Can cryptocurrency recover from its recent collapse?

Can cryptocurrency recover from its recent collapse?

Even if you don't live and breathe cryptocurrency, you've most likely observed some upheaval in the market. The media's attention is drawn to missing apes and falling stablecoins, but what's really happening?

What happened to the cryptocurrency market?

As with so many things, it happened gradually at first, then all at once. Consider bitcoin, the initial cryptocurrency, which accounts for around one-third of the sector's worth. Since the end of March, the price of a single bitcoin has been gradually declining, paralleling a larger malaise in the technology industry.

That makes sense: investing in bitcoin, like investing in any other technology stock, is a wager on the likelihood of more technological change. With inflation cutting down post-pandemic growth on both sides of the Atlantic, and a nagging feeling that excessive optimism had led to an overvaluation of technology in general over a previous couple of years, the entire industry began to fall.

The dam then burst in early May. It fell more in a week than it had in the previous month. The immediate cause was infection from another cryptocurrency project, Terra, which was originally valued at more than $50 billion but finished the week practically worthless.

Other coins followed Terra's demise. Initially, comparable projects' valuations fell as investors thought they would follow; later, panic grabbed the entire industry, and even comparably blue-chip tokens, such as bitcoin itself, fell.

The crisis didn't end until mid-May, and while the market has restored some stability, it shows no signs of rebounding to last month's highs. According to one CEO, we may be on the verge of a "crypto winter." That is the optimistic attitude within the industry; pessimists believe this is the beginning of the end.

Was it drop connected to the general economy's turmoil?

Probably. In recent months, technology equities, in general, have been hammered, with rising inflation undermining the attraction of fast-growth, low-profit investments and a succession of devastating revelations from the major businesses raising fundamental doubts about their prospective development.

Bitcoin supporters may portray their currency as a kind of "digital gold," with a restricted supply that allows it to operate as an effective inflation hedge. In actuality, however, as inflation increases, bitcoin falls, and as economic prospects decrease, so does the potential of a digital revolution.

Furthermore, the crypto economy appears to be disproportionately driven by retail investors, who regard the sector as a midway house between traditional day-trading (already a stunningly dangerous form of investing money) and plain gambling. As growing expenses hit, those investors may be obliged to sell part of their assets, further depressing the industry.

What occurred to Terra that caused it to crumble?

Terra was a proposal to create a "stablecoin," which is a cryptocurrency token with a constant value of one US dollar.

Stablecoins are not a new concept. Tether and USDC are two of the most popular in the industry, and they act essentially as banks: consumers send them money, and they receive stablecoins in exchange, which can be turned in for money at any time. This "reserve-backed" concept has flaws, namely that you must trust the corporation behind the stablecoin to keep the money secure and immediately available, rather than putting it all on red in Las Vegas to make a fast profit with other people's money.

"Just trust us" is anathema in the cryptocurrency industry, therefore there has long been a drive for a new form of stablecoin, one that maintains its value algorithmically rather than through the actions of bankers. Terra was one of such attempts: a pair of currencies, one of which, luna, is meant to float freely while the other, terra, is meant to always have a value of $1. Luna can always be converted into terra for $1, therefore if the price of terra becomes too high, luna owners are incentivized to print more. And because terra can always be converted into luna for $1, terra holders are incentivized to destroy it if the price of terra falls too low.

The issue is that the mechanism only works if luna has any value. For a time, it did, due to a bold offer to pay a 20% return on funds kept in the currency. And then, in the midst of the meltdown, as investors began to withdraw their funds to cover losses elsewhere... it suddenly didn't. This sparked a "death spiral," in which investors converted terra into luna, lowering the price of luna, which meant that the following redemption dropped the price of luna even further, and so on. The value of the luna coin dropped from $80 to about one-thousandth of a penny in a matter of weeks. The experiment had concluded.

When cab drivers start chatting about stocks, it's time to sell, according to an old financial proverb. Early last year, crypto exchange Luno transformed this into a daring marketing pitch.

Who are the losers and winners?

