I want to discuss the recent crypto crash and its potential implications, so I’m going to take a short diversion from my usual approach of providing programming advice and code examples with this post. Understandably, the rapid fall in the valuations of cryptocurrencies is a topic that interests many of us who work in the tech industry.
While I don’t have any investments in crypto myself, I’m aware that some of my friends and colleagues do, and I take no pleasure in seeing anyone lose large amounts of money. So I want to understand what’s happened and what the prospects are for recovery.
Why Do Cryptocurrencies Even Matter?
Cryptocurrencies have become more mainstream over recent years. These digital currencies rely on data maintained by decentralized machines — each of them nodes in the network — in order to keep track of transactions.
(I’m just discussing the economics behind cryptocurrency here, but I plan to write a post for this website in the near future discussing the basic ideas behind a decentralized blockchain, which can be used to securely log transactions, and how one can be implemented in Go code.)
The use of decentralized technology is different to the more traditional online services provided by companies like PayPal, where accounts and records of transactions are stored on their servers.
We have to trust the company when we hand our money over to them, whereas with cryptocurrencies we only have to trust the underlying technology, which is designed to protect against bad actors.
At least, that’s the theory anyway. In practice, there’s a large amount of centralization in the crypto world: many people buy digital currencies on exchanges, trusting the corporations that run them, rather than setting up wallets on their own secure computers.
Indeed, Paypal itself allows users to buy cryptocoins and hold them on its servers. It has offered this service since 2020, when it saw that cryptocurrencies were gaining wider mainstream adoption and entering into direct competition with its own business model. As the old saying goes, if you can’t beat them, you’d better find a way to join them!
What Is the Crypto Crash?
The crypto crash is a recent event that saw huge falls in the price of major cryptocurrencies, such as Bitcoin and Ethereum, as well as many smaller cryptocurrencies, which may not have the heft to recover.
There were noticeable declines in the values of digital assets beginning in November 2021, but by January 2022 the losses had become huge, and the situation could only be described as a crash.
What Caused the Collapse in Cryptocurrency Prices?
As bad economic news started to emerge, investors lost confidence that cryptocurrencies would hold their value. There was panic in the markets and values fell precipitously.
This is an example of a self-fulfilling prophecy, because the lack of belief that crypto would be able to hold its value actually caused a loss in value.
Inflation in the United States and Britain has reached highs not seen for decades. This means that goods and services cost much more than they did even a few months ago.
There are many potential causes of this inflation: the major shock to the global economy that occurred in the wake of the coronavirus pandemic, and the lockdowns that were put in place to tackle it, is certainly one factor. Major factories in China and elsewhere closed entirely, causing supply-chain issues that have made certain goods harder to source.
Many employees have also left jobs after taking time to reflect on their lives, in what has been grandly titled the Great Resignation. Those workers who were able to spend more time at home during the pandemic are now seeking to retain the work-life balance that they achieved.
Since fewer people have been travelling across borders and moving from one country to another, the supply of labour from overseas has also reduced, potentially meaning that domestic workers have greater power to bargain for higher wages and conditions.
Moreover, the Russian invasion of Ukraine has pushed up the price of oil, wheat and other commodities, since it’s harder to source and transport goods from the warzone, while Western countries have placed sanctions on major Russian companies, making it illegal to do business with them.
It’s possible to debate and disagree about which of these factors are more important in causing higher inflation levels, but what can’t be denied is that prices are rising.
This is a problem for everyone who has to buy basic goods such as food and fuel. However, the current situation also makes it harder for investors to turn a profit, because they need to set aside more of their returns just to keep pace with inflation.
Isn’t Bitcoin a Hedge Against Inflation?
We were told by advocates of crypto that the major digital currencies, such as Bitcoin, would hold their value even in times of crisis. In this sense, it was thought to be like gold, which has long been a stable investment when commodity prices rise.
This is what it means to say that Bitcoin is a hedge against inflation: it would allow you to keep the intrinsic value of your wealth, when dollar bills are losing value.
However, this hasn’t happened. It would be much closer to the truth to say that the exact opposite is the case.
The value of gold has increased, as wealthy investors rush to buy into the precious metal. Bitcoin’s price, on the other hand, has dipped below $30,000 for the first time in over a year. (Just a few months ago it was worth more than double that.)
So Bitcoin has much higher levels of volatility — a measure of the frequency of big highs and big lows — than traditional currencies. It is also more volatile than commodities, like gold, and global stock markets.
The MSCI World Index, which can be used as a single measure of stock prices around the world, has fallen over the last year, but only by around 10%, which is much less catastrophic than what investors into cryptocurrencies have seen.
What Happened to Luna?
A relatively small cryptocoin called Luna has dropped by more than 99% in value. Earlier in the year, a single coin was worth over $100, but now it’s worth much less than a single cent.
Luna is an algorithmic stablecoin, which means that its value was intended to be tied to that of another asset through the use of complicated algorithms. In the case of Luna, it was intended to follow rises and falls in the value of the US dollar (with the help of its sister coin TerraUSD, which has now collapsed).
