After the crash
The crypto crash is in full swing. Falls of 80–90% from the peak have already happened. What does this mean?
The economist Scott Sumner says “never reason from a price change”. The fact that a price changed is unarguable, but we need to know why it changed in order to understand what to do about it. As Scott says:
My suggestion is that people should never reason from a price change, but always start one step earlier — what caused the price to change. If oil prices fall because Saudi Arabia increases production, then that is bullish news. If oil prices fall because of falling AD in Europe, that might be expansionary for the US. But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.
With this in mind, let’s ask: why are crypto prices falling?
The answer is pretty simple: demand is lower than it was previously. We can draw up many complex charts, but they all tell the same story. Fewer people want to buy Bitcoin, Ether, or other cryptocurrencies and tokens, at their current prices. The fall may continue until an equilibrium is reached, and opinions differ on where that equilibrium point is. Prices are unlikely to rise until potential buyers are persuaded that a higher price is justifiable.
Of course, “lower than it was previously” means we’re making a comparison to the peak of the market. Prices could fall a lot further than still be higher than they were at, say, the beginning of 2017.
The bubble of late 2017/early 2018 represented an enormous infusion of capital into blockchain projects. We know that many of these projects were turkeys in a tornado, with not much value beyond having the words ‘block’, ‘chain’, or ‘blockchain’ somewhere in their names. Some were outright scams. Some raised funding illegally. A substantial fraction of the market is therefore dead, and ought to be assigned a value of near zero. People who bought these tokens in order to HODL them will lose, big-time.
What about the rest? Once we have discounted the scams, the pump-n-dumps, the over-hyped and under-designed, and those that assumed that blockchain was miracle potion for otherwise mediocre business ideas, we’re left with a few fundamental facts:
- There is some genuine technical innovation in applying cryptography to distributed databases; cryptography is generally under-applied in the real world and the potential value from applying it more broadly is real.
- The major public blockchains have demonstrated stability and security despite using novel mechanisms for consensus and predictability.
- The core application of managing scarce resources using distributed databases appears to work well for Bitcoin.
- Managing a much larger fraction of the world’s scarce resources using current blockchain technology is not feasible without relaxing the requirement for true decentralisation.
So, we have some genuine technical innovations, a reasonable belief that more such innovations can be found, and a decent grasp on the problems of scalability and cost. A global network of stateful, distributed and consensus-forming databases, capable of modelling scarce, long-lived resources and multi-party relationships to those resources sounds genuinely useful.
This sounds bullish. Why, then, is everyone depressed?
If you’re making a bear case for crypto applications based on the movements of Bitcoin, Ether, or token prices, then you’re probably making the mistake that Scott Sumner warned about: reasoning from a price change. Much of the “technical analysis” you see on Twitter is doing this too — attempting to understand the future by looking at a narrow measurement of the past.
This is important because demand for crypto tokens is not like demand for oil. Much of the money flowing into tokens over the last year was investment, not consumption. Investments are designed to produce long-term value, not short-term returns. Investments follow cycles, and down-cycles are inevitable for innovative products that take time to develop and mature.
A better model for understanding this is Carlota Perez’s model of the interaction of finance and innovation:
Put simply, innovations occur somewhat spontaneously and unpredictably. Some initial investment is made, and success follows (or doesn’t). After a while, the momentum becomes visible to the wider world. Suddenly, everyone wants a piece. A frenzy begins.
The inevitable consequence of the frenzy is the crash. Inevitable. The market cannot react fast enough to deliver enough investable opportunities to satisfy the frenzied demand. Once the good opportunities are taken, bad investments are made, and the quality of each new opportunity falls as all of the good opportunities are already well-capitalised. The only way to avoid further bad investments is for investment levels to fall.
Software engineers might recognise the “mythical man-month” problem here. Building useful infrastructure takes time, and having 10x as many people working on it doesn’t result in it getting done any faster. 10x more capital doesn’t help, either.
The crash, then, isn’t necessarily bullish or bearish as a long-term signal. It’s consistent with the view that crypto was over-hyped and will be remembered as an embarrassing fad. It’s also consistent with the view that investment takes time to yield returns, and the timescale from the peak to now (less than a year) is far too short to know what those returns will be.
Of course, this is no help to those who are holding falling tokens right now, any more than the eventual success of Amazon was a comfort to people who lost everything on WebVan in the dot com bubble. Investing is hard! In retrospect, it is obvious that the crypto markets couldn’t absorb hundreds of billions of dollars and allocate all of them to successful projects — the baseline for startups is a 90%+ failure rate, even in normal times. You can hope that one of your investments turns out to have long-term value after the crash, but most won’t.
In the interests of balance, let’s look at the bullish case for crypto.
The ICO scams were great for the total “crypto market cap” but bad for any long-term infrastructure or product development. The death of the scam market and the return to sane notions of risk and investment is a positive, not a negative.
Blockchains are great technology for managing scarce resources and their metadata, but plugging those resources into blockchain technology takes time. We’re starting to see projects like Harbor which are plugging scarce real-world assets in — and this makes a lot more sense than trying to manage the supply of some arbitrarily-defined “utility token” that has no natural need for scarcity beyond the ability to speculate on its price. (Disclosure: at Mattereum we are also focusing on plugging the real world into the blockchain). If you want to see tokens that hold real value and move independently of the price of Bitcoin, this will be how it happens in the short-term.
Fundamental technical innovations are still coming — Ethereum will get a substantial upgrade, and rival technologies will compete. This simply wasn’t true even a year ago.
The great wave of investment has left us with a number of well-capitalised teams that will continue to innovate for years. As uncertainties around technology, scaling and legal issues subside, the focus on user experience will predominate and we will see products that look very different from today’s prototypes.
Perez’s model gives us some idea of what to look for after a crash — an adjustment in which the projects that find the best fit between the technology and the market succeed, and the rest disappear. In total size and scale, this phase is bigger than what came before it, but will also proceed more slowly and more carefully. Once the crash bottoms out, it may take years for the total valuation of blockchain projects to approach the peak again. Still, once we clear away the wreckage of the bubble, the real opportunities are still there.
