by Tartan Ow

Remember when the running joke about crypto or blockchain was that no one could really explain it? As Einstein said, “if you can’t explain it to a 6-year old, you don’t understand it yourself”. And officially as of last month, the joke was on the millions who somehow still convinced themselves investing in crypto was a good idea, without ever actually understanding how it really worked before the big crypto crash happened.

According to Oscar-nominated Matt Damon in his now (in)famous TV commercial, fortune favours the brave.” The message: someone has to be the pioneer, and in doing so, will be rewarded. In crypto’s case it was true to a certain extent. Anyone who bravely acquired 20 bitcoins in 2010 and sold them last year would be a millionaire now. 

Die hard crypto fans have always talked about how crypto will democratise finance, money, investment, etc. But after last months’ $2 trillion bloodbath, arguably the biggest thing crypto’s succeeded in democratising are the losses. By the same token (no pun intended), those who bought coins on the day Damon’s ad aired, would’ve lost roughly 63% of their investment (as of mid-June 2022). 

If it feels like we’ve been here before, that’s because this isn’t crypto’s first crash. There’s been many other high-profile crypto crashes since its inception in 2009. While crypto devotees claim the crash this time is no different and people should just HODL, this time is very different. So what went wrong?

Crypto is not a currency

Firstly, many economists and finance folks have been saying for years that cryptocurrency isn’t a “currency.” It’s a digital asset.

What is a currency?

By definition, a currency is a physical piece of money (ie. a note/coin, or “fiat”), issued and underwritten by a government who sets monetary policy, and through legislation in its jurisdiction ensures there’s no hanky-panky going on.

For example, you have 50 physical dollars worth of currency and you deposit into a bank account, you get a receipt for $50 worth of money in your account. Upon depositing your $50 in currency, that amount changed from being physical currency to digital money. It’s still accounted for in a unit of currency. It’s monetary value is still $50, but it’s no longer your physical currency.

Conversely, money needn’t be physical. Your $50 is still worth $50, its physical existence is decoupled from its monetary value to you. The difference may seem theoretical, but it’s not when it comes to when the government issues currency (with an agreed value), versus when a private company issues something that has monetary value, but isn’t an actual currency.

That’s because, in the case of currency, the government acts in its own economic self interests to keep the currency stable through raising or lowering interest rates, controlling how much money it prints, etc. As former US President Harry Truman succinctly put it: the buck stops here.

That’s why in times of crisis, governments actively fight to manage their currencies to keep them stable, and keep the cost of living stable for their citizens.

What is crypto?

In contrast, crypto is decentralised, free of government interference, and “democratic”. It’s the exact opposite of how an actual currency works. So if currencies work because a government has oversight, then how does crypto work? 

Crypto was envisioned as peer-to-peer (P2P) without government regulation. It’s believed that when enough people used it, they’d settle on how best to use it in the financial ecosystem. This happens with real currencies as well. For example, oil is priced in US dollars because it’s widely trusted and universally accepted. It made more sense to globally price oil in US dollars instead of Saudi riyals or Emirati dirhams. 

Crypto users also argued that crypto was like any other currency – that all currencies work because you believe in them. For instance, the only reason a dollar is worth a dollar is because we all agree to trust the system. This is why crypto evangelists always claim people need to just “believe” in it and eventually it’ll work.

However, history and economics show us that anywhere consumers lose faith in one currency, they adopt another, more stable currency to transact in. No buyer or seller wants to transact in something none of them fully believe in. They may speculate in it as a sort of risky investment (with the aim of making a quick profit from the uncertainty), but they won’t willingly use it as a currency. 

Sticking with the example of US dollars, we’ve seen it happen everywhere from Vietnam to Venezuela and Zimbabwe, where locals lose faith in their currency. That’s why even among crypto diehards, they’d probably refuse to buy a crypto currency that couldn’t somehow be converted into an actual physical currency of some kind (ie. euros, dollars, yen). No amount of “believing” in something changes that. 

Crypto billed as the innovative way to pay

Crypto’s always pushed the narrative that it’s cutting-edge. But it doesn’t actually solve specific problems with our existing money. For example, if a major company – say, Tesla – starts accepting crypto and it’s somehow better than using dollars, then other car makers would follow suit. Theoretically, crypto would then be more stable as it becomes increasingly adopted by consumers as an easier, faster, or better way to buy stuff. It could be a car, a 6-piece Chicken McNugget meal, or a million other things.