It was pegged to a traditional currency, which is why it was seen as relatively safe and stable, but the algorithms failed and it wasn’t able to hold its value.
The algorithms were intended to incentivize certain behaviour among the people buying and selling cryptocoins, as well as manipulating the circulating supply of total coins, in order to keep the price at a certain level. It was a very clever idea in theory, less so in practice.
The founder of Binance — one of the biggest cryptocurrency exchanges — backed Luna in a big way. The company bought coins that, at their height, became worth $1.6 billion. After the crypto crash, Binance’s Luna coins are now worth only a few thousand dollars. They are now practically worthless.
The company behind Luna is — perhaps ironically — named Terra (Luna is the Latin word for “moon”, while Terra means “earth”, where valuations have fallen back down to). It has just launched a new version of the Luna cryptocurrency, called Terra 2.0. It remains to be seen whether the new coin will hold its value.
Are Algorithmic Stablecoins Inherently Prone to Greater Instability Than Collateralized Stablecoins?
The other major type of stablecoin is a collateralized stablecoin. The value of these digital coins is backed by physical assets held in a reserve.
The assets are used as collateral in the same way that a house can be used as collateral against a mortgage. In other words, just as if a borrower stops making the necessary repayments on their mortgage, the bank can take control of the house, a similar dynamic is at play with collateralized stablecoins: if buyers lose faith in the digital currency, they can always redeem their coins for US dollars or other assets that can more easily be used in real-world transactions.
Tether is one of the more popular collateralized stablecoins. Its value is intended to stay as close to one American dollar as possible (as I write now, the price of one Tether coin is currently $0.9991 USD).
Around three quarters of Tether’s value is backed by cash and similar holdings such as promissory notes and government bonds. However, even this may not be enough to support Tether’s value in a crisis when investors feel an acute lack of confidence (especially since only around three percent of Tether’s value is actually backed by hard cash).
However, Tether has retained its value in the current crypto crash while many algorithmic stablecoins have not. Some analysts are now questioning whether it’s even possible to create a reliable digital asset backed only by algorithms that can be relied upon to align its value with more traditional assets like US dollars.
This is a warning against hubris that we programmers should take on board. It doesn’t matter how clever and complicated your code is: if it can’t perform the job that it’s designed to do, then simpler technologies will outcompete it.
There are two ways of constructing a software design. One way is to make it so simple that there are obviously no deficiencies. And the other way is to make it so complicated that there are no obvious deficiencies.
While they may work reasonably well in normal times, it is clear that algorithmic stablecoins are much less able to maintain their peg to other assets like the US dollar when market conditions become unpredictable. And the one thing that we can reliably predict is that markets will become unpredictable.
What Determines the Value of Cryptocurrencies?
Investing in cryptocurrency is inherently speculative: there’s no way to predict how prices will rise or fall in the future.
At least if you’re buying stocks, you can look at the accounts and financial reports published by the companies you’re investing in, and you can make a reasonable estimate of future values based on past performance.
You can be fairly confident that if a company grows its market share and increases its earnings, then the stock price will eventually rise or the dividends paid out will increase.
On the other hand, the value of cryptocurrencies is dependent entirely on market sentiment. In other words, how people feel about digital assets will determine their prices.
And there isn’t the same kind of historical record for cryptocurrency prices as there is for other assets. If you want to see how property prices have responded to various economic events, for example, you can look at data that stretches back hundreds of years.
Bitcoin is only thirteen years old, so it’s clear that the crypto market is still very much in its infancy.
Will Cryptocurrencies Recover Their Value?
It’s worth noting that this isn’t the only crash we’ve seen in cryptocurrency prices. In May of last year, for example, Bitcoin lost just over half its value. Yet it bounced back, before it fell again.
So these are extremely volatile markets. Digital currencies shouldn’t be considered as safe investments, but rather as gambles on future trends. Only if they’re adopted more widely will current holders of crypto win big.
It seems that, at least, the major cryptocurrencies will eventually recover their values — while many of the smaller coins will collapse, as the weakest are allowed to fail and the strongest are supported by the remaining investors. However, this is certainly not guaranteed, and even the biggest coins could see further fails in their market value.
If I had investments in crypto — which, as I said earlier, I don’t — then I’d probably be tempted to hold onto them in hope that there’s an eventual recovery. Selling during a downturn would feel like a bad move. But I wouldn’t feel confident that my money was going to be safe, and I’d be acutely aware that I could lose everything.
This is why it’s important to diversify your investments. Don’t put everything into a single cryptocoin, but, equally, don’t put a large proportion of your wealth into digital assets at all.
If you’re fortunate enough to have a significant amount of money to spare and want to see it grow, then buy a wide range of traditional investments — such as equities, bonds, commodities, ETFs and mutual funds — so that you will reduce your risk of being wiped out completely.
If you’re unsure, talk to a financial advisor. But I’m not here to offer any advice for others, because everyone’s circumstances are different, and you must make your own mind up about whether you think cryptocurrencies will continue to provide the great returns that they have in the past — or whether they’ll crash and burn.