On one level, the answer is straightforward: the winners are those who sold their cryptocurrency holdings in early April, and the losers are those who bought them. It's so widespread in the industry that there's even a rallying cry for those left standing when the music stops: "HODL" (Hold On for Dear Life) - an implied guarantee that the boom times will return and only those who don't panic and sell at the bottom will profit in the next part of the cycle.

There are, however, differences. Those who held blue-chip cryptocurrencies like bitcoin and Ethereum have only lost about half their value since the peak, whereas those who bought "shitcoins" - low-effort projects where almost everyone involved admits that the goal is simply to buy low, sell high, and leave someone else to pick up the pieces - have lost much more. Similarly, people who were able to cash out into one of the stablecoins that survived the volatility are virtually as well off as those who were able to convert their crypto into cash.

The same is true in other sectors of the economy: if you bought a "Bored Ape" NFT at the pinnacle of the market, you may have difficulty selling it for exactly what you paid for it, but it's still very straightforward to resale it for more than £100,000 today. Not so if you bought, say, a snapshot of Jack Dorsey's first tweet on Twitter for $2.9 million and now can't sell it for $14,000.

The corporate sponsors of the industry, however, appear to be the greatest winners in all of this: venture capital funds such as Andreessen Horowitz and the successful businesses that have produced repeating boom/bust cycles. After all, the only thing better than buying low and selling high is having the power to print for free what everyone else is attempting to purchase.

Does this imply that the underlying technology is also flawed?

Everything in the cryptocurrency industry is based on a few common ideas, most notably the notion of a blockchain - a decentralized ledger that monitors ownership of digital assets without giving any one person or organization control of the network.

Other common aspects include "proof of work," a method of securing a blockchain by requiring massive amounts of energy to be burned every second in order to economically dissuade attackers from attempting to break the system, and the use of cryptographic "wallets," which allow assets to be held in a way that prevents any transactions without the account holder's secret key.

Each of these technologies has received criticism in its own manner. Proof of work, for example, is responsible for the bitcoin network's astounding carbon footprint, which is equivalent to the entire country of Thailand, while the blockchain itself functions as little more than a tremendously slow and inefficient database in any case where decentralization isn't the primary benefit.

However, in particular cases, these technologies remain extremely strong. Any circumstance in which a government attempts to halt the economic activity, for example, becomes far more difficult to enforce when there is no centralized entity to police the regulations. This might include campaigners seeking cash to promote democracy in countries with strict capital restrictions, as well as ransomware merchants extorting payments from schools and hospitals in countries with no extradition treaties.

Will the crypto meltdown have any consequences for traditional financial institutions?

Fortunately, it now appears improbable. Conventional financial institutions have mostly avoided the crypto sector, and when they have, they have considered it as a high-risk investment option. Even if the entire sector vanished overnight, the potential for contagion would be limited: the knock-on effect would be devastating for some traditional stocks, and investors in venture capital funds such as Andreessen Horowitz's recent $4.5 billion round of investment in cryptocurrency companies would be wiped out, but systemic effects would be unlikely.

However, the crypto economy is still worth more than $1 trillion, and such riches do not vanish without causing significant suffering in the real world, even if it does not result in a Lehman Brothers-style bank failure. It might create or worsen a recession, or it could spawn a new wave of more traditional issues like mortgage foreclosures, bankruptcies, and insolvencies.

Bored Ape NFTs – collectible digital artifacts – are traded using the ether cryptocurrency.

Could cryptocurrencies recover?

The bitcoin industry has already weathered devastating collapses. That's what spurred the recent discussion about us entering a "crypto winter": it's horrible, but winter comes before spring. The expectation is that investors will only have to wait for the market to defrost.

If there is cause to be pessimistic, it is that this time may be different. Crypto has traditionally expanded by attracting larger and larger pools of new clients. However, this current bust might be so large and ubiquitous that there are few new clients to be found. And, ultimately, those who have saved their money in cryptocurrency will need to sell in order to pay their bills in the real world, and they will be unable to find a buyer. If everyone in the developed world lost money in the crypto meltdown or knows someone who did, the pool of foolish wealth to invest in the next time around will be quite little.

However, work on consumer items continues in the meanwhile. Perhaps someone will have created a great "play to earn" game or an NFT that millions desire to acquire. In any case, the clock is ticking.