History may not repeat itself, but it certainly rhymes. The aftermath of the crypto market carnage isn’t as massive or disastrous as the aftermath of the 2008 financial crisis, but the similarities between the two episodes give us an idea of what could go wrong and what could happen.
All financial geeks have a few things in common. Strong beliefs encourage self-reinforcing feedback loops. Positive results and speculation complement each other on the rise, fueled by debt. Below is the opposite. Failure erodes trust and participants keep running until the whole system falls apart.
In the 2000s, the underlying belief was that house prices could never fall across the country. This boosted home prices, made homeowners wealthier, attracted more investors, and also supported a subprime mortgage boom that encouraged more lending in volatile conditions. As this was happening, the risks of subprime lending became apparent, demand waned, and prices fell further. Investors fled, counterparties demanded more collateral, leading to bankruptcies and further erosion of confidence until an entire chain of interconnected financial intermediaries was on the brink of collapse.
Cryptocurrencies believed that this new market would continue to grow until it replaced traditional finance. Consider tokens issued by crypto exchanges (including FTX) that offer fee discounts. Its value depended on the increasing trading volume. Trade depended on a constant belief in growth, which depended on increased trade. But as soon as something went wrong, with the so-called Terra “stablecoin” losing its peg, or the Celsius banking organization limiting its clients, confidence and enthusiasm faded. The failures of some companies have undermined others, and now this dynamic is engulfing FTX. And the failure of FTX will undoubtedly further weaken the cryptocurrency industry.
So what does a comparison to the 2008 crash tell us about the future of crypto?
First, the bloodshed has not ended. In 2008, central banks and governments restored confidence by providing emergency liquidity and recapitalizing financial institutions. But cryptocurrencies have no central bank, no lenders of last resort, and no well-resourced market makers. The government (understandably) does not consider it systemically important to bail him out. Nothing will stop most of the market, including the brokers, from going bankrupt.
Second, comes regulation. Among other things, the 2008 financial crisis passed the Dodd-Frank Act, the Consumer Financial Protection Bureau, bank stress tests, and a sweeping overhaul of how derivatives are traded. Cryptocurrency customers are demanding protections similar to those used in traditional finance, increasing pressure on regulators as the number of victims grows.
Third, some business models survive and thrive. Credit derivatives, which played a significant role in the 2008 financial crisis, remain a resilient, albeit reformed, market. Similarly, moving Ethereum to a new, more efficient transaction processing model could provide resiliency, improve performance, and reduce transaction costs. And now, with short-term interest rates well above zero, the supply of stablecoins backed by central bank interest reserves is becoming a sustainable business model that benefits issuers and users and can provide security.
The potential of decentralized finance lies in blockchain technology, not in speculative activities related to digital tokens. This innovation could also help in the areas of trade finance, cross-border payments, securities settlement, and digital identity. So even if the mania is over, don’t underestimate this part of the crypto ecosystem.
