Don’t Buy Into Fear — Crypto’s Decline Is Transient
Despite the decline in price among cryptocurrencies, the fundamentals are still sound and improving.
Crypto’s Recent Slip
The world has turned their eyes to the recent decline in the price of many cryptocurrencies. The two largest — Bitcoin and Ethereum — have declined by nearly 50% between October 2021 and January 2022.
Critics have been quick to point out its “flaws” and predict its demise.
But, that’s very premature.
Every asset is priced according to its current cashflows and expectations about its future performance. While current cashflows and value are often easy to quantify, expectations about the future can be heterogeneous.
That’s especially true in the cryptocurrency space where we’re still learning about how they work, new coins and dApps are coming to the market, and more people are entering the investing and trading space every day.
It’s also important to still remember that we’re in the early days of crypto. Just look at the volatility that the U.S. dollar had around it’s founding!
For many assets, it’s hard for people to converge on the future value. It’s not just cryptocurrencies that experiences bubbles — plenty of other asset markets do too. Don’t forget the severity of the 2007–08 financial crisis.
Back in 2007, many developed countries entered into a deep recession driven by a deterioration in the balance sheets of banks, largely a function of the residential market. House prices were expected to continue rising, but eventually the optimism about future growth wasn’t matching reality: too many people were living beyond their means in homes they could not afford.
We can argue about the origins of the financial crisis — and many have and continue to do so. How much of the rise in housing prices was driven by investor speculation versus federal incentives that led to an expansion of housing portfolios and securitization, or the process of lumping different assets of varying quality together into new packages, is still hotly debated.
That said, we can all agree that expectations about housing prices over certain asset classes were too optimistic and that drove up the price beyond their true value… and that was unsustainable, so eventually that got reconciled.
Does the presence of a bubble in the housing market mean that we shouldn’t buy or rent homes again? Obviously not!
Understanding the Recent Decline
Despite the big decline in the price, the fundamentals of crypto have not changed. It’s useful to take inventory of several of the highlights.
- Security — a properly designed crypto, especially in the decentralized finance (DeFi) space, is designed with security in mind because of the way that consensus is formed on the blockchain. That doesn’t mean there are no risks — that’s inevitable, but they’re less likely.
- Speed — bank transfers can take time, but crypto transactions, especially in DeFi, can take just a matter of seconds in most cases.
- Decentralization — one of the biggest concerns about the current financial system is that centralized entities, like central banks, can exert so much control over the money supply and flow of funds. Institutional investors and hedgefunds can literally shape the market — for better or worse.
There are also a handful of other optimistic indicators. Would venture capital increase its funding for crypto startups by 445% between 2020 and 2021? Would there be a growing number of Layer-2 protocols? (Click here for a refresher on Layer-1 and Layer-2 protocols.) Would there be a rising market share of decentralized apps (dApps)? These are just a few.
With these fundamentals in mind, what can help us understand the recent shift in the crypto market… and what’s going to happen next?
Here are some factors explaining the recent volatility and decline.
- Federal Reserve and regulatory policy — the recent announcements from central banks to raise interest rates is a step forward in dealing with inflation, which reduces the relative value of cryptocurrencies as a hedge. That, however, likely pales in comparison with the specter of regulation from the SEC (and, to some extent, FinCEN) that has generally signaled a combative attitude towards crypto and heightened uncertainty.
- New entrants — the surge in the number of investors and traders into the market has shifted the supply curve, which drives down the price. Further, the influx of new people has made the space more heterogeneous, which introduces some uncertainty as the “market” learns their preferences.
- Geopolitics — the world is still in a pretty fragile and rough state with many countries reeling from the adverse effects of the virus and corresponding policies that were undertaken. Although crypto stands to benefit from some of the uncertainty — since geopolitical actions generally breeds distrust in centralized institutions — ultimately people are affected and it influences daily behavior and optimism about the future.
- Speculation — because NFTs, metaverse (and #meta), and other forms of distributed ledger technologies (DLT) are so trendy right now, there’s a lot of velocity in the market, meaning that these DLT services are trading quickly and not always with a lot of attention paid to fundamentals.
No one can forecast the future and each person needs to make their own investment decisions, but the reality is that crypto is still alive and well with a comeback that will probably shock many of its critics.
This article was written by Christos A. Makridis, the Chief Technology Officer and Head of Research at Living Opera. He is also a research affiliate at Stanford University’s Digital Economy Lab and Columbia Business School’s Chazen Institute, and holds dual doctorates in economics and management science & engineering from Stanford University. Follow us at @living_opera!
Don’t Buy Into Fear — Crypto’s Decline Is Transient was originally published in DataDrivenInvestor on Medium, where people are continuing the conversation by highlighting and responding to this story.