2022 Global Crypto Financial Market Report: Industry Rebirth under the Financial Crisis

2022 has passed. Looking back on this year, global economic growth has slowed down significantly due to the impact of multiple factors. The chain reaction caused by factors such as high global inflation, the conflict between Russia and Ukraine, and the recurrence of the COVID-19 epidemic in many places has brought more uncertainty to the investment market. The major central banks in the world, represented by the Federal Reserve and the European Central Bank, have launched a radical interest rate hike to resist the worsening of inflation and prevent structural risks. The traditional financial investment market has experienced a series of shocks from the rise in the US dollar exchange rate and the continuous plunge in global stock markets. Major economies are struggling to move forward under the shadow of the financial crisis.

As one of the important investment markets, the digital crypto market is also not immune to the impact. After experiencing the cold winter of the biggest bull market in history, the leverage behind the prosperous bubble has given rise to the most tragic chain reaction collapse of the crypto market since the birth of Bitcoin. LUNA-UST collapsed, Three Arrows Capital went bankrupt and liquidated, FTX suddenly died... How to find a way to survive in this crypto winter has become an industry consensus.

1. Stagflation and interest rate hikes: a noose and a dagger?

According to the International Financial Forum (IFF) report, the global economy is expected to grow by 3.1% this year, lower than the 6% growth in 2021; the global consumer price index (CPI) is expected to rise to 9.0% from 4.6% in 2021. Global economic growth has slowed significantly due to multiple factors, including the rapid rise in inflation, the shift in monetary policy in developed countries, the Russia-Ukraine war, the recurrence of the COVID-19 epidemic in some regions, and the continued global supply-side bottleneck.

Changes in consumer price index of major economies (data source: IFF)

The acceleration of global inflation reflects many factors, including a rebound in consumer demand due to the improvement of the epidemic, a surge in liquidity caused by large-scale quantitative easing policies, rising prices of commodities such as energy and food, and persistent supply chain bottlenecks caused by the epidemic. The rise in commodity prices such as energy and food partly reflects market changes caused by the Russo-Ukrainian war and related international relations. Inflationary pressures are expected to continue in 2023, but the market generally believes that global inflation will ease for a variety of reasons. The main supporting factors are the following three:

1. The COVID-19 prevention and control has entered a new stage, and the pressure on the supply side has slowed down;

2. Demand is slowing down, and there is a possibility of commodity prices softening;

3. Global monetary tightening has effectively curbed inflation.

However, there are still huge downside risks to the global economic outlook. If the risks are not avoided, the global growth slowdown will be greater than expected, and the continued deterioration of inflation will eventually lead to the possibility of the global economy falling into recession or stagflation.

1. Black swan events such as regional wars, conflicts, and epidemics worsen again

2. Inflationary pressure failed to slow down as expected

3. The continued appreciation of major currencies, represented by the US dollar, has led to a debt crisis

The interest rate hikes and balance sheet reductions by major central banks, represented by the Federal Reserve, have led to a tightening of global financial conditions, which will have a significant impact on the financial stability of some economies. Increased international borrowing costs and capital outflows have put pressure on the foreign exchange reserves of these countries, causing the depreciation of their currencies and making it more difficult to repay their foreign debts. Due to factors such as the epidemic, the average public debt-to-GDP ratio of emerging market countries rose to 64% in 2021, a record high. Currency depreciation has caused the government's foreign debt denominated in local currency to expand, making public finances more difficult and leaving less room for fiscal policy support. According to estimates by the International Monetary Fund (IMF), 60% of low-income countries are in or about to fall into government debt distress in the second half of 2022, which will directly affect the weakening of investor and consumer confidence and restrict the global economic recovery.

As of December 1, the U.S. government debt significantly exceeded the U.S. GDP of approximately $23 trillion in 2021, and has approached or even exceeded the statutory debt ceiling of $31.4 trillion several times.

Changes in the value of some major currencies against the US dollar (data source: IMF)

Ultimately, how to curb inflation as quickly as possible while avoiding stagflation is the key to promoting global economic recovery.

The Fed has raised its policy rate six times this year and has signaled more rate hikes to achieve its 2% inflation target. Quantitative easing has more than doubled the Fed's balance sheet from about $4 trillion before the pandemic to nearly $9 trillion at the beginning of 2022. The Fed ended its balance sheet expansion in March and began shrinking it in June.

The ECB has raised its benchmark interest rate twice this year, from zero to 1.25%. With inflation currently well above its medium-term target of 2%, it is expected that rate hikes will continue. The ECB ended its balance sheet expansion in March this year, but has not yet started to shrink it. However, the global financial market has reacted sharply to the tightening of monetary policy, with stock markets falling, volatility increasing, and global currencies depreciating against the US dollar.

