Making sense of the crypto crash
The global fascination with cryptocurrencies shows just how far we have come from the ordered world set out in economics textbooks a generation ago. This is now a world where the links between economic fundamentals and asset valuations have grown even more tenuous and volatility is the new normal. Crypto assets bring a whole new dimension to investment today.
Paradoxically, most crypto investors have little understanding of what they are trading in. And it is no surprise that most cryptos are not underpinned by physical assets nor explicitly linked to them. Money is often made by ‘going with the flow,’ or not.
Cryptocurrencies, typified by the largest virtual currency, Bitcoin, have made many fortunes to date. The prospect of easy money has brought countless others along for the ride, something that attests to the enduring appeal of the unregulated fringe of financial services. Crypto has now reached a point where it is too well known and established for even significant financial establishments to ignore.
As retail investors have been priced out of some crypto assets due to their rapid appreciation, the market has attracted a growing supply of new entrants offering the same magic. A recent estimate indicated that 16 percent of Americans and 10 percent of Europeans are exposed to crypto assets. More importantly, the crypto market is now larger than subprime mortgages, which triggered the 2007 global financial crisis. Bitcoin leverage hit an all-time high in January, according to database CryptoQuant.
However, the ride of crypto investors has become increasingly bumpy in recent months, not least because crypto’s success now has to hinge on something more than just being yet another conduit for the massive waves of liquidity pumped into financial markets by central banks. The days of quantitative easing have given way to quantitative tightening, even if real interest rates are still declining due to inflation. Tighter money matters because the limited liquidity of individual crypto assets has always been an inherent source of volatility.
The crypto collapse in May brought down the value of the asset class by close to a third; close to $2 trillion of value has been lost since the asset class peaked last November. There have been some particularly painful reversals, including the total collapse of digital coin TerraUSD and the plunge of Tether, which lost its safe-haven proposition as it temporarily de-pegged from the dollar — albeit not for the first time; the peg also frayed in 2018. Terra’s sister Luna similarly imploded, as what was supposed to be the safest area of the crypto universe showed itself to be anything but. Valuation of the Nasdaq-listed Coinbase platform crashed as fear undermined confidence.
Painful as the drop was, it was not unprecedented. Almost exactly a year ago, between last May and July, Bitcoin almost halved in value. Earlier Bitcoin plunges included an 84 percent drop between 2018 and 2020 and an 85 percent drop between 2013 and 2015. Interestingly, as the investor base has expanded, the behavior of crypto assets has begun to correlate more with other markets. The latest volatility suggests that crypto today has the nature of a high-risk asset rather than a hedge against inflation that many had hoped it would provide. It is obvious that the crypto market is being stress-tested, but it is far less obvious how this asset class will react.
These developments raise two important questions. Firstly, is it time for regulators to bring order to this booming industry? Secondly, how serious should investors be about crypto?
Apart from China’s 2018 sledgehammer crackdown, developments on the ground will likely provide an answer to the first question shortly. A US presidential executive order is expected in early June and the European Commission is preparing a regulatory framework for crypto assets. G7 financial policymakers last week called for the rapid development of regulation of these assets. The challenge of such a task is its inherent conflict with the increasingly aggressive efforts of some jurisdictions to position themselves as crypto hubs.
It is clear that crypto is now too important to ignore. Given the scale and popularity of the asset class, investors deserve at least the right to know what they are buying. At a minimum, some basic transparency and reporting standards are needed to inform buyers.
Given the importance of retail investors, consumers deserve basic protection through appropriate reserve requirements for exchanges, even if they must also accept the possibility of losing their savings. Some regulation is also justified by the real economic costs associated with some crypto assets. Bitcoin mining consumes 0.5 percent of global electricity.
The answer to the second question is less conclusive. It is obvious that crypto offers a value proposition. A currency not tied to a monetary regulator, or the monetary policy conditions of a given country, holds obvious appeal. As does an asset supported by a trusted technology, although it is important to note that this does not necessarily prevent manipulation.
Perhaps more important, a currency that can be traded internationally without the customary costs and friction of national currencies can be a major source of efficiency. Stable coins, which combined are now worth $150 billion, can offer opportunities for tokenizing and improving the tradability of other assets. But for all of this to deliver true value, it must be reliable and transparent. The time has likely now come to take the crypto market from adolescence to maturity. Regulators, step forward.
• Jarmo Kotilaine is an economist and strategist focusing on the Gulf region. He writes on issues ranging from economic development to changes within the corporate sector.