Want to Know Where Crypto Is Headed? Remember 2008 | Tech News

Want to Know Where Crypto Is Headed? Remember 2008

The repercussions won’t be as dire as those of the financial crisis. But a comparison offers insights into what comes next.

| Updated on: Nov 22 2022, 02:15 IST
In crypto, the belief was that this new market would keep growing until it displaced traditional finance. (HT_PRINT)

History may not repeat, but it certainly rhymes. Although the repercussions of the carnage in crypto markets won't be as broad or dire as those of the 2008 financial crisis, the parallels between the two episodes offer insights into what went wrong, and what's likely to come.

All financial manias have some features in common. Strong beliefs feed into self-reinforcing feedback loops. On the way up, positive performance and speculation compound one another, fueled by borrowed money. On the way down, everything runs in reverse. Failures erode trust and participants flee until the whole system breaks down.

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In the 2000s, the central belief was that home prices couldn't decline on a national basis. This supported a boom in subprime mortgage lending, which pushed home prices higher and made owners look wealthier, drawing in more investors and encouraging more lending on ever more precarious terms. The increase in prices led to greater supply, which caused prices to flatten out and then decline. When this happened, the risks of subprime lending became evident, undermining demand and weakening prices further. Investors fled and counterparties demanded more collateral, triggering failures and further undermining trust until the entire interconnected constellation of financial intermediaries was on the brink of collapse.

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In crypto, the belief was that this new market would keep growing until it displaced traditional finance. Consider the tokens issued by crypto exchanges (including FTX), offering discounts on fees: Their value was contingent on persistent growth in trading volumes. Trading depended on continued faith in growth, which in turn depended on more trading. But as soon as something faltered — the so-called “stablecoin” Terra losing its peg, or the bank-like entity Celsius stiffing its customers — the trust and enthusiasm dissipated. Failures of some firms weakened others, in a dynamic that has now consumed FTX, which until recently appeared to be among the strongest. And the failure of FTX will undoubtedly weaken the crypto industry further. 

So, what can a comparison with the 2008 crisis tell us about what comes next for crypto?

First, the bloodshed isn't over. In 2008, central banks and governments restored trust by providing emergency liquidity and recapitalizing financial institutions. But crypto has no central bank — no lender or market-maker of last resort with adequate resources — and governments (rightly) don't see it as systemically important enough to rescue. So while there may be lulls and even rallies, as there were back then, there's nothing to prevent much of the market — including exchanges and other intermediaries — from going under.

Second, regulation is coming. Among other things, the 2008 crisis engendered the Dodd Frank Act, the Consumer Financial Protection Bureau, bank stress tests and a complete overhaul of the way derivatives are traded. Crypto customers will demand protections similar to those in traditional finance, and the pressure on regulators to act will increase as the number of people harmed climbs further. 

Third, some business models will survive and prosper. The credit derivatives that played a big role in the 2008 crisis remain a robust, albeit reformed market. Similarly, Ethereum's move to a new, more efficient model for processing transactions might give it staying power, by allowing increased throughput and lower transaction costs. And now that short-term interest rates are well above zero, offering stablecoins backed by interest-bearing central bank reserves becomes a sustainable business model, potentially delivering both profits for issuers and safety for users. 

The promise of decentralized finance lies not in the speculative activity associated with digital tokens, but with blockchain technology. This innovation could yet prove useful in trade finance, cross-border payments, securities settlement and digital identity. So even if the mania is over, don't count this part of the crypto-ecosystem out.

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First Published Date: 22 Nov, 02:15 IST