The above impacts directly affect changes in the financial investment environment and economic growth. The United States is expected to grow by 1.6% and 1.0% in 2022 and 2023, respectively, down from 5.7% in 2021. The main reasons for the slowdown are the decline in household purchasing power caused by rapidly rising inflation, while the tightening of monetary policy and financial conditions have restricted private investment. The European Union is expected to grow by 3.2% and 0.7% in 2022 and 2023, respectively, down from 5.2% in 2021. The main reasons for the slowdown include the decline in household purchasing power caused by high inflation, the impact of the Russian-Ukrainian war on energy supply and prices and the resulting uncertainty, and the tightening of monetary policy. In order to curb inflation, the European Central Bank ended its net asset purchases in March 2022 and began to raise interest rates in July. Among the three major EU member states, Germany is expected to grow by 1.4% and -0.3% in 2022 and 2023, France by 2.5% and 0.6%, and Italy by 3.2% and 0.2%.

2. How to view the emerging encryption market

The global financial environment has been affected by factors such as the monetary policies of major central banks, the Russia-Ukraine war and conflict, and the COVID-19 pandemic, resulting in a decline in market confidence and private investment willingness for a period of time, causing a decline in the overall investment market, and concerns about economic recession continue to shroud the market.

The cryptocurrency market, as one of the major investment markets, is also deeply affected by changes in the global financial environment.

Here we will try to analyze a representative major event as a case study.

1. Changes in crypto regulation in major economies

The regulation of emerging crypto markets in major economies is also in a state of dynamic development. In the common law countries represented by the United States, the overall ideology formed is based on economic liberalism centered on the market and individuals, with an individual-centered, market- and industry-based self-discipline. In June 2022, key members of the U.S. House of Representatives and Senate Commerce Committees jointly released a draft of the American Data Privacy and Protection Act (ADPPA). In terms of the main content, more stringent compliance obligations are established for "large data holders". And crypto service providers are undoubtedly an important part of it. The European Parliament and the Council also reached a temporary new agreement in June 2022, seeking consumer protection and a unified legal framework for cryptocurrencies in the European Union. MiCA (Market for Crypto Assets) will cover crypto assets that are not regulated by existing financial services legislation. ESMA (European Securities and Markets Authority) will provide guidance in this regard. The new regulations will impose strict operating rules on stablecoins, restricting whether they are widely used as payments, and capping transactions at 200 million euros per day.

In Asia, the competition for the crypto financial center is just beginning. In October 2022, the Hong Kong Special Administrative Region Government of China issued the "Policy Declaration on the Development of Virtual Assets in Hong Kong", which clarified the policy stance and guidelines for the development of the virtual asset industry and ecosystem, and demonstrated the local government's vision for the virtual asset industry. Singapore, which has always been more positive about crypto institutions, is also not to be outdone. As early as May this year, Singapore's Deputy Prime Minister Heng Swee Keat publicly stated that he would build Singapore into a "decentralized financial center." However, it is necessary to be vigilant that in a relatively loose market environment, avoiding vicious competition in the industry will become a new challenge.

2. The crypto market fell amid global interest rate hikes.

Under the influence of multiple factors, global inflation is high, and anti-inflation has become the main theme of the central bank this year. As the core institution, the Federal Reserve has continued to implement a tight monetary policy this year, and the frequency and frequency of interest rate hikes have significantly increased.

As global funds tighten, major asset classes have fallen sharply, and the crypto industry, which has a higher leverage ratio than traditional industries, has been hit the hardest, with violent liquidation evident.

3. During the Russia-Ukraine war, Ukraine announced that it would accept cryptocurrency donations.

Cryptocurrency has become one of the focal points in this regional war that has affected the world. Within days of the outbreak of the conflict, the official Twitter account of the Ukrainian government published a post that included Bitcoin and Ethereum wallet addresses, hoping that donors could donate BTC and ETH. The initial donation campaign was just one of the government's historic moves to embrace cryptocurrency during a time of crisis. Soon after, the Ukrainian Ministry of Digital Transformation also launched the NFT Museum, selling NFTs that record war events to raise more funds. The role of cryptocurrency has demonstrated the power of "borderlessness" more clearly than ever before.

4. Chain reaction in the cryptocurrency world

Due to factors such as insufficient market development, lagging regulatory development, and relatively small market size in the crypto industry, the industry has high risk-return ratio, accumulated leverage, and high degree of industry target consistency. Together, these factors led to a large-scale chain "collapse" in the crypto industry in 2022.

Everything stems from the chain reaction caused by the oversell of Bitcoin. On May 8, UST, an algorithmic stablecoin issued by LUNA, went into a death spiral due to the sell-off of LUNA. UST quickly decoupled from the US dollar and collapsed to zero. The combination of these two factors also caused losses and bankruptcy of cryptocurrency investment institutions represented by Three Arrows Capital.

5. Ethereum 2.0 merge upgrade.

Investor hype over Ethereum mergers could go some way to lifting the market out of despair after June’s liquidity crisis, with discussions about the network’s proof-of-work fork igniting more investor enthusiasm.

Finally, the merger was officially completed on September 15, 2022. It is also hailed as the biggest crypto technology update since the launch of Bitcoin and can be regarded as one of the milestone events in the history of crypto.

