In the last two months of 2022, the value of the global cryptocurrency market decreased 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 risen. in value at about $1.1 trillion; and this raises the question of whether the global cryptocurrency sector is now less fragile.
PARIS, FRANCE - FEBRUARY 26: In this photo illustration the Coinbase cryptocurrency exchange logo ... [+]
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Without a doubt, the sector has been extremely fragile. Think about the list of companies experiencing financial difficulties and bankruptcies: FTX, Genesis, Core Scientific, BlockFi, Voyager Capital and Three Arrows Capital. In 2022, crypto investors experienced the collapse of the TerraUSD stablecoin and its sister token Luna. Investors, not to mention regulators, have raised many questions about the financial strength of the stablecoin Tether
USDT
Crypto investors may feel that the crypto market is less fragile today than it was at the end of the year. Since the beginning of the year, the price of Bitcoin has risen by around 50%; and Bitcoin's share of the global cryptocurrency market capitalization is about 40%.
It can plausibly be argued that the market is less fragile in the short term than it was at the end of the year. However, in the long term, the crypto market remains extremely fragile. In fact, I suggest that the recent price increases have made the crypto market more fragile, not less fragile.
The Nobel Prize in Economics George Akerlof developed a theory which explains why, in a rational world, markets for objects like cryptocurrencies are unsustainable and collapse.
To understand why, consider buying an item whose intrinsic value is known for certain by the seller, but unknown to you. All you know is that the intrinsic value of the item is between $0 (no value) and $100, and any value in this range is as likely as any other.
On average, how much is this item worth? If you answered $50, you would be correct.
Suppose you have the opportunity to make an offer for the item to the seller on a take-it-or-leave-it basis. Suppose further that you were to put down a deposit, that is, the amount of your offer, on the condition that if the seller rejects your offer, you will receive your deposit.
How much would you bid for the item?
- More than $50?
- $50?
- $40?
- $25?
- Less than $25?
If you are a rational bidder, then you would bid $0 and not a penny more. This is the message of 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 offer $50 and the seller agrees to sell you the item, you will experience buyer's remorse. Because? Because the item will be worth at most $50, in which case its expected value, depending on the transaction that takes placenow it costs only $25. It would not be rational to pay $50 for an item that you estimate is worth $25.
The same logic applies to a $40 offer as it does to a $50 offer; and applies to any offer you may 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 cryptocurrency buyers would not trust potential sellers. Given the absence of a robust regulatory environment, as is the case today, rational crypto investors would not trust brokers either, unless investors are fully informed. Think about what happened at FTX, which financed operations with its clients' funds.
That the FTX saga actually happened makes it clear that the world is not populated only by rational investors.
Consider Binance, FTX's main competitor and dominant player. Does Binance have the reserves to protect its client accounts? In the wake of the FTX crash, cryptocurrency investors have been asking this question. Binance has attempted to reassure its clients that it has adequate reserves by providing so-called audited statements regarding its reserves. The problem is that such statements are ad hoc, vague, and not part of a complete set of audited financial statements. Even the accounting firm that performed the audit has suspended its work of producing "proof of reserves" disclosure reports.
Is there a strong information asymmetry between Binance and its clients? Note that information asymmetry is at the heart of Akerlof's theory.
Regarding cryptocurrencies, I would add that there are serious doubts about the intrinsic value. You can think of intrinsic crypto value as what cryptocurrencies would be worth in a rational world. However, there are good reasons to argue that most of the value of cryptocurrencies, at least in today's market, reflects much more sentiment than fundamentals.
The point is that high market capitalization and sentiment ratios are major contributors to financial fragility. Minsky made it very clearand this is why I argue that the recent rise in the value of global cryptocurrencies has made the crypto sector more fragile in the long run.
