18 July 2022
Pasaules tirgus
Ziņas un Viedokļi
«Cryptofall!», A Review of the Latest Season of This Gripping Investment Drama

Why Did Cryptocurrencies Emerge, Why Are They So Unstable and Do They Have Any Future?

All is not quiet in the world, including in the world of cryptocurrencies and cryptoassets. The price of bitcoin has plunged by 70% since November 2021, while some cryptocurrencies have ceased to exist altogether. Crypto skeptics are gloating: “We told you so!”. Crypto enthusiasts are stoically enduring the latest painful season of this “Сryptofall!” investment drama: “We will survive!”. Impartial observers, for their part, are just trying to rationally explain why this is happening and what can be expected from the future (see Picture 1 below).

What does our “crystal ball” tell us?

1. A Loss of Confidence in Today’s Financial System. Why did cryptoassets emerge in the first place? The term “bitcoin” was first mentioned in a white or concept paper released on October 31, 2008. I can remind you that the investment bank Lehman Brothers declared its bankruptcy on September 15, 2008. This was the time when the world’s major central banks were involved in extinguishing a raging high-intensity “fire” that threatened to engulf the entire financial system. Even the world’s largest commercial banks were experiencing a loss of mutual trust and confidence, while the interbank lending market was practically frozen. That is why one of the major reasons for the emergence of a cryptoworld was the crisis of confidence in today’s financial system.

2. Fiat (“Paper”) Money Debasement. How was this “fire” that was raging during the global financial crisis extinguished? It was extinguished by providing a huge amount of liquidity over the following years to maintain the solvency of commercial banks, real estate and securities markets. As a result, too much fiat or “paper” money circulating in the financial system was chasing too few viable investment opportunities available in the economy at that time (see Picture 2 below). More broadly, a loose monetary policy has been an integral part of the global economy since the final abandonment of the gold standard in the early 1970s (see the article https://www.linkedin.com/pulse/gold-standard-golden-jubilee-role-investment-jemeljanovs-phd-cfa/), the launch of the financialization process in the 1980s (see Picture 3 and Picture 4 below) and the “inflationalization” of our economic life. In practical terms, this meant that in the period from 1971 to 2020, the US dollar lost 85% of its purchasing power (see the article https://www.linkedin.com/pulse/gold-investors-manifesto-why-just-metal-olegs-jemeljanovs-phd-cfa/).

3. In Search of “Digital” Gold. What are most cryptoassets striving to achieve? Ideally, they are striving to achieve the status that gold and, to a certain degree, silver (the “poor man’s gold”) have historically occupied by becoming new “safe haven” assets but at a more advanced level of technological development.

What are the historical characteristics of a “safe haven” asset?

• Universal Acceptability of Value. The value of a “safe haven” asset is universally accepted across all cultures and civilizations. For example, gold is recognized as a “safe haven” asset in any culture and on any continent.

• Anonymity and Perpetuity. The ownership of a “safe haven” asset is anonymous. It also has no maturity date unlike government debt securities. A “safe haven” asset can be sold without anyone knowing who its previous owner was. In turn, fiat or “paper” money is a government-issued security where the rules of circulation are determined by the government itself.

• Limited or Controlled Supply. The supply of a “safe haven” asset cannot be increased by pressing a button on the central bank’s computer keyboard. Its supply is either limited or it rises in a controlled manner without exerting a debasement or devaluation pressure on its value.

• Stability and Independence of Demand. A “safe haven” asset does not depend on the subjective will of controlling shareholders, issuers or regulators. Its use can be banned. But, most likely, this will only result in the emergence of a booming “black” market.

• Durability. A “safe haven” asset does not burn like buildings. It also does not depend on the benevolence of insurance companies and court decisions.

Cryptoassets have been trying to achieve this status at a more advanced level in terms of technology. This implies that there is no need for physical storage of “safe haven” assets, while their transfers and payments are on course to becoming almost instant and increasingly secure.

