Increase in cryptocurrency prices makes the crypto market more fragile, not less fragile

In the last two months of 2022, the global cryptocurrency market fell in value by about a third, from just under $3 trillion on November 10 to around $0.83 trillion on December 31. However, in the first two months of 2023, global cryptocurrencies have increased in value to around $1.1 trillion; and this raises the question of whether the global cryptocurrency sector is now less fragile?

Certainly the sector has been extremely fragile. Consider the list of firms experiencing financial distress and bankruptcy: FTX, Genesis, Core Scientific, BlockFi, Voyager Capital and Three Arrows Capital. In 2022, crypto investors experienced the collapse of stablecoin TerraUSD and its sister token Luna. Investors, not to mention regulators, have raised many questions about the financial soundness of stablecoin TetherUSDT, which is a critical component of the entire crypto market.

Crypto investors may feel that the crypto market is less fragile today than it was at the turn of the year. Since the beginning of the year, Bitcoin’s price has increased by about 50%; and Bitcoin’s share of the global cryptocurrency market cap is roughly 40%.

A plausible argument can be made that the market is less fragile in the short term than it was at the turn of the year. However, the crypto market remains extremely fragile in the long term. In fact, I suggest that the recent price increases have made the crypto market more fragile, not less fragile.

Nobel laureate in economics George Akerlof developed a theory that explains why, in a rational world, markets for objects such as cryptocurrencies are unsustainable and collapse.

To understand why, consider buying an item whose intrinsic value is known with certainty by the seller, but unknown to you. All you know is that the intrinsic value of the item is somewhere between $0 (worthless) and $100, and any value in this range is as likely as any other.

How much is this item worth on average? If you answered $50, you would be correct.

Suppose you had an opportunity to bid on the item, to the seller, on a take it or leave it basis. Suppose further that you had to put down a deposit, namely the amount of your bid, with the proviso that if the seller rejects your offer, you will get your deposit back.

How much would you like to bid for the item?

1. More than $50?
2. $50?
3. $40?
4. $25?
5. Less than $25?

If you are a rational bidder, you will bid $0 and not a dime more. This is the message from Akerlof’s theory. In other words, there is no viable market for the product. The reason is that the seller will not accept less for the item than its intrinsic value. If you bid $50 and the seller agreed to sell the item to you, you would experience buyer’s remorse. Why? Because the item will be worth no more than $50, in which case the expected value, based on the transaction taking place, is now just $25. You would not be rational to pay $50 for an item that you estimate to be worth $25.

The same logic applies to a $40 bid as to a $50 bid; and that applies to any bid you may place, except $0.

The point here is that you will 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 buyers of cryptocurrency will not trust potential sellers. Given the absence of a strong regulatory environment, which is the case today, rational crypto investors would also not trust brokers – unless the investors are fully informed. Consider what happened at FTX, which funded trades with customers’ funds.

That the FTX saga actually happened makes it clear that the world is not only populated by rational investors.

Consider Binance, FTX’s biggest competitor and dominant player. Does Binance have the reserves to protect customers’ accounts? In the wake of FTX’s collapse, crypto investors have been asking this question. Binance has attempted to reassure its customers that they have sufficient reserves by providing so-called audited statements of their reserves. The problem is that such statements are ad hoc, vague and not part of a complete set of audited accounts. Even the accounting firm that performed the audit has suspended its work on producing proof-of-reserves disclosure reports.

Is there a strong information asymmetry between Binance and its customers? Remember that information asymmetry is at the heart of Akerlof’s theory.

Regarding cryptocurrencies, I would add that there are serious questions about intrinsic value. You can think of intrinsic crypto value as what cryptocurrencies would be worth in a rational world. However, there is good reason to argue that most of the value of cryptocurrencies, at least in today’s market, reflects sentiment much more than fundamentals.

The fact is that high sentiment-to-market values ​​are major contributors to financial fragility; and 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 term.

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