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 didn’t become uncorrelated assets independent of 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’s even clearer when we look at the impact of rate hikes and central bank balance sheet increases or contractions.
Cryptocurrencies should have benefitted from the rise in inflation and the destruction of the purchasing power of currencies. However, their market value ended up 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 U.S. 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 U.S. dollars or euros, world reserve currencies. If you live in Argentina, Turkey, Venezuela, and many other countries where the 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) a reserve of value, (b) a generalized means of payment, and (c) units of measure. Clearly, the vast majority of cryptocurrencies don’t 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 doesn’t make it money, stable, or valuable. In fact, if we look at many state-issued currencies in the world, they aren’t even accepted by their own citizens as a reserve of value and means of payment.
Cryptocurrencies have fallen 70 to 80 percent this year. However, sovereign bonds, the allegedly lowest risk and safest assets, have fallen 15 to 20 percent. 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 a limited supply doesn’t make it increase in value forever relative to the U.S. 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, 50 gallons of water cost less than 0.1 percent of the average earnings of the households with the lowest incomes, according to the Food and Agriculture Organization and We Are Water. Furthermore, a capped supply doesn’t 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 a limited supply, but if there are thousands of them, the fact that each has a limited supply tells us nothing about their valuation when we know even less about the likely use of that asset for transactions. That’s when limited supply doesn’t equal exponential value, but a nonexistent one.
Investing in start-ups is risky. Seventy-five percent fail. Investing in start-up currencies is even riskier. The value of a currency isn’t 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’s why currency is the most democratic item in the world. Even the most authoritarian government can’t 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’s no such thing as constantly rising prices due to limited supply. Liquidity matters, and crypto assets relied on the U.S. 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’s 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 the blockchain and the amazing disintermediation effect it creates should tell us that the road to success will be paved by market collapses. You can’t create a technology that destroys intermediation and 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 doesn’t 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 an 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 isn’t 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 U.S. dollar using the Fed’s liquidity. The only thing the Fed had to do was pull the plug and the music stopped.
