and growth metrics and thinking you used to gauge the health of a company,” Nichols said. “We work closely with DAR to discern what that means, because the standards for what that means have not been built yet.”