But that’s also how any other currency works. However, crypto hasn’t actually made buying things easier, faster or better than a plain old dollar in any meaningful way, yet. At best, it’s novel.

For instance in 2010, Bitcoin’s first transaction was when Laszlo Hanyecz famously bought two large pizzas for 10,000 bitcoins (worth around $40 then). But Laszlo had to first obtain the coins either by slowly mining or buying them. Then he had to find someone to agree on a price to convert bitcoins to pizza. He also had to wait for the transaction to go through, which took over an hour to complete. 

Would it have been easier to pay for his pizzas in cash? Yes, but Laszlo probably did it for novelty. It wasn’t making it cheaper, faster, or better. It was a community of tech-oriented people trying to create something that was a different approach to money.

Today, the average transaction time by various blockchains could be anywhere from minutes to hours depending on the cryptocurrency and the volume of traffic. Plus there’s expensive crypto gas fees and its value can dive with a crash. With Visa or Mastercard or any credit card, it’s instantaneous and cheaper. So if it’s not cheaper, faster or better, then what’s the point of cryptocurrency?

Crypto becomes an investment

It’s fair to say that most people using crypto today no longer treat it like a currency. They’re holding onto it – aka HODLing – because they’re treating crypto as an investment.

That creates a fundamental schism in the ethos of crypto, because a currency and an investment are incompatible with each other. If a currency’s going to be willingly accepted as a medium of exchange, it needs to be relatively stable over time. It’s essentially the opposite of an investment, which deliberately comes with built-in risk that people weigh against a potential return.

This can be easily illustrated in the context of today’s global inflation. For instance, if you’d kept a $2 hong bao for the last 20 years, it’d still be worth $2 today. But it would buy you far less now because the currency’s lost value relative to inflation. If you’d invested the $2 in an investment that kept pace with inflation, you’d have around $3.40 today. As currency, there was zero risk that your $2 bill would not be worth $2 later. But compared to an investment, there was also zero chance it would be worth more than $2.

That’s the difference between a currency and an investment. People don’t want a risky currency, and investors won’t invest in something with zero chance of growing and an almost guaranteed chance of depreciating. A currency and an investment can’t normally coexist in the same thing.

Laszlo’s 10,000 bitcoins he paid for pizza in 2010 would eventually be worth around $300 million at their highest point. He was spending bitcoin as a currency like many early adopters were. If he didn’t, the value could be eroded by inflation.

If he’d foreseen it would become an investment, he wouldn’t have spent it. When enough other people also started thinking of crypto as investment not currency, they naturally started speculating on its value, rather than finding ways to spend it. This fundamentally changed the entire corporate culture of the cryptocurrency ecosystem. It starts to explain how we ended up where we are today.

Crypto’s mass adoption

The allure of crypto and its mainstreaming through celebrity endorsements, tacit approval by major institutions, and even wholesale adoption by entire countries, gave everyone from uni students and kopitiam uncles the confidence to invest in something.

Photo by Eftakher Alam on Unsplash

The obvious problem is if crypto is an investment, it essentially presumes its value will always go up. But in order for someone to profit from buying low and selling high, someone else has to lose. If everyone thinks crypto’s going to continually rise, then no one wants to sell at a loss unless they’re forced to. 

Because everyone was treating it as an investment, many crypto traders would double down on their bets. They made increasingly riskier moves trying to take advantage of what they assumed would be continually quick profits. It’s a situation that’s not sustainable in the long term.

Of course, this practice isn’t unique to crypto. It also happens in traditional markets, but almost never with everyone doing it constantly, all at once. As such, when big brokerages, pension funds, and companies (eg. Tesla) started dealing in it, people inevitably thought crypto would start to behave more like a traditional asset. Their entry to crypto gave it an air of respectability, but also the illusion of being something it’s not.

Crypto already had a unique systemic culture of risk-taking that isn’t for the masses. But everyone knew someone who was getting in on the action, and that ultimately led to June’s $2 trillion bloodletting. Whereas in previous crashes, it often felt like it was just some risky people making risky bets trying to get rich quick. 

