Home / Markets / Cryptocurrency /  Crypto speculation is all but over. Its systemic troubles aren’t

The first question cryptocurrency owners should be asking themselves at the moment is whether their bitcoin, dogecoin and other tokens are safe. Hold them with the wrong broker or custodian, and they might vanish into an interminable bankruptcy proceeding, perhaps never to emerge.

The second question is closely linked: Have prices fallen enough to justify buying back in? There is no definitive answer, of course, since these are speculative assets with no basis for valuation. But for both the remaining speculators and the true believers who think eventually we will all use a crypto financial system, it is worth thinking about how much investors are prepared for a systemic crisis. For the rest of us, it’s amusing to watch from the sidelines.

The simplest approach is to look at the fall in prices. From its November peak bitcoin is down 77% against the dollar, a horrible drop. Just from the first troubles in crypto back in May—before Sam Bankman-Fried‘s FTX stepped in to calm things down—bitcoin has almost halved. And since the run on FTX began with a CoinDesk story about its interlinked hedge fund earlier this month, leading to its bankruptcy, the price is down more than 20%.

There’s no way to say for sure how much confidence in the crypto ecosystem was knocked by the cascading wave of failures. But at the extreme, the 77% fall in price isn’t that far from the 85% fall in U.S. bank stocks from peak to trough in the 2007-2009 financial crisis. Bitcoin’s better than the banks, too, since it can’t itself go bust, even if the exchanges that enable trading of it appear to be falling like dominoes (and unlike banks, don’t have the Federal Reserve to save them). Take this view, and perhaps much of the loss of confidence in the system is already priced in.

There is further evidence for that from the withdrawal of speculators. Some of the crypto hedge funds had no choice but to stop trading, because their money is locked up in failed exchanges. Others have chosen to take less risk, which means less real money to support the value of crypto.

The evidence is, first, that there’s less demand to borrow crypto assets, because speculators no longer want to take on extra risk. The interest that can be earned by lending out tether, a “stablecoin" tied to the value of the dollar, has dropped to just 2-3%—less than can be earned on risk-free dollars themselves. There is pretty much no demand to borrow bitcoin, with lending rates on Aave and Compound, two decentralized finance platforms for matching borrowers and lenders, close to zero.

Second, spreads on popular arbitrage trades have widened out dramatically. These are trades that flourish when investors want to take risk, because the gains are easy to calculate—examples include profiting from the gap in prices for the very same crypto on different exchanges, or buying stock-market-listed firms that hold crypto at a discount. These and other arbitrage trades are out of favor, because they need lots of leverage and involve the risk of the counterparty, the exchange or the listed firm, failing.

Third, the amount of stablecoins outstanding has plunged as borrowing is repaid. There are just $65 billion of tether outstanding, from a peak of $83 billion in May.

Yet, much of the fall in prices this year had nothing to do with the crisis in crypto. From the peak to the first set of blowups in May prices collapsed as the 2020-21 bubble deflated. Treat crypto as what it really is—a gambling token dressed up as an investment asset—and it is clear that bitcoin dropped exactly in line with other similar highly-speculative bets.

From the peak, bitcoin deflated closely in line with the deflation of the ARK Innovation ETF, which had also attracted a lot of speculative private investor interest for its bets on lossmaking do-or-die technology stocks.

The close link to ARK Innovation even continued during the blowups of crypto in May, when the TerraUSD algorithmic stablecoin collapsed. Lender BlockFi and broker Voyager Digital hit trouble, and Mr. Bankman-Fried stepped in (though Voyager still went bankrupt). Only when Mr. Bankman-Fried’s FTX itself failed this month did bitcoin and ARK Innovation diverge.

There is a tiny bit of logic connecting the ARK ETF and bitcoin, as the ETF holds shares in listed crypto broker Coinbase. But it has far bigger bets on cloud computing, gene therapy, e-commerce and Tesla than on the blockchain. The true link is the reliance for value on major tech breakthroughs and adoption—and since a year ago, the shared drop in that value.

If we take only the additional drop in bitcoin since it diverged from ARK Innovation, it means the systemic crisis in crypto has led to a fall of a bit more than 20%. That doesn’t sound like much.

As backup to this view, both ARK and bitcoin have also traded this year very much like a triple-leveraged version of the S&P 500. Indeed, when the FTX problems began bitcoin and the ProShares Ultrapro 3x-leveraged ETF had been down almost exactly the same amount, 56% and 58% respectively. Again, the link between the two broke only when FTX ran into trouble.

With Genesis Global Capital teetering on the edge—“We have no plans to file bankruptcy imminently," a spokesman said on Monday—the systemic troubles in crypto don’t seem to be over.

But for true believers, systemic problems are just something that crypto has to live with, because part of the point of a trustless blockchain is that it is not government-issued money—and so doesn’t get government-backed rescues, either.

“It’s crypto being crypto," said Omid Malekan, who teaches blockchain and crypto courses at Columbia Business School and counts himself a believer. “The people who came in because of the hype, the FOMO [fear of missing out], the rising prices and didn’t have a fundamental understanding of what’s going on have all blown up."

If they’ve really gone, maybe the bubble itself is fully deflated. But prices will still fall further if more crypto firms fail, as seems likely. As Mr. Malekan says, no one should buy crypto unless they are happy to see prices fall by half in the short run. They easily could.

 

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