Will Rising Interest Rates Destroy the Crypto Ecosystem?

By David Z Morris

Compiled and edited by Amy Liu

Competition for capital is hitting speculative investments such as technology stocks hard. So far, digital assets have performed relatively well.

Interest rates across the U.S. economy are beginning to rise, and in some cases soar. These rates obviously affect borrowers, but they also offer lenders higher returns, including on some relatively safe assets. This competition for capital has spelled doom for speculative assets, including stocks of “growth” technology companies.

The most notable rate spikes occurred in the mortgage market, with the average rate on a 30-year fixed-rate mortgage hitting 5.3% on April 19, a 12-year high. On the same day, the 10-year Treasury note yield reached 2.94%, still historically low but the highest level since 2018.

These are still early signs of rising capital costs. That’s because changes in the Fed’s lending rates to banks can trickle down to the broader economy based on complex judgments about the future, broadly speaking. A bank that believes a spike in rates is temporary, for example, might continue to lend at lower rates to steal volume from competitors that raised rates first. So the changes now appearing, a month after the Fed began planning its rate hikes, could be just the beginning.

Rising interest rates have changed the risk-reward calculus for investors, especially large investors like hedge funds. It’s a complicated calculus because “safe” investments like bonds easily attract money that would otherwise flow to higher-return but riskier assets. Those riskier assets certainly include most cryptocurrencies and other tokens.

There are already clear signs that investors are moving into less risky assets. The Nasdaq 100 is down more than 12% since January, while the Dow Jones Industrial Average is down 4.4%.

ARK Innovation is an active fund managed by Cathie Wood. Wood has made a lot of bets on truly speculative tech, fintech, and biotech growth companies, including Robinhood (HOOD), Shopify, Unity, Block, Tesla, and Zoom. These companies are either not yet profitable (most biotech companies) or are expected to have more room to make profits (Zoom).

Notably, Bitcoin is currently down about 38% from its 2021 peak. Ethereum is down a smaller 35%, while the total market capitalization of all cryptocurrencies is down nearly 36%, according to Coingecko.

It’s really striking to see cryptocurrencies outperforming more traditional technology growth funds. Of course, part of this is due to continued investor optimism about cryptocurrencies and blockchain.

However, cryptocurrencies also have significant structural and transparency differences that have consequences. Most importantly, in a higher interest rate environment, a traditional startup that spends more than it earns will see its equity value decline faster, because “burning cash” implies future borrowing. Compared to stocks, it’s harder to figure out the true financial health of a blockchain ecosystem, especially if it’s somehow dependent on external financing.

However, there are specific cases where the protocol is clearly dependent on external funding. Some of these are emergencies, such as the hacked Wormhole Bridge being “saved” by Jump Trading. More worrying are the obvious and persistent deficits of various staking or lending pools.

For example, Terra’s Anchor protocol’s yields are heavily subsidized, with about half of lenders’ returns coming from outside capital rather than borrowers. For now, funders see this as a worthwhile marketing expense, but rising rates elsewhere will almost inevitably create some crowding-out.

Cryptocurrencies have significant tail risks, and coupled with external pressures from safer higher returns elsewhere, it’s not hard to imagine a storm brewing.