Want to know where encryption is headed?  Remember 2008

Want to know where encryption is headed? Remember 2008

The repercussions of the financial crisis will not be as dire as the repercussions of the financial crisis. But the comparison offers an insight into what comes next.

History may not repeat, but it sure rhymes. While the repercussions of the carnage on the cryptocurrency markets will not be as widespread or dire as those of the 2008 financial crisis, the similarities between the two episodes offer insight into what went wrong, and what is likely to happen.

All financial manias share some traits. Strong beliefs fuel self-reinforcing feedback loops. On the way up, positive and speculative performance accumulates, supported by borrowed funds. On the way, everything goes the other way. Failures undermine trust and participants run away until the entire system collapses.

In the 2000s, the common belief was that home prices could not fall on a national basis. This has supported a boom in subprime lending, which has pushed up home prices and made homeowners look richer, attracting more investors and encouraging more lending on ever riskier terms. An increase in prices leads to an increase in supply, which causes prices to stabilize and then fall. When this happened, the dangers of subprime lending became apparent, undermining demand and weakening prices even further. Investors fled and the other side demanded more collateral, creating failures and further undermining confidence until the entire interconnected group of financial intermediaries was on the brink of collapse.

In cryptocurrencies, the belief was that this new market would continue to grow until it replaced traditional finance. Consider tokens issued by cryptocurrency exchanges (including FTX), which offer discounts on fees: their value has been contingent on the continued growth in trading volumes. Trading depended on a constant belief in growth, which in turn depended on more trading. But as soon as something went awry—Terra lost its so-called “stablecoin” peg, or the bank-like entity that fortifies its customers—the confidence and enthusiasm dissipated. The failure of some companies has 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 even further.

So what can a comparison to the 2008 crisis tell us about what happens next for cryptocurrency?

First, the bloodshed is far from over. In 2008, central banks and governments restored confidence by providing emergency liquidity and recapitalizing financial institutions. But cryptocurrencies have no central bank — no lender or market maker to turn to as a last resort with sufficient resources — and governments (rightfully) don’t see it as systemically important enough to bail it out. So while there may be lulls and even rallies, as there was then, there is nothing stopping much of the market – including the exchanges and other brokers – from crashing.

Secondly, regulation is coming. Among other things, the 2008 crisis spawned the Dodd-Frank Act, the Consumer Financial Protection Bureau, stress tests for banks, and an 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 affected increases.

Third, some business models will survive and thrive. The credit derivatives that played a large role in the 2008 crisis is still a strong, albeit reformed, market. Likewise, Ethereum’s transition to a new, more efficient transaction processing model could give it staying power, by allowing higher throughput and lower transaction costs. Now that short-term interest rates are well above zero, offering stable currencies backed by central bank interest-bearing reserves becomes a sustainable business model, potentially profitable for issuers and security for users.

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

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