Surge In Cryptocurrency Prices Renders Crypto Market More Fragile, Not Less Fragile
In the last two months of 2022, the global cryptocurrency market declined in value by about a third, from just under $3 Trillion on November 10 to about $0.83 Trillion on December 31. However, during the first two months of 2023, global cryptocurrencies have increased in value to about $1.1 Trillion; and this raises the question of whether the global cryptocurrency sector is now less fragile?
To be sure, the sector has been extremely fragile. Think about the list of firms experiencing financial distress and bankruptcy: FTX, Genesis, Core Scientific, BlockFi, Voyager Capital, and Three Arrows Capital. In 2022, crypto investors experienced the collapse of the stablecoin TerraUSD and its sister token Luna. Investors, not to mention regulators, have raised many questions about the financial soundness of stablecoin Tether
Crypto investors might be feeling that the crypto-market is less fragile today than it was at year-end. Since the beginning of the year, Bitcoin’s price has increased by about 50%; and Bitcoin’s share of the global cryptocurrency market cap is about 40%.
A plausible argument can be made that the market is less fragile in the short-term than it was at year-end. However, in the long-term, the crypto market remains extremely fragile. Indeed, I suggest that the recent price increases has made the crypto-market more fragile, not less fragile.
Economics Nobel laureate George Akerlof developed a theory which explains why, in a rational world, markets for objects like cryptocurrencies are unsustainable and collapse.
To understand the reason, consider purchasing an item whose intrinsic value is known with certainty by the seller, but unknown to you. All that you know is that the intrinsic value of the item lies somewhere between $0 (worthless) and $100, with any value in this range being as likely as any other.
On average, how much is this item worth? If you answered $50, you would be correct.
Suppose you had an opportunity to enter a bid for the item, to the seller, on a take it or leave it basis. Suppose further that you had to put down a deposit, namely the amount of your bid, with the proviso that if the seller rejects your offer, you receive back your deposit.
How much would you bid for the item?
- More than $50?
- Less than $25?
If you are a rational bidder, then you would bid $0 and not a penny more. This is the message from Akerlof’s theory. In other words, there is no viable market for the item. The reason is that the seller will not accept less for the item than its intrinsic value. If you bid $50 and the seller agreed to sell the item to you, then you would experience buyer’s remorse. Why? Because the item will be worth at most $50, in which case its expected value, based on the transaction taking place, is now only $25. You would not be rational to pay $50 for an item which you estimate to be worth $25.
The same logic applies to a bid of $40 as to a bid of $50; and it applies to any bid you might enter, except $0.
The bottom line here is that you would refuse to participate in this market.
In a world populated only by rational crypto investors, and the kind of asymmetric information just described, the crypto market would collapse. Potential purchasers of cryptocurrency would not trust potential sellers, or even brokerage firms. Think about what happened at FTX, which funded trades using its customers’ funds.
That the FTX saga actually occurred makes clear that the world is not populated only by rational investors.
FTX experienced a bank run, which led it to fail when it did. Bank runs are often viewed as the manifestation of irrational panics, when depositors en masse run to withdraw their funds from the bank while they still can. On the flip side, the run at FTX might have failed during a moment of rational clarity, when its customers experienced an “Akerlof moment.”
The sharp decline in global cryptocurrency values during the last two months of 2022 can be viewed as the beginning of an Akerlof moment. In the Akerlof dynamic, a collapse in trust, associated with asymmetric information, leads to a collapse in the market. Notably, this dynamic played out until year-end, when trust bottomed out but did not reach zero.
Think about Binance, FTX’s major competitor and dominant player. Does Binance have the reserves to protect their customers’ accounts? In the wake of FTX’s collapse, crypto-investors have been asking this question. Binance has attempted to reassure its customers that it does have adequate reserves, by providing so-called audited statements about its reserves. The trouble is that such statements are ad hoc, vague, and not part of a full set of audited financial statements. Even the accounting firm that conducted the audit has suspended its work producing “proof-of-reserves” disclosure reports.
Is there a strong information asymmetry between Binance and its customers? Keep in mind that information asymmetry lies at the heart of Akerlof’s theory. In a rational world, Binance’s faulty “proof-of-reserves” scheme would have underscored the information asymmetry and induced a run on its deposits. However, we do not live in a rational world, and Binance continues to function.
In respect to cryptocurrencies, I would add that there are serious questions about intrinsic value. You can think of intrinsic crypto value as what cryptocurrencies would be worth in a rational world. However, there is good reason to argue that most of the value of cryptocurrencies, at least in today’s market, reflects sentiment much more than fundamentals.
The thing is that high sentiment-to-market cap ratios are major contributors to financial fragility. Minsky made this very clear, and this is why I contend that the recent rise in the value of global cryptocurrencies has made the crypto sector more fragile in the long-term.