Cryptocurrencies are in a precarious position, and as the Terra debacle showed the crypto sphere is built on a shaky foundation. Might the bubble pop once and for all?
During the last few weeks even typically dovish central banks like Sweden’s Riksbanken have reversed course after months and months of above target inflation. At the same time the crypto sphere has had a tough couple of weeks. I don’t think this is a coincidence but rather the first signs that crypto can’t survive in a world where interest rates aren’t at rock bottom. Many crypto skeptics have made comparisons to Amsterdam’s tulip mania in the 1630’s, and I think that is in many ways apt; just like tulip bulbs, blockchain technology has other uses than as speculative vehicles. Markets may well be able to remain irrational longer than one can remain solvent, but they can’t remain irrational forever. If the current trend of rising interest rates continue we might see the crypto bubble pop once and for all before the year is out.
The first indication of trouble in cryptoland is reports coming out about certain high profile non-fungible tokens (NFTs) having lost most of their values. Take for example, Sina Estavi’s recent attempted sale of the NFT of the first ever tweet which received a top bid of $6800. Certainly not a bad sum for something so ephemeral as the “ownership” of a tweet, but far below the $2.9 million Estavi paid for it just over a year earlier. The story is a microcosm of the crypto sphere, with people paying of ludicrous amounts of money in exchange for totally inane things like digital “money”, backed by nothing, and the “ownership” of digital artwork or concepts, without actually being recognised by the law as ownership, which is treated as a sensible investment by the buyer despite the fact that crypto is incredibly rife with scams. To quote Dan Olson’s fantastic ‘Line Goes Up - The Problem With NFTs’: “The one market that cryptocurrency has successfully disrupted is the market of fraud”. The Guardian’s article covering Estavi’s attempted sale of the first tweet NFT is a good example of how disconnected some crypto enthusiasts are from reality. Estavi makes bizarre statements like: “It’s important to me who wants to buy it, I will not sell this NFT to anyone because I do not think everyone deserves this NFT”, and “This NFT is not just a tweet, this is the Mona Lisa of the digital world”, and according to the article he expected the price of the NFT to be at least $25 million when it was sold.
The second indication of trouble for crypto is the recent debacle surrounding Terra, a so-called stablecoin. The idea of a stablecoin is to be a crypto equivalent to a real currency, most often the US dollar, as it is easier to buy crypto with other crypto than to buy crypto with real currencies. Some stablecoins are backed by real money and maintains their values by having a dollar for each coin whereas others like Terra maintain their pegs by other means. Terra’s 1:1 peg with the US dollar was maintained by having a sister currency, Luna, which one Terra could be redeemed for one US dollar worth of Luna. Luna could also be redeemed for Terra and the whole system was built on the concept of arbitrage. Essentially the peg was to be maintained by relying on traders looking to profit when Terra and Luna’s prices were out of sync. The problem of course was that Luna doesn’t have any real value; essentially Terra was digital monopoly money backed by another brand of digital monopoly money in the form of Luna. Though the story doesn’t end there, it’s crypto all the way down. In order to protect Terra’s peg Terraform Labs, the firm behind Terra and Luna, sold Bitcoin in order to prop up the Terra which was down to $0.18 at one point. The sheer absurdity of having cryptocurrencies which are backed by other cryptocurrencies which are backed by other cryptocurrencies shows how unstable crypto is.
I’ve made the case many times that any given cryptocurrency is practically worthless as it’s only backed by air and the promise that there’s a fixed maximum supply of coins, as if the fact that something is a limited quantity gives it real value. Author David Gerard is quoted in a Euronews.Next article as comparing the Terra crash to the 2008 financial crisis, and while that might seem like a hyperbolic statement I think it's spot on. One of the reasons 2008 became such a mess was that there was a lot of financial instruments backed by mortgage debt which the big players in American finance saw as safe. As long as the housing market in aggregate was stable and appreciating the system worked as intended and the proceeds from mortgaged backed securities (MBS) could be reinvested in new MBSand banks created second and third order derivative products on the housing market. However, when the housing market started collapsing so too did the system of financial instruments built on it. The Terra situation is very similar. If Terra is backed by Luna and Luna is backed by Terra, and Terraform Labs sells Bitcoin to stabilise Luna and Terra then both are ultimately backed by Bitcoin. Which brings us to the second folly of the Great Recession which is repeated in crypto. Those who invested in MBS assumed that since any given MBS was made up of hundreds of mortgages, and thus diversified, investing in several MBS was further diversification. In actuality though, by investing in just MBS rather than MBS and say stocks banks made sure all of their investments were sensitive to the housing market. It didn’t matter that MBS was made up of hundreds of individually sound mortgages, in the end all of them were impacted by the housing market. The same is true for crypto as different cryptocurrencies tend to move together. When Terra collapsed Terraform Labs had to sell their Bitcoin to try to save Terra which puts pressure on Bitcoin which can trigger a third completely different cryptocurrency to have issues as it is also backed by Bitcoin. This wouldn’t be a problem if different crypto’s were backed by different assets but as we saw with Estavi crypto enthusiasts are often absolutely convinced that crypto is the future and thus invest the money they make from one crypto project in a another which can create structural problems in the crypto infrastructure where everyone is exposed to everyone else. The system works well until the market on aggregate starts facing serious problemes at which point everything collapses in on itself like a house of cards.
If material factors in the form of higher interest rates starts to impact crypto as a whole then I believe there is a real risk that the whole market collapses. As I said in my predictions for 2022, I don’t think that interest rates will go very high before central banks will be forced to reverse course but we shouldn’t ignore the risk of a crypto collapse. It may even be that raising rates triggers the crypto crash which in turn forces central banks to start lowering interest rates again. As we say in Swedish: den som lever får se. Still, I’m worried for crypto enthusiasts.
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I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
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Cover photo by Rūdolfs Klintsons from Pexels, edited by Karl Johansson
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