End Of Crypto

Crypto is in big trouble. One of Crypto’s biggest exchanges FTX just filed for bankruptcy and therefore many are now making the comparison to the infamous collapse of the U.S. bank Lehman Brothers.

This bank nearly ended the global financial system. Major financial institutions have teetered on the edge of collapse. The only reason that it didn’t was that central banks stepped in to save the system. But since crypto has no central bank, many are now asking the question, Is this the end of crypto?

Is This The End Of Crypto?

Well, based on what economists have learned from the previous financial crisis, yes, it could very well be. I think that crypto is likely heading to a bottom that is so low that many would basically consider it the end of crypto. But why now? I mean, many economists already argued in 2017 that crypto was the speculative bubble of a lifetime that would collapse in the long run, and they were always wrong. Well, the difference now is that the crypto industry has committed to the same sin as the banks did in 2008. They are up to their necks in debt. That that was based on one assumption. Crypto prices will keep going up and now that they’ve been falling for a year. Crypto institutions are collapsing left and right. Just like the banks did in 2008.

Lessons From The 2008 Financial Crisis

Luckily, economists have learned two key lessons from that 2008 crisis that can help you make sense of the current crypto collapse. Speculators breed speculators. This is the first lesson economists relearned after 2008. And it comes from a well known behavioral framework. In this framework, financial market prices can roughly be explained by the interaction of two types of traders. Fundamentalists and speculators for crypto fundamentalists are those who use it to buy non-crypto stuff like groceries. On the other hand, speculators are those who purely own crypto as a way to get rich quickly. The demand of fundamental crypto users sets the face value of the entire crypto industry. Economists call this the fundamental value.

Positive Feedback Loop

However, as currency acceptance and therefore the fundamental value rises, speculators might come in and try to profit from the rising prices simply because they now want to own some crypto as well. This actually pushes the price above its fundamental value. This type of speculation in financial markets can be extremely successful, thanks to a positive feedback loop between prices and actions. This makes an actual market fundamentally different from the normal markets you might learn about in a standard economics class. You see, in normal markets there is a negative feedback loop. For example, if I decide to drastically increase my consumption of oranges, this might actually push up the price of oranges at my local market. However, seeing its price go up, others will now find them less attractive, instead preferring to switch to apples. This is called a negative feedback loop because my increased demand is offset by someone else’s decreased demand.

Speculators Don’t Need To Know Much

However, if this speculator buys an asset, he pushes up the price of that asset. And so he and other speculators will get richer. Now, other speculators might see this and also buy more assets, making all the other speculators even richer. As you can see, speculators don’t really need to know much about the fundamental value of the asset they are investing in. As long as they convince others to buy more. Their strategy will pay off. This explains why so many charismatic or famous people that seemingly didn’t know much about investing or money got really rich with crypto.

The Cycle Cannot Go On Forever

Now, of course, this dynamic cannot go on forever. Speculation is risky. It is not for everyone. At some point, there are no more potential speculators left to buy in, and at this point, the price might start declining as some speculators start to cash out. Now the positive feedback loop becomes a bad thing in the normal market. If I change my mind, then stop eating oranges. Its declining price makes it more attractive for others. Stabilizing the price for investments. This simply doesn’t work. Remember that speculators were only trying to get rich. Now that the price keeps falling, they face a stronger and stronger incentive to cash out by selling the assets. And if everyone is selling, this will make the price drop even more.

Experiments And Simulations

Using experiments and simulations, economists have discovered that the dynamic between these people leads to a cyclical price dynamic around the fundamental value. From time to time, speculators enter the market, inviting more and more, driving up the price until there are no more speculators to enter the market. And at that point the cycle turns and they all start selling. Thanks to the positive feedback loop, the crash is pretty bad and will fall below the fundamental value. Of course, at some point demand from the fundamental users will make the price return back to its fundamental value. Seeing the price move up again, the speculators might then return and the cycle starts all over again.

Applying This To Crypto

So let’s now apply this to crypto. What you see here is the S&P Broad Crypto Index, which represents the value of all major cryptocurrencies. We can clearly see some speculative cycles, but they have been moving upwards. So maybe the fundamental value has been moving upwards as well. Could this actually mean that we are already close to the bottom for crypto?

Well, perhaps, but I don’t think that would be enough to save crypto at this point. The reason is that compared to the crypto bust in 2018, its speculators have now committed one cardinal sin getting themselves into debt to speculate even more. But first, let’s go back to the second lesson that economists learned from previous financial crises. After 2008, economists learned a very painful and also very valuable lesson. It is almost always a really bad idea to get into debt, to speculate. Okay, perhaps not for the individual. After all, it might make you fabulously rich. No, it’s a really bad idea for the system because it basically turns your financial system into a house of cards.

Extra Money

You see, even though crypto and specifically Bitcoin was created by people who hated the 2008 bankers for their debt fueled excesses, the crypto industry has slowly but surely added possibilities for speculators to get into debt to buy more crypto. So okay, to make sense of this, let’s go back to our speculative investor example and give them all alone. The most obvious consequence of this extra money is that speculators can push up prices faster and higher.