Over-Leveraging is a problem

Crypto’s unique culture of risk taking relies heavily on leverage. Traders often borrow increasingly bigger sums to place higher-risk bets, with crypto brokerage sites offering up to 100-200x leverage. It’s something unheard of in traditional stock markets or banking because it’s just too risky.

A bank would never loan you a $1 million mortgage on a house if you only had $5,000 collateral. But you could do that with crypto – and often, even the collaterals were guaranteed with other crypto. This risky situation only works as long as prices continue to climb. But if the market does crash, it’s a double whammy because the traders lose their highly leveraged bets on the crypto itself. The underlying collateral of the loans they took to underwrite the bets is also worth less. Ultimately, it undermines the financial stability of the entire system.

Ironically, what drove crypto’s huge profits (in the boom times) were things like 200x leveraging, which no mainstream bank would ever underwrite in the first place. So ironically it was all the big institutional money pouring into crypto, chasing after big, risky profits, that created the impression of crypto becoming more mainstream and “safe” when it wasn’t. This was arguably the final piece of the puzzle for explaining the size of last month’s crash.

The crypto crash cycle

As we all know, crypto’s huge profits made daily headlines around the world. But there were also spectacular crashes.

In 2013, crypto had its first strike from a government, when China banned its banks from dealing with Bitcoin. As a result, the value of BTC dropped from $1,151 to over half that value in a fortnight. However, it made a spectacular comeback in 2017, when it was worth $19,497 by December. But that didn’t last long, as it crashed by as much as 80% and took 18 months to recover. The crash period between 2017 and 2018 is infamously coined the “Crypto Winter.”

Despite being hit by the pandemic, investors, traders, and founders were going full throttle in the early months of 2021. Bitcoin’s value hit a record high of $69,000 per coin! This was on the back of a very confident investor market. There was a huge rise in DeFi platforms, NFTs, and games utilising cryptocurrencies. This then attracted all the big institutions, as people began to see crypto’s use cases expanding beyond speculative trading into a real ecosystem. Those hunkered down in their homes due to the pandemic wanted an alternative income; this ecosystem gave them the perfect way in.

However, that rise didn’t last long. Reflecting crypto’s extreme volatility, June’s crypto crash was almost inevitable. But this time, it’s also a result of macroeconomic forces.

June 2022’s crypto crash

In May, stablecoin TerraUSD broke and wiped out more than $500 billion from the crypto market. That contagion rolled over to other major digital assets such as Bitcoin, which lost more than 50% of its value since May. Other cryptocurrencies like Ethereum and altcoins like Cardano and Polygon were also inevitably affected.

The freezing of $11 billion in assets, followed by a bankruptcy filing by crypto lender Celsius Network (which some say was a scam), and the layoff of 18% of its full-time staff by bitcoin wallet Coinbase combined to plunge the market further down. To make matters more complex, we also have the war in Ukraine, the highest inflation in 40 years, the bearish stock market, and current monetary policies (e.g. the US Federal Reserve is expected to raise interest rates by a further 1% later this month, to rein in inflation) to add to the fire.

This is why this year’s crypto crash is different from all the previous crashes. The 2017-2018 Crypto Winter was precipitated by a series of factors inherent to the crypto world. These include overleveraged investors and doubts about regulations. This time, the crypto crash is tied to the stock market and the economy more than ever before, triggered by the financial crisis linked to the Ukraine war.

Photo by Maxim Hopman on Unsplash

When will this winter end?

Crypto began life as the domain of tech geeks, then speculators, and later, mom-and-pop investors. When it finally attracted institutional money, it gave it a veneer of credibility. In a sense, crypto supporters have gotten exactly what they’d been wishing for all along: it’s become mainstream. But this means it’s vulnerable to all the exact same forces as any other currency, stock market, or ecosystem.

Unlike past crashes – due to crypto’s mass adoption in gaming, NFTs and elsewhere in the last few years – plenty of financial pundits think that interest in crypto shouldn’t decrease as much as the crash in 2018’s Crypto Winter. With the necessary corporate policies and government regulations, cryptos could fully evolve into a new class of digital assets with unique economic properties. 

Sure, the crypto market is composed of cycles, but it’s unsustainable for any industry to maintain constant growth anyway. For newcomers, this crypto crash might feel like the bubble has burst. But has it? The blockchain industry has proven to be resilient in the face of crypto winters in the past. The question is, how long until spring arrives?