If we look at the staggering decline of the cryptocurrency index in 2022, we may understand an uncomfortable truth. Cryptocurrencies were created as an alternative to the monetary insanity in the fiat currency world yet became a massive bet on the money expansion they were supposed to combat. Cryptocurrencies did not become uncorrelated assets, independent to the monetary policy cycle. Their market value was entirely dependent on monetary expansion.
The correlation between cryptocurrencies and non-profit tech stocks is enormous, but it is even clearer when we look at the impact of rate hikes and central bank balance sheet increase or contraction.
Cryptocurrencies should have benefitted from the rise in inflation and the destruction of purchasing power of currencies. However, their market value ended being a monster trade on central bank balance sheets rising.
The Achilles’ heel of cryptocurrencies was liquidity, and the crypto exchanges and assets liquidity was provided by the US dollar. It only took a few rate hikes and a modest decrease in the Fed’s balance sheet to make the seemingly ever-rising valuations roundtrip.
This is true if you invested in cryptocurrencies to realize gains in US dollars or euros, world reserve currencies. If you live in Argentina, Turkey, Venezuela, and many other countries where their currencies have collapsed every year, having Bitcoin has clearly been a blessing compared to the destruction of the purchasing power of the local money.
What does this all tell us?
Cryptocurrencies, even Bitcoin or Ethereum, are start-up currencies. To be “money” they must be a) reserve of value b) generalized means of payment and c) units of measure. Clearly, the vast majority of cryptocurrencies do not comply with these three requirements. However, neither do many of the domestic currencies of numerous countries in the world. The fact that a currency is issued by a state does not make it money, stable or valuable. In fact, if we look at many state-issued currencies in the world, they are not even accepted by their own citizens as reserve of value and means of payment.
Cryptocurrencies have fallen 70-80% this year. However, sovereign bonds, the allegedly lowest risk, and safest assets, have fallen 15-20%. If we adjust for risk and volatility, the slump in bonds to me is significantly worse and more damaging for more citizens globally -pension funds, etc- than the collapse in valuation of some assets that are owned by a few high-risk prone investors.
The problem is that many retail investors were led to believe that a high-risk asset had exceptionally low risk because of an alleged limited supply.
The fact that a cryptocurrency has limited supply does not make it increase in value forever relative to the US dollar. There are thousands of goods and services with limited supply that see their price in dollars fall. Water, for example, is cheaper than ever in real terms yet limited in availability and essential. In the UK, fifty gallons of water cost less than 0.1% of the average earnings of the households with the lowest incomes, according to the FAO and We Are Water. Furthermore, a capped supply does not make a currency equal to gold when its history as a reserve of value and use as money is so limited and volatile.
One cryptocurrency may have limited supply, but if there are thousands of them, the fact that each has limited supply tells us nothing about their valuation when we know even less about the likely use of that asset for transactions. That is when limited supply does not equal exponential value, but inexistent one.
Investing in start-ups is risky. Seventy-five percent fail. Investing in start-up currencies is even riskier. The value of a currency is not dictated by investors, banks, a government, or an army, but by the next person willing to use it for a commercial or financial transaction. That is why currency is the most democratic item in the world. Even the most authoritarian government cannot impose its purchasing power.
Investors in cryptocurrencies tend to assume that limited supply is a strength, yet when the Fed drained liquidity in the world reserve currency the collapse of valuations showed that there is no such thing as constantly rising prices due to limited supply. Liquidity matters, and crypto assets relied on the US dollar for it. The minute that crypto assets became a minor threat to the king dollar all the Fed had to do was hike rates and the entire house of cards collapsed.
If we look at technology development, history shows that we need to separate market valuation from technology implementation. There is no doubt that we will continue to see new milestones achieved in the blockchain world, tokens, and cryptocurrencies. Just like we have seen in solar technology or on the internet. But in the process of making a breakthrough technology a reality, there are always a lot of zero valuations and bankruptcies.
The very existence of blockchain and the amazing disintermediation effect it creates should tell us that the road to success will be paved by market collapses. You cannot create a technology that destroys intermediation, pricing inefficiencies and accelerates disinflation and at the same time bet that its valuations will soar alongside fiat currency inflation. It makes no sense.
The beauty of technology is creative destruction. The result is always a massive improvement for citizens and prosperity. However, the widespread implementation of a technology does not make the valuation of its providers rise. What Enron did is today common and widespread. What the thousands of solar companies that went bankrupt produced is now industrial and viable.
The road to monetary freedom and alternative to the fiat currency world can only come from an unprecedented wave of bankruptcies and demises of most of the crypto assets that have been issued. An investor should know that few will live, and most will vanish. Investors should know that we must separate the implementation of the technology from expectations of market valuations.
Allow me to make an observation: A cryptocurrency will never be an alternative to a global fiat currency if its supply makes it impossible to strengthen the credit creation mechanism which, in itself, is always money creation. A real alternative must create its own liquidity and facilitate the credit mechanism. Cryptocurrencies were created to avoid central banks because their independence was rightly questioned but have probably found that they will need some form of central liquidity system that is not biased or influenced by government nor controlled by crooks. Not easy.
Cryptocurrencies fell into the same trap as almost all asset classes. They were massive bets against the US dollar using the Fed’s liquidity. The only thing the Fed had to do was pull the plug and the music stopped.