6. The exchange FTX declared bankruptcy.

On November 11, FTX, one of the world's largest centralized crypto asset exchanges, declared bankruptcy. At the time of the bankruptcy, FTX only held $900 million in saleable assets, while its liabilities were $8.9 billion, with a funding gap of up to $8 billion, and user assets were misappropriated.

The chain collapse of crypto institutions represented by FTX and Three Arrows Capital stems from the fact that in the absence of regulation in the investment market, there are too few restrictions or too low costs on behaviors such as misappropriation of funds, increased leverage, and risk transfer by fund holders. The fact is that in 2022, many countries continue to advocate for increased regulatory intervention in the crypto market. Although a large number of institutions fell into trouble in 2022, this proves that the environment of the crypto investment market is gradually moving towards a healthy and orderly environment.

As mentioned above, there are differences in the regulation of the crypto industry among major economies.

The reason for the difference is that the economic development levels of different regions are different. Unlike digital financial industries such as digital banks and digital insurance, which have been mature and developed for a long time and have physical regulatory objects, cryptocurrency is currently the fastest-growing, most controversial, and most difficult to regulate field in the digital financial field, and it may have a subversive impact on the existing financial system. On the other hand, it is also restricted by the different stages of the development of the encryption market.

Compared with relying on external supervision, which requires solving issues one by one from the technical, legal and other aspects, internal innovation in the industry appears to be more urgent and effective at this moment in 2022.

After the FTX incident, the centralized exchange business, which is the foundation of the crypto market, encountered an industry trust crisis. How to ensure the security of funds has become the foundation of the stable industry trust. Crypto institutions that provide fund custody services centrally issue proof of reserves (PoR: Proof of Reserves, which means that the custody business holding cryptocurrencies should create public certificates about its reserves and match them with the proof of user balances/liabilities).

At present, although the proof of reserve can provide a certain degree of proof of solvency, it still has certain limitations. For example, there is still room for fraud in the proof of fund snapshots and incomplete disclosure of funds/liabilities. However, it has to be admitted that this has positive significance for improving the transparency of the industry and regulating practitioners. In the long run, the adoption of the proof of reserve standard is a form of self-regulation that can enhance users' confidence in centralized platforms and industries. A safer ecosystem will attract more investors and provide a springboard for more institutional capital to flow into the crypto market.

On the other hand, the market's call for decentralized business has begun to rise. From a practical perspective, decentralized transactions not only increase transparency, but also the entire financial agreement is automatically executed through smart contracts, which greatly reduces the potential risks in the centralized trading service process, such as misappropriation of funds. However, due to the constraints of current technical conditions and other factors, the existence of the "impossible triangle" of decentralization, security, and scalability shows that security improvement is still the bottleneck currently encountered in the development of DEX business.

Moreover, the Web3 track is also developing in full swing in 2022. Web3.0 is relative to Web1.0 and Web2.0. Web3.0 is essentially a contract. This contract forms a common standard through technologies such as blockchain, which is universal in different apps and fields. This provides the possibility for users to interact on a larger scale, so Web3.0 can be called the contract Internet. Today's Web3.0 is actually a new network production organization method based on the underlying architecture of blockchain. Its core is to return the control of the Internet to users, and to add content to the Internet through user creation. In the process of interconnected users creating content, a distributed production organization system is established through blockchain, such as DeFi and NFT.

At present, the blue ocean of Web3.0 is waiting for Internet companies to explore. But at the same time, it should be noted that the current Web3.0 is actually an extension of blockchain technology, and major Internet platforms are still in the stage of technology reserve. Many Internet platform companies only use the concept of Web3.0 to plan the future form of their own business, and may not have a clear path to realize Web3.0 technology. Although blockchain platforms represented by Ethereum have many practical attempts, many practices are based on financialization and are still far from being widely used tools. Therefore, the current Internet giants must reserve at the technical level and actively explore at the application scenario level to provide more possibilities for the future development of Web3.0.

3. Conclusion

2022 may be a difficult year for the crypto industry and even the global financial investment market. The concentrated outbreak of risk points under the influence of black swan events is the main influencing factor. But for investors, risk also means opportunity. The crypto industry may usher in spring after going through hardships. For crypto market practitioners and investors, the word "turbulence" runs through the whole year. From relief in war to the outbreak of industry turmoil, the entire market is feeling the fierceness of the bear market in the ups and downs. The crypto market is both emerging and more global. As mentioned above, the crypto market will react most sensitively to major events, but precisely because of this characteristic, it is not difficult to find from several events that have occurred in 2022 that it has super anti-fragility.

This is like the two sides of a coin. On the one hand, crypto finance represents a new financial format, a new stage of financial development, and a continuation of the sustainable development of the financial industry. But on the other hand, the problems of the global financial market have also been amplified and exacerbated in the crypto market. Through the self-regulation of practitioners and the development and upgrading of reasonable supervision, the future of the crypto market is still promising.