Cryptocurrencies have enjoyed a roller-coaster ride in 2021. They have gone from the brink of collapse to soaring to new heights and back down again. But why does this happen? In this video, I’ll be discussing why debt-fueled speculation is driving the boom and bust cycles in crypto and how it could lead to a financial crisis.

Positive Feedback Loops

But it gets worse because of what is seemingly a good thing. You see, lenders are not stupid. They know speculation is risky. Therefore, they’re going to ask the speculators to give them some collateral. The deal is that speculators can buy crypto with borrowed money, but if they cannot repay their loan, the crypto they purchase will automatically go to the lender. As you might recognize, this is the same principle that underpins mortgage lending. Sure, you can get a mortgage to buy a house, but if something goes wrong, the bank now owns the house.

What could go wrong? Well, the problem is that this triggers several other positive feedback loops. The main reason for this is that the asset that you speculate with can serve as collateral for more loans. Crucially, this means that if asset prices go up, you can get more loans. Of course, the reverse also holds. If asset prices start dropping, the value of your collateral decreases. So your lender will ask you to post more to protect your loan. And if you cannot do that, you will automatically get liquidated, meaning that the lender will sell your collateral for you to minimize their losses.

In total, I’ve actually identified five positive feedback loops in a debt fueled speculative bubble and bust. The first is related to the first lesson economists learned that speculators breed speculators. So if, for example, asset prices drop. Speculators lose interest leading to a further fold.

Second, once asset prices start falling, speculators will find it difficult to borrow more. And this means that there is now even less demand for this asset. And this, in turn, will mean that prices will drop even more. And then things really start to break. Loans cannot be repaid. Collateral will automatically be sold on the market, and asset prices will drop even further.

And now, are you ready for a fourth positive feedback loop? At this point, the value of collateral will get so low that the lenders themselves will start to get into trouble. They will need to start selling their assets as well, and this will drop the price even further. Okay, then what about a fifth and final positive feedback loop? Let’s say that the lenders have also been lending to each other. Now, if one big one fails, it could very well take the rest of the lenders with it.

Current Situation

And I know you’ve been waiting for this moment, but that basically would mean this, because with crypto we are already well into this last phase. It started in May when Stablecoin Luna Terra collapsed and soon after crypto bank Celsius collapsed. And now after the fall of FTX, many more are at risk.

What you’re seeing in crypto right now is the full force of these five positive feedback loops. Falling asset prices reduces the speculative hype, the value of collateral then falls, and this reduces borrowing asset prices fall further, and now borrowers get into real trouble and will be liquidated. And finally, financial institutions are starting to fail. Taking down the rest of the system with them. In other words, while lending to speculators and accepting their speculative asset as collateral makes total sense from the perspective of the individual lender or individual borrower, it is something that economists have been warning against ever since the great financial crisis because it potentially creates much more severe asset booms and busts.

Crypto’s Fundamental Value

So the same forces that pushed crypto so close to the moon in 2021 are now crashing it right back down to earth. But how close to earth will it stop? To answer that question, we basically need to determine what Crypto’s fundamental value really is.

So how close is crypto to its fundamental value? To find out, we need to know how many people use it for speculative purposes versus those who use it for real fundamental reasons. Sadly, as Elon still hasn’t finished his Neuralink brain interface, all we can do at this point is ask crypto users. So I asked my followers the following question Have you ever owned crypto for any real economic purpose, such as to buy groceries or to start a non-financial business?

Conclusion

And what I learned from you wasn’t very encouraging for crypto. Only just over 30% of you that had ever owned crypto had ever used it for some productive purpose, and those 30% had mainly used it to buy less legal goods or to transfer money across borders. But it’s really important to note here that this 30% includes people who had used it only once or twice for a productive purpose like this.

So given that information, as well as research pointing to the fact that the vast majority of crypto users use it to speculate, I would roughly estimate that crypto’s fundamental value given to it by people that use it as money to buy non-crypto stuff is very low.

Hello? Well, honestly, nobody really knows. Besides, economists like Nobel winner Eugene Fama argue that the fundamental value of crypto is actually zero. On the other hand, true Bitcoin believers like Michael Saylor argue that when Bitcoin becomes the world’s reserve currency, its fundamental demand will skyrocket. Personally, I think that there are some coins specifically like Monero for illicit transactions and stellar for cross-border transactions that indeed have a fundamental value. However, even for these, it is far from clear if their price will stabilize around that fundamental value. When central bank digital currencies or more government regulation arrives and makes them much less useful.

But for now, it might not even matter what the fundamental value of crypto is, because this sector appears to be in a full blown financial crisis with no central bank to save them. A 2008 style central bank rescue not being a possibility means that the value of crypto could crash far below its fundamental value, even below the lows of 2019.

But hey, let’s make one thing clear. Economists such as myself cannot accurately predict what happens next in financial markets. After all, we do not have data on individual investment strategies, nor on how indebted, important financial institutions really are because they’re actively trying to hide it.

Still, I hope that you can use the key lessons presented in this video to shape your own thoughts about what will happen to crypto in the future. What’s more, I hope that you found the behavioral framework with its speculators and fundamentalists helpful to structure your thoughts around crypto and perhaps also other financial markets.