Words by Ahmed Suliman, a Technology and Gaming Sub-Editor for Pelican Magazine.
In the midst of a broader economic downturn precipitated by inflation and the subsequent rise in interest rates, the world of cryptocurrencies has been particularly hard hit. As the price of Bitcoin fell to an eighteen-month low and Ether lost nearly half its value within a month, the Australian Financial Review declared on Friday that “cryptocurrencies could be on the brink of collapse”.
In truth, and to channel the Mark Twain misquote, the news of crypto’s death is likely greatly exaggerated. The market cap of the ten largest coins, at the time of writing, was still over a trillion dollars. Crypto advocates keenly point out that there have been several such dips before. It certainly seems clear that the uncertainty about jobs and purchasing power is driving away investment from speculative asset classes. Much of that capital (both from financial institutions as well as ordinary investors) is likely to come back once greater confidence returns to the economy.
However, in my view, merely waiting out the economic cycle would be a defining mistake for those involved in the often starry-eyed crypto community. This particular crypto collapse has featured some worrying signs for the sector that go far beyond price fluctuations. The demise of TerraUSD and its sister coin Luna, previously one of the top ten coins in the world, has highlighted the folly of so-called “algorithmic stable coins” that promise users parity with real-world dollars but without holding any real-world cash reserves. Meanwhile, high-profile coin offerings promoted by celebrities like Kim Kardashian have turned out to be little more than “pump and dump” schemes.
This is not to mention the very-much-burst NFT bubble, which would require an article of its own to delve into. Sufficient to say that those who rushed to buy strange blockchain-linked pictures of digital monkeys during the peak of the 2021 hype will not be breaking even on their purchases any time soon.
The main problems
Fundamentally, I think this downturn has highlighted two overarching challenges that the crypto ecosystem currently faces, and they are ones that it must address if cryptocurrencies and associated projects are to regain credibility in the long term.
Firstly, this downturn has confirmed the hypothesis that cryptocurrency prices have been simply tracking the stock market since the pandemic began. An analysis by the International Monetary Fund (IMF) shows that the “correlation of crypto assets with traditional holdings like stocks has increased significantly” since early 2020. This correlation was practically in sync with the recent decline in major indices such as the S&P 500.
This reality of cryptocurrencies as a regular asset class that tracks the economic cycle is a far cry from the lofty ambitions underpinned in their founding. After Bitcoin was launched by its (mysterious) founder in 2009, its early adopters – who were living through the aftermath of the GFC – envisioned a future where cryptocurrencies become a tool by which ordinary people can bypass major banking institutions and governments entirely and herald the age of a new economic system.
Eventually, as the cryptocurrency community became larger and (somewhat) less ideological, the dominant view became that the real value of crypto was as a gold-like hedge against economic trends like inflation and stock market turmoil. Through the power of cryptography maths, scarcity, and mass adoption, cryptocurrencies would provide a ticket to growing wealth and preserving it. Instead, crypto markets have degenerated into a more volatile younger sibling of the stock market.
That volatility ties into the second challenge facing cryptocurrencies in the future: substantial downside risk for ordinary investors from both a lack of investor education and unscrupulous crypto businesses. The stratospheric rise in the value of Bitcoin, and smaller currencies (known as altcoins), between 2013 and 2021 lured in large amounts of ordinary people, who were hoping that this weird internet money might help them achieve financial freedom during an era of stagnating wages. It also attracted institutional investors, who were initially sceptical but eventually could not resist the outsized returns.
However, while big investment firms have armies of analysts and sophisticated ways to hedge their bets, many ordinary investors often went in on a wing and a prayer, hoping that the good times will continue. Such lack of research would be concerning when buying into any type of investment, but crypto projects and tokens have no investor protection like normal financial products nor a deposit guarantee like what is available with regular bank accounts (in many countries).
An example of this is the crypto pseudo-bank, Celsius Network. In return for users depositing their coins with the entity, they promised outlandish returns of up to 30%. Such returns depend on Celsius lending out those coins to other entities and investors multiple times for each deposit. This may sound exactly like how a bank works to you, but according to founder Alex Mashinsky, Celsius is not a bank at all. In fact, banks are not your friend. In reality, Mashinsky’s ability to claim this depends on the “Network” avoiding financial regulations through treating deposits as unsecured loans, and stating in its terms that expressions like ‘deposits’ and ‘interest’ are purely marketing terms.
Despite this sleight of hand, retail investor money continued to pour in. In customer forums, it is easy to hear stories of ordinary people putting all their life savings into Celsius, adding up to billions of dollars. However, as the recent crypto crash started to take momentum, fear took hold and depositors began to ask for their money back, in a classic “run on the bank” style of chaos. After days of telling its customers that their withdrawals would not be halted, Celsius did exactly that on June 13th. There is speculation that it has now been rendered insolvent, and it is currently being investigated by five US states.
Where to from here?
While cryptocurrencies will likely recover from this downturn, its effects have cast substantial doubt on crypto as a realistic challenger to the existing global financial system. If crypto is to restore confidence, its communities will need to mature into the real world with projects built on practical use cases that are well suited to blockchain solutions rather than chasing fads and get-rich-quick schemes. This will depend on cracking down on the culture of attracting low-information investors and then subjecting them to elaborate scams. Furthermore, it will need to attract mass adoption and frequent usage for its flagship currencies like Bitcoin and Ether rather than merely acting as stock market-tracking speculative assets. Easier said than done.
Of course, cryptocurrencies have other structural challenges that long predate this cycle, including their vast energy usage. This is less of a problem in newer and more efficient blockchain models, but running the Bitcoin blockchain alone uses more electricity than the entire country of Argentina. In a world increasingly concerned with climate action and energy prices, this will also continue to be an inhibitor to mass adoption.