4. Speculative Frenzy. While there were the three objective factors that facilitated the emergence of cryptoassets, a subjective speculative factor undoubtedly played an important role too. “Rags-to-riches” stories continue to motivate and inspire many novice crypto investors. However, due to a large mismatch between the amount of available liquidity and viable investment opportunities you may as well find this speculative frenzy in real estate, high-tech stocks, high-yield bonds, special purpose acquisition companies (SPACs) or “peer-to-peer” lending platforms. That same logic applies to the use of the cryptoworld in illicit activities due to its anonymity as well as its potential to be infiltrated with various Ponzi schemes and other investment scams. Criminals are equally interested in many other areas and industries: from finance to construction to gambling, etc. That is why the cryptoworld is certainly not unique in this regard.

Tentatively, we can say that so far most cryptocurrencies and cryptoassets have been able to provide their investors with anonymity under conditions of limited supply at a more advanced   level of technology. However, their value is not yet universally accepted even among younger generations. There are also multiple question marks regarding their perpetuity, stability, independence of demand and durability.

As of today, the number of cryptocurrencies and cryptoassets in existence is too large to be taken seriously: 19,000 (!) according to a CNBC report. Their algorithms are also too diverse (“proof-of-work” versus “proof-of-stake”, etc.). Finally, most investors, particularly small ones, still view cryptocurrencies as speculative assets rather than “safe haven” alternatives (see Picture 5 below).

Until recently, bitcoin, the world’s largest cryptocurrency, has been a useful investment instrument in terms of its portfolio diversification potential since its price, despite being very volatile, has exhibited low correlation to the prices of most other assets (see Picture 6 below). Over the past two years, however, the price of bitcoin has continued to become increasingly tied to the US stock market and, particularly, to the stock prices of US technology companies.

Most importantly, to become a “safe haven” any asset must pass its real-life test in times of political, economic and social instability. This implies that in times of stress its price should be much more stable when compared with the prices of competing assets. Stressed market conditions associated with the Covid-19 pandemic in early 2020 as well as with the geopolitical crisis in early 2022 revealed that the prices of cryptoassets are very unstable. They are also prone to widespread panic sell-offs and, in general, are still acting more like highly speculative technology assets rather than “safe havens”.

Does it mean that crypto assets have no chance of becoming “safe haven” assets? Not necessarily. As long as there is a monetary policy framework that leads to a systemic debasement and devaluation of “paper” money, the search for new “safe haven” assets will continue. The introduction of digital “paper” money will not be able to prevent this search from happening in any way. This is because a fast and reliable transfer of constantly depreciating electronic money will not make them a “safe haven” asset.

In theory, the fiat or “paper” money system might be seen as a workable solution if there is a proper framework in place to exert a real, effective and independent control over the supply of money. In fact, over the last 50 years fiat money has been used to prop up every economic downturn. The result is that ordinary people, businesses and governments alike behave like preschoolers who expect their “parents” – central banks – to help them in all situations.

So, what do we have in the end? We have a declining pace of technological progress in the developed economies since the 1970s. We have wealth and income disparity last seen during the roaring 1920s. It is true that there have been smoother economic downturns at the expense of rising debt and almost no consumer inflation over the last 30 years thanks to incorporating China into global supply chains. Now, however, when a partial decoupling from China is already underway, all the previously hidden problems – vulnerable supply chains, resource scarcity, no meaningful technological progress, high inflation, income disparity, rapidly depreciating fiat money, gigantic debts, exuberance in financial markets, crypto and fintech, political instability, etc. – have re-appeared as expected.

The gold standard had its own obvious problems due to its extreme inflexibility. The fiat money system has its own obvious problems too due to its extreme flexibility. It is time for something new.

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Autors: Oļegs Jemeļjanovs, LinkedIn profile

SWEDBANK FINANŠU TIRGUS DAĻAS INVESTĪCIJU JOMAS VADĪTĀJS Oļegs Jemeļjanovs Latvijas Universitātē ir ieguvis maģistra grādu uzņēmējdarbības vadībā, kā arī doktora grādu ekonomikā Roterdamas Erasma Universitātē Nīderlandē. Arī ir ieguvis sertificētā finanšu analītiķa (CFA) kvalifikāciju. Ir strādājis finanšu jomā gan privātajā, gan valsts sektorā (Latvijas Banka, FKTK, Finanšu ministrija). Finanšu tirgus jomā ir strādājis kopš 1999. gadā, tirgus risku vadības, finanšu aktīvu pārvaldīšanas un pārdošanas sfērā. 2019. gadā kļuvis par Swedbank Finanšu tirgus daļas investīciju jomas vadītāju.