What skeptics are wrong about Crypto’s volatility
The last few months have been dark times for the crypto industry. Between April and June, Bitcoin’s value more than halved, from just over $ 45,000 to around $ 20,000; other coins have fallen even more. The Terra-UST ecosystem, which paired a cryptocurrency with one designed to be linked to the dollar, collapsed in May, wiping out $ 60 billion in valuables, leading to overlapping errors among lenders. Established companies such as Coinbase, a popular cryptocurrency exchange, have announced layoffs.
In the midst of the unrest, crypto-skeptics have doubled the criticism, often focusing on the speculative surplus, claiming that the crash has revealed crypto as a Ponzi scheme. As evidence, some mention the extreme volatility. How can crypto live up to the hype if participation feels like a roller coaster – one whose operator is opposed to security inspections? Although some of the criticism is well deserved, the focus on price volatility is not as strong an argument as critics may think. Rather, it reveals a misunderstanding of what different cryptocurrencies represent.
Crypto is a young industry. Most projects are barely five years old. Gradually, different coins are meant to serve different functions, but today they all function more or less as start-up stocks with the distinctive features of having liquidity and price discovery from the start. This unique feature – activated by the novelty of the underlying infrastructure – leads to a more benign explanation for volatility.
Equity, liquidity and volatility
Startup equity is a core concept in the business. Everything from a venture capital investment in a software company to an ownership stake in your cousin’s new restaurant falls into that category. But traditional start-up stocks have no liquidity – you do not invest in a restaurant hoping to turn your stocks around a month later. No liquidity also means no price finds. Your investment is difficult to value.
Crypto is different because a token can start trading right away – sometimes even before the function the token is meant to be used for is live. This feature is enabled by crypto’s underlying infrastructure, designed for a post-digital world where data roams freely and important tasks are performed by code, not functionaries. This does not mean that every project has to issue a token right away, but many do.
Early liquidity has advantages and disadvantages. Before analyzing them, it may help to understand why the older financial system does not offer this option, even to those who may prefer it.
Despite becoming more digital, the architecture of the Wall Street-powered system is the same as it was decades ago. It relies on opaque systems that do not talk to each other and still require a good deal of manual processing. Trading may look hyperactive, but back office settlement is a bottleneck that leads to access being restricted to the shares of the largest companies. Regulations also play a role in this gatekeeper, but infrastructure is the primary bottleneck. The start-up boom of the last decade has led to the creation of tailor-made markets for smaller companies, but they are also limited in scope. Most companies cannot issue liquid shares, even if they so wish.
The original digital design of a blockchain platform such as Ethereum allows it to handle multiple assets in orders of magnitude – hundreds of thousands (and soon millions) of tokens that can be traded around the clock. Code automates how tokens are issued, traded and transferred from one owner to the next. All assets are programmable, which improves how different assets (such as a cryptocurrency and a fiat currency, which are linked to traditional currency) interact, and reduces errors. Shared ownership is easy to accommodate, and universal access to the infrastructure is provided to both entrepreneurs and investors. If this was the media industry, Ethereum would be for Wall Street what YouTube was for cable TV, for better or worse. Better infrastructure and a lack of gatekeepers result in greater participation and innovation, but the lack of curation also means more rubbish.
These features enable cheaper to operate and more dynamic markets, and in some cases financial models that otherwise would not exist, and therefore everyone explores from central banks to Wall Street blockchain technology. However, the extra efficiency comes with trade-offs. On the one hand, capital formation is improved, and entrepreneurs can take advantage of a larger pool of potential investors. But an inevitable consequence of bringing such increased efficiency to the shares of any young project is extreme volatility.
Most startups fail, and to invest in one is to bet in a race against oblivion. From the entrepreneur’s point of view, every decision – what kind of food a new restaurant should serve – has an enhanced impact. The same applies to developments outside, such as obtaining a license to serve alcohol. From the investor’s point of view, it is just as frightening to try to discount the consequences of these decisions. The distribution of any outcomes for any business is greatest at birth, so rational investors have no choice but to overreact all the time.
