The continuing downturn in the cryptocurrency market may be considered an inevitable consequence of a volatile environment characterised by high rewards and even higher risk. There are, however, signs that the most recent "crypto winter" may be different from previous dips.

In contrast to previous slumps, the crypto/digital asset world has developed its own financial ecosystem and the worlds of mainstream financial services and crypto are more closely intertwined. Traditional financial institutions are increasingly becoming exposed to financial products backed by digital assets.

Cryptocurrency exchanges and funds are also permeating traditional finance. Public and professional interest in the cryptocurrency market is at an all-time high. It is no longer just isolated "tech bros" feeling the cold, therefore; crypto businesses and mainstream businesses are facing significant business pressure and even insolvency as a result.

So what will happen next?

A new wave of litigation

As with the 2008 financial crisis, this crypto winter is likely to prompt a wave of litigation.

Hitherto, the focus of the courts has been on considering remedies for victims of cryptocurrency fraud. The emphasis thus far has been to establish whether cryptocurrencies can be defined as property under English law, what remedies are available as a result and whether such claims can be heard in this jurisdiction.

This crypto winter is likely to expand the role of the legal community in the digital assets market.

Where businesses have failed, it is likely there will be a proliferation of claims relating to the security over digital assets, valuations and transactions involving digital assets leading up to insolvency. These claims may also encompass alleged breaches of directors' duties or duties under the Companies Act, as directors navigate their way through the current volatility into unchartered waters. These areas have not been considered in detail by the courts, and claims arising out of the insolvency of businesses will invariably take years to resolve, particularly as higher-value and more sophisticated businesses have been failing and are expected to fail.

Furthermore, there will be a growth in the number of companies and individuals alleging they were mis-sold investments in digital assets, and they will seek redress for these losses. It is envisaged that these types of claim will overtake fraud claims as the main source of digital asset-related disputes.

At the time of writing, digital assets are not comprehensively regulated by the Financial Conduct Authority (FCA), but the courts have already indicated their willingness to consider novel issues in this area. The issues of property and jurisdiction have largely been resolved, at least at an interim level. It is likely that parties seeking damages for mis-selling of digital assets will also seek to find a connection to England and Wales to benefit from the courts' flexibility, speed and innovation in this area, as well as the more traditional benefits of litigating in this jurisdiction.

Survival of the fittest

Until this crypto winter set in, there had been a clear upward trajectory in market sentiment toward digital assets. While this phenomenon did not appear to be a bubble in the traditional sense, it shared some of the same characteristics, and particularly a widespread belief that the upward trajectory would not falter, at least when averaged over the longer term.

The initial signs, however, are that this crash is different. Even stablecoins (digital currencies that are intended to be pegged in value to a stable reserve asset such as the U.S. dollar or gold) have not been protected from the dramatic crash in cryptocurrency values. This is new; it has always been accepted that volatility was the hallmark of the cryptomarkets, hence the rise of interest in stablecoins, seen as more reliable. Since May 2022, however, when stablecoin USTerra lost its dollar peg and its companion token (Luna) fell in value 99%, this notion has come under renewed scrutiny.

The abrupt loss of assets coupled with widespread acceptance that these markets are capable of going down as well as up may prompt a reorganisation. The authors expect to see a move toward consolidation of crypto businesses, with more mature, risk-averse businesses which have strong governance surviving the winter, while those who did not adopt the necessary safeguards may fail.

A crypto spring?

Given the speed of innovation, multi-jurisdictional reach and experimental nature of many crypto-projects, it is impossible to know what the future in this market will look like. Looking beyond the short-term pain, however, this crisis may ultimately provide opportunities for longer-term growth.

For example, as the market recalibrates and growing businesses that have suffered are perceived as good value, there may be a rise in mergers and acquisitions activity as the businesses consolidate. With significant investor capital available, there may be significant investment in more stable businesses as investors maintain the desire for exposure to higher-quality businesses in this market.

The authors also anticipate the current shock waves should provide the impetus for the strengthening of underlying legal frameworks and governance where needed. The downturn has also shown that all parties, including regulators, suppliers and in-house teams, need to work together to gain a better understanding of the issues specific to this sector. While some digital assets projects are suffering in the current climate, the groundwork for them remains, and can be built on as the market recovers.

Stronger ties between the crypto and legal communities can only benefit the sector as a whole, and as talented workers experienced in the financial services industry move into the digital asset sector, the expertise to support this growth moves with them. Ultimately, the development of such underlying legislative frameworks may give investors confidence that there are sufficient protections and expertise in place should something go wrong.

It is possible that the current strife will eventually be revealed as part of the necessary growing pains that will allow the digital asset market to adapt, evolve and mature. Notwithstanding the negative consequences for many individuals, this could eventually come to be seen as the turning point at which digital assets became a mainstream pursuit.

What does this all mean?

The digital assets market needed to evolve to play a significant role in the finance world. The expectation that there would be continuous, exponential rises in the value of cryptocurrencies was not only misplaced, but had the effect of distorting the market.

The significant losses and inevitable wave of litigation will be painful for many as market participants seek to recapture value, but it is crucial to establish trust and confidence in the market. In years to come we may look back on the current crypto winter as a decisive turning point which paved the way for more sustainable growth.

The contents of this article do not constitute legal advice and are provided for general information purposes only.

This article was first published in Thomson Reuters Regulatory Intelligence in August 2022