Colin Read • May 13, 2022

A Crypto Market Meltdown - May 15, 2022

A Crypto Market Meltdown - May 15 2022


We have all seen market meltdowns by now. The Global Financial Meltdown of 2008 is seared into our psyche, but we recall 2000, 1987, the COVID-19 recession. Some may even remember the 1979-81 Stagflation. It appears we are again in a recession, perhaps even a stagflation. So far, though, as much as markets are in bear territory, they are not melting down - except for cryptocurrencies. 


What is so different about these “securities”? Let me count the ways. 


Securities by their very name are titles to future flow of income. For bonds it is coupon payments and the repayment of their face value. For stocks it is earnings per share, either reinvested for future gain or paid out in dividends. For mortgage-backed securities, it is the mortgage payments of myriad households. For cryptocurrency, it is, hmm, nothing. 


Gambling is the same. An ante may offer the right to hit a jackpot, but there is no title to future revenue generated. Currencies don’t create revenue in themselves, even if they may be in demand because they facilitate transactions. Gambling is the same. They say “you can’t win if you don’t play.” The crypto version of this pithy slogan is “Fortune favors the Brave.”


This is not at all to say that currency speculation does not perform some function. After all, lining up sufficient currency or foreign exchange for a transaction in the future has some value, but also some alternatives. And, gambling is certainly entertaining to some (but not me!). 


But, there is a Ponzi-like aspect to these speculative vehicles. I can’t really call a gambling ante or a cryptocurrency purchase a security because there is nothing to secure their value. These “investments” only rise in value if there are more people who follow you and hold on for dear life (HODL) to keep the scheme rising in value. 


Let’s contrast Bitcoin to gold, a comparison that is often made. Heck, there was once even a Bitcoin variant called BitGold. Certainly people seize on gold in times of uncertainty as a safe harbor. They do so because we know there is a floor to gold’s value. If for some reason speculative demand collapses, gold’s underlying value is in the many products that depend on gold, especially in the semiconductor and electronics industry. There is also secondary value in jewelry and art. These uses act as a floor for how low gold could possibly go. 


There is no such floor of support for cryptocurrency. Bitcoin does not produce anything. It merely acts as a (very resource-intensive and expensive) avenue for transactions. If transaction demand declines, or if a better coin can replace it, Bitcoin’s value can go to zero. 


The decline in crypto prices, including Bitcoin, is inducing a downward spiral. So called Stablecoins kept their value pegged within a narrow band of value by holding Bitcoin as collateral in complex arrangements designed to maintain the Stablecoin’s value. That’s assuming the collateral holds its value. But, since Bitcoin is really not a security, neither are Stablecoins. 


The problem is that far too many inexperienced investors have been enticed into “investing’ in such non-securities. Crypto brokers, called exchanges, even lent buying power to such investors so they could buy more crypto than they could afford. Such margin purchases increases financial leverage but also increases risk. Then, once the crypto market plunges, these investors are underwater. They try to hold on for dear life because the mantra tells them so. 


But eventually their brokers cannot afford the risk that these loans may not be paid back, and may sell the underlying crypto out from under the underwater investors. This merely accelerates selling and worsens the situation. 


One of the largest exchanges in the world, Coinbase, recently announced that they don’t consider the balances of their account holders as custodial. In other words, the savings in crypto their customers hold with them are not liabilities to the brokers for which they are obliged to make good, but instead are regarded as equity investments in Coinbase, which then is entirely at risk if Coinbase goes bankrupt or files for reorganization. 


I can think of no analogies to these non-securities. Their price or value is completely devoid of future income generation potential that allows one to price based on net present value. Indeed, value depends only enticing more people to invest, which allows you to quickly see why the industry feels the need to advertise for more future investors at every possible turn. 


I do believe that some digital currencies have some value. The Ethereum Protocol behind the Ether coin has some utility in decentralizing some financial functions. If such digital apps under the Decentralized Finance rubric succeed spectacularly, we may be able to trim a percent or three off of costs in sophisticated economies. In less developed economies where currencies have failed, banking is underdeveloped, and capital is difficult to mobilize, digital coin applications may even stimulate these economies by five or ten percent. 


Some of these efficiencies may be monetized by corporations associated with such coins. If so, there may be some value that can support such currencies from sinking to zero value. But, these potential future flows of revenue that may occur if such value can be tapped, diverted, and capitalized, are few and far between in the crypto world. The vast majority of digital coins offer no such utility. 


Certainly the incredible level of capitalization in the crypto industry, tallied in the trillions of dollars of coin value or exchange value, are completely disassociated with a flow of real future value. When there is no visible means of support, then such markets can sink dramatically. Only the willingness of some to prop up such markets for fear that, if they don’t, the entire game is over. 


Because of these factors, there is a lot of fear and loathing among the crypto bros these days. Unfortunately, because many investors must cover their losses by selling traditional and true securities, other markets suffer as well. There is no such thing as a disconnected and isolated market anymore. 


While we forget this lesson time and time again, when greed replaces common sense in financial markets, the level of fear rises and so does volatility. These are explosive mixes that merely need a spike in inflation, a pandemic, a major armed conflict, or many other such macro events for this explosive mixture to ignite. Wait, we have all these problems impinging on markets now!


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