If your cousin’s new restaurant had tradable shares, they would probably be as volatile as crypto. Landing a liquor license can make them quadruple, while a bad review can make them think. Given the uncertainty, external development will also have a stronger effect. A new restaurant is more vulnerable to things like fashions or bad weather than an established restaurant.
Everything is bigger on Blockchain
Crypto-investors are struggling with a stronger version of this phenomenon because everything is limitless and the total addressable market is huge. Unlike a new social bank, a blockchain-based lending protocol can theoretically serve hundreds of millions of people worldwide. Success can significantly increase the value of the symbol, but the project can also fail. Early investors have no choice but to flip back and forth between hope and despair.
Their dilemma is exacerbated by the fact that most digital assets cannot be divided into traditional categories, making valuation so much more difficult. Traditional investors can always rely on established calculations such as a share price / earnings ratio (PE) ratio for a common sense check. Crypto investors have no such opportunity. Most digital assets are a hybrid and go from one category to another throughout the life cycle.
Ether, for example, started as a security, when the coins were sold in advance to finance development. But when the blockchain was launched, it became a cross between a currency and a commodity. Some used it as a store of value or barter, while others used it to pay for transaction validation and code execution. These features set it apart from traditional stocks and commodities – you can not pay for a cab ride with Uber stocks, and you do not save on oil. Today, it has further developed into a return-bearing instrument, a collateral for loans, a reference currency for NFTs, and the way validators participate in consensus.
All these features make it difficult to assess the value of even the most mature crypto project, do not worry about the thousands that have launched recently. A skeptic may argue that these challenges are the very reason why budding projects should not have negotiable equity. In fact, access to start-up investments in traditional finance is often limited to institutional and “sophisticated” investors. But such restrictions have their own disadvantages.
Lack of access to start-up investments has contributed to the growing wealth gap. Successful companies like Meta (Facebook) remained private for as long as possible, and VC funds could not – and still can not – take retail money. Other investments such as real estate or collective art had too high an entry price for most people. Bitcoin was the only exception, the only high-performance asset that was universally available and partially owned from day one.
Bitcoin was still volatile during that period, but volatility is not always bad. Price fluctuations communicate important information to founders and investors, especially in the crucial youth phase of any startup. And limiting price discovery to periodic rounds of financing negotiated with a handful of investors can be dangerous. WeWork raised $ 47 billion less than a year before it ended up flirting with bankruptcy; Theranos was valued at $ 9 billion before going bankrupt. Despite several red flags for both companies, there was little price information until the bitter end. Both investments turned out to be as volatile as crypto, we just could not see the volatility – and worried investors could not get out.
The good news about bad news
Universal access, immediate price discovery and greater transparency also contribute to both the reality and the perception of fraud and shady behavior in crypto. Like all friction-removing technology, the ease with which new projects can be launched has been a boon for scammers and fly-by-night operators, just as the availability and efficiency of email has led to an increase in suspected Nigerian princes looking for a place to park their money.
This is not to say that the error rate for crypto projects is not higher than new restaurants – new industries naturally have a lower success rate than established ones. But it is safe to assume that the rate in crypto is not as high as it seems. But total transparency makes crypto see worse than it is. Sincere entrepreneurs who collect money from unsuspecting brands are an ancient practice in all industries. Thousands of new restaurants fail every year, and some of these mistakes inevitably prove to be scams. However, these investments are not discussed on Twitter, and we can not see their shares collapse on a public website like FoodMarketCap.com. Crypto is unique in that even fraud is transparent, and in the long run, transparency is a powerful tool for counteracting shady behavior, in any industry.
The crypto industry has a lot to grow up to, and the current downturn certainly offers some hard lessons. Understanding what volatility means in crypto markets – what signals it sends and responds to – is an integral step in this process. Investors and entrepreneurs are learning not only what is possible in this new ecosystem, but also what is not, and why some of the lessons have been learned from the sectors that crypto hopes to disrupt transcending technology. Money and hubris give a bad mix, and nothing enhances the importance of humility better than a crash. But skeptics who are constantly harping on volatility would be wise not to fall into a similar trap, confusing necessary growing pains with a deadly condition.
