Is the crypto market slump a worrying sign for the future?

The following article was originally posted on the?Mercer Yield Point Blog .?You can find this article along with more wealth news content?here .?

By Matt Scott, Investment Research - Lead Specialist

Mercer’s Matt Scott says we are now seeing the narratives that Bitcoin enthusiasts have relied on beginning to fail. At the same time as the digital currency flagship?flounders, regulatory scrutiny increases. But Web 3.0 could hold a bright future for cryptos.

Since the launch of Bitcoin over a decade ago, decentralised digital currencies, aka cryptocurrencies have captured imaginations and rocketed in value despite frequent and massive crashes.?

Bitcoin’s shiny allure has attracted swathes of investors in recent years but the more we unwrap it layer by layer, the more we are disappointed by its interior.

We are starting to see some of the narratives that Bitcoin enthusiasts have relied on begin to collapse.

No longer an inflation hedge

Bitcoin has been widely touted as an inflation hedge because there is a limit on how many coins can be mined – similar to gold which is often perceived as a safe-haven asset when consumer prices are rising.?

This “digital gold” narrative gained significant traction in 2021 due to simultaneous ETF flows out of gold and a great year for cryptocurrencies, which was interpreted as a shift in power to the new kid on the block.

Unlike Bitcoin and gold, which are perceived to have finite resources, central banks and governments are relatively unhindered in their ability to expand the monetary base. Seigniorage is the amount of economic advantage a government gains from printing money; the concept behind crypto is to both limit and democratize seignorage.??

But investors should not rely on the limit on 21 million Bitcoins set by the originator of the blockchain, Satoshi Nakamoto, as the reality is it can be changed whenever the developer community decides to.

We strongly believe the comparison of Bitcoin with gold has been much overplayed. In recent months, the notion of Bitcoin being an inflation hedge has been dented as its price has collapsed while inflation continues to rise.?

According to CoinDesk, the price of the world’s most famous cryptocurrency reached a peak of $67,554 last November, but this year has fallen by a staggering 54% from $47,739 on 1 January to $20,881 on 17 June.

To some extent this has been a case of “The Emperor’s New Clothes”, where Bitcoin’s credentials as a diversifier or store of value have been impaired. However the boom town of Decentralized Finance has also been to blame. When investors were being offered as much as 18% returns to lend US stablecoin Terra speculative finance precedents such as Icelandic banks spring to mind quite easily.

High lending rates in the space have in part been based on the premise that collateral prices only ever go up. For example, if I borrow stable coins at a 15% interest rate and I buy Bitcoin with it and the price of Bitcoin goes up by 50%, then the latter easily covers the amount of interest I have to pay.

This is reminiscent of speculative finance in the global financial crisis where a lot of lending was predicated on the idea that property prices would go up forever. As we discovered in the crisis, when there is a problem, the whole thing blows up.

We believe cryptos have been pure speculative assets – there are no substantial real economic returns from the space and a rather flimsy set of use cases supporting it.?

Floods of speculative investors appear to have propped up the price of cryptocurrencies in recent years – but these ‘pump and dump’ type of investments now seem to have run their course. To keep speculative price rises going requires successive waves of investors to enter the system – but it feels like the search for greater fools is getting harder. This is of course, assuming that there is no explosion in usefulness coming down the line… (I come to Web 3.0 later).

Regulation is still the major threat to cryptos

While the industry remains both under-regulated and patchily regulated, many watchdogs around the world are nevertheless keeping a close eye on cryptos and ramping up their capabilities. The huge amount of speculative finance in cryptos and the problems the sector has faced recently will almost certainly draw closer scrutiny from regulators. The March Executive Order from President Biden was a welcome call for a whole-of-government approach for regulating and stewarding the crypto space, it should lead to a more sustainable trajectory whilst also exposing pockets of systemic risk and malpractice.

There is too much market manipulation in the sector – for example wash trading. This is where trades are executed by investors, illegally acting as both the buyer and the seller of the asset to make it look like the network is more active than it is. There has been some regulatory action in the US by the CFTC on crypto wash trading, however jurisdictional questions remain (some have challenged whether CFTC’s enforcement scope extends to crypto, and there is a lack of clarity over the precise geographic location of transactions on the blockchain occur).

Increased regulatory proximity to the digital ecosystem, an accelerating legislative timetable, as well as an uptick in resourcing would mean that the level of artificial volumes in the space are unlikely to persist.?

Although the government regulates, it also competes. One reason why regulators have not come down on the sector yet is because governments haven't perceived their own currencies to be under threat, simply put they don’t see any current blockchains as scalable competitors or as replacement “numeraires”. But if governments decide they do not want to give away seigniorage and take action, then we could see a wholesale taming of the sector in the future.

Web 3.0: Decentralised internet on blockchain

For cryptos to have a genuine benefit, they must be improving people’s lives and creating real value. That’s why venture capitalists are getting excited about Web 3.0 – the third generation of the internet where the system will be decentralised using blockchain technology.?

Under the current generation, Web 2.0, databases and apps are hosted on centralised servers but with Web 3.0, apps will be hosted on blockchains and decentralised data networks.?

While Bitcoin is seen as a store of value or payment system, it is likely to be Ethereum, the decentralized open-source blockchain system (host to the token Ether), that will provide the base layer for this Web 3.0. concept.

If the theory that decentralised systems are inherently more robust than their centralized competitors, then crypto is about to come to life, and there will be a lot of money to be made from Web 3.0. Whilst it’s hard to see how Web 3.0 concepts can be applied to marketplaces that rely on real world infrastructure, or social networks with their huge private data moats, there are some encouraging examples of use cases, for example in gaming.

Interestingly, the price falls of various major cryptocurrencies since highs in November 2021 follows a very similar path to the NASDAQ index of leading technology firms. This suggests that cryptos are acting like tech stocks, and that is because the future of the system heavily relies on Web 3.0. The third generation of the internet will clearly need a lot of institutional money for it to really take off.?

Whilst the trajectories of Web 3.0 and cryptocurrencies are linked, they are not necessarily intrinsically so. Does web 3.0 actually need free-float cryptocurrencies or could it rely on Central Bank Digital Currencies? This may be one reason why the more cautious investors in the space rely diversify cryptocurrency exposure, with crypto venture capital and equity ownership.

The crypto sector faces many risks beyond the turbulent events of recent weeks and months. But if Web 3.0, where the next phase of the internet is decentralised using blockchain technology, really takes off, this could provide vast opportunity at a compelling price. Lack of regulation and compelling use cases are keeping most institutional investors away for the time being.