Every downturn in the crypto space causes fear and panic among investors and communities- just as economic recessions also cause panic for everyone from Wall Street analysts to fresh graduates.
But a closer examination of how severe crypto winters are and how severe economic recessions are yield some interesting differences.
The most significant, and most obvious difference is the scale of the events. Even during the depths of the 2008 financial crisis, global GDP decreased from US$64 trillion to US$60 trillion, a decrease of around 6%. Within the US itself, GDP decreased from US$14.7 trillion to US$ 14.4 trillion, or around 2%.
Yet, the collapse of a single Luna token led to the global crypto market cap crashing from around US$1.8 trillion to US$1.2 trillion within a week, and to around US$0.8 trillion by the end of the year as more and more companies went under. This represents a more than 50% decline- a sharp and unnecessary loss.
Why is there such a large discrepancy between the crypto industry and financial industry? And what are the impacts of such a discrepancy?
The safety mechanisms of traditional finance
Firstly, we should take a look at the crypto companies that collapsed during the past year.
After Luna collapsed, several other companies were caught up in the collapse. Of course, this included some companies like Celsius, which were discovered to be misusing customer funds.
But there were also other companies like Hodlnaut, Zipmex, and Three Arrows Capital which also collapsed because of their exposure to Luna.
Luna’s own market cap was around US$27 billion, and the total value of coins in the ecosystem was around US$60 billion.
But the cascade of bankruptcies and crashes that followed soon after meant that the initial US$60 billion loss ballooned to the US$1 trillion dollar loss that we saw by the end of the year.
Fear undoubtedly took its toll, as did foolishness.
But at the same time, these are not exclusive to the crypto world- investors in traditional finance are not immune to fear and traditional financial institutions also mismanage funds. So why is the cascading effect limited to crypto companies and the crypto ecosystem?
The point is that it is not- when banks fail, especially large banks that operate on a national or global scale, there is always the possibility of contagion. Other banks that had deposited funds in the failing bank may suddenly find that their own financial position is precarious or outright untenable.
It is often at this stage that central banks often step in- providing emergency funds to ensure that banks are able to survive. The central bank here operates as a lender of last resort, providing banks with much-needed liquidity to avoid one collapse turning into a national disaster.
This money, however, must come from somewhere- in Singapore this would be our past reserves, but for countries without such reserves, this often means additional borrowing funded by future tax revenue.
Such borrowing, however, has its limits.This money, while borrowed from the future, is created now- and it means that there is more money circulating in the economy, while production is not necessarily increasing. Inflation is the natural result, as the buying power of each unit of currency is diluted by an increased amount of total currency circulating in the economy.
In the worst cases, faith in the fiat currency could collapse altogether, resulting in hyperinflation and dollarisation.
As such, central banks themselves have another emergency lever that they can pull when they cannot borrow any more- and that is to obtain additional liquidity for them to play with by calling on the International Monetary Fund (IMF).
The IMF acts as an international central bank- it provides central banks with loans to stabilise their own exchange rates. These loans allow central banks to provide further loans with funded rather than unfunded borrowing, and stabilise the financial situation.
And therein lies the reason why traditional financial institutions are resilient, while crypto ecosystems can collapse and cause a domino effect- it is not that traditional finance has no contagion effect, but that institutions exist to prevent contagion from spreading too far.
Bank bailouts are simply part of an effort to stem the tide, and prevent one collapse from leading to many collapses.
In this case, central banks and the IMF act as a lender of last resort- as institutions that can provide capital to financial institutions when no other source of capital can be found.
The crypto world has no such parallel- when an ecosystem fails, it fails entirely. Once a death spiral starts, there is very little that can be done to stop it- and because of how interconnected the crypto world is, every collapse has the potential to wipe out a large portion of the Web3 world’s value.
Collateral, utility, and speculative demand
So what can the crypto world do to backstop such unnecessary losses? It also needs a lender of last resort, which can provide liquidity to crypto ecosystems that are threatened by a death spiral, especially if they are simply a victim of the domino effect.
Such an institution would need to hold large amounts of cryptocurrency in reserve, especially one that would be able to maintain its value even during times of economic crisis.
Right now, however, cryptocurrency values are almost always positively correlated with Bitcoin prices. What this means is that during a crypto downturn, Bitcoin prices are likely to also fall- and a treasury of Bitcoin, Ethereum, and other cryptocurrencies are likely to also fall in value.
Therefore, simply holding a large treasury of coins may not actually be sufficient to bail out all the ecosystems that are badly affected. There is always the chance that if the crisis is bad enough, the treasury itself may devalue so much because of capital flight from the crypto space as a whole that it will not be enough.
What is required is for Bitcoin and other blue-chip cryptocurrencies to be used for more than mere speculation. While I have previously discussed currency demand, and the unhealthy balance between transaction demand, emergency use demand, and speculative demand for cryptocurrency in the past, there is also another change that should be made- a change of mindset.
From one reserve currency to another
Generally, it is accepted that cryptocurrencies can be used as money- they generally fulfil the conditions of acting as a medium of exchange, a store of value, and a unit of account.
But while cryptocurrencies like Bitcoin have really taken off as a store of value, especially in countries where the local fiat currency is susceptible to high levels of inflation, they have yet to really take off as a medium of exchange or a unit of account.
We don’t really see people going around trading in Bitcoins or Ethereum- and instead, we judge how valuable these currencies are according to how many US Dollars we can get for them.
This is not productive for the future of cryptocurrencies- until cryptocurrencies are seen as a unit of account and a medium of exchange in their own right, and not simply valuable because they are an appreciating asset, cryptocurrencies will continue to see inflows of speculative demand that makes them increasingly unsuitable for transactional use.
Increasing utility for cryptocurrencies by onboarding more businesses into the crypto space, and getting customers used to receiving and paying in cryptocurrencies will do a great deal towards stabilising crypto markets and bringing about a world where fiat currencies and cryptocurrencies can compete on equal ground.
And it will also enable cryptocurrencies and ecosystems in the future to be less reliant on each other and more independent- meaning that crypto-wide institutions can be made possible.
The future of money may be virtual- and cryptocurrencies may well be the future. But we cannot take for granted that progress is inevitable or that the past holds nothing of value. After all, to replace fiat currencies and central banks, cryptocurrencies and DAOs must first prove themselves superior- not just workable.
While the Web3 world seeks to advance the future of finance and other fields, we should also adapt the innovations of old for what they can offer us, while continuing to find novel ways to improve the ecosystem.