It was in the last couple of months of 2022 that the value of the global cryptocurrency markets declined to a third of its value. On November 10, the global cryptocurrency market value stood at just below $3 Trillion. However, by 31st December, the value fell to $0.83 Trillion.
Now, in the first two months of 2023, an entirely new story has come into the picture. The global value of cryptocurrencies is up by $1.1 trillion. So, we wonder if the global cryptocurrency sector is more fragile than it earlier used to be.
It cannot be denied that the fragility of the sector has been overwhelming. A whole lot of firms have been experiencing bankruptcy and financial distress. They include FTX, Core Scientific, Genesis, BlockFi, three Arrows Capital, and Voyager Capital.
The year 2022 will be remembered for the collapse of TerraUSD, which was a stablecoin. Luna, the sister token of TerraUSD has also collapsed. So, the investors have raised a whole lot of questions, and so have the regulators. Both these parties are concerned about the financial soundness of stablecoin TetherUSDT -0.1%. It is noteworthy that for the entire crypto market, Tether is a critical component.
A crypto investor is sure to come to feel that the fragility of the crypto market now is more than what it used to be at the year-end. Ever since 2023 has begun, the price of Bitcoin is higher by 50%. Interestingly, Bitcoin’s share of the global cryptocurrency market cap is about 40%.
It may be argued that the fragility of the market, as it stands currently is lower than what it used to be at the year’s end. This is only when we consider short-term fragility. Across the long term, the fragility of the crypto market is unquestionable.
One of the opinions that prevail in the market is that the recent price increase has only made the crypto market more fragile, not less fragile.
George Akerlof is an economics Nobel laureate. He has come up with a theory according to which in a world that is rational, markets for objects such as cryptocurrencies are unsustainable. Such markets collapse.
There is sound reasoning behind Akerlof’s theory. To recognize this hypothesis, let us consider that you are purchasing an item whose intrinsic value, you do not know with certainty. But the seller knows the intrinsic value with certainty.
All that you know about the intrinsic value is that it lies somewhere between $0 and $100. Any value in this range has an equal probability of being.
On average, what is the worth of this item? If you consider it to be $50 you’re right.
Now let us suppose that you have been granted an opportunity to bid for this item on a take-it-or-leave-it basis, to the seller. Another supposition is that you put down a deposit. This deposit will be the same amount as your bid. However, the provision involved here will be that in case the seller rejects your offer, you’d receive your deposit back.
Let us now put forth some postulations regarding how much you’d bid for the object.
- Over $50?
- Fewer than $25?
If as a bidder, you are rational, then $0 is the bid that you’d choose to go ahead with. You wouldn’t be bidding anymore. That is exactly what Akerlof’s theory tells us. Another way of expressing this is that for the item, no viable market exists, because the seller won’t be accepting less for the item as compared to its intrinsic value.
Now let us suppose that you bid $50 over the item and the seller decides to sell the object to you, then you will be victimized by buyer’s remorse. That’s because the maximum value of the item, in this case, would be $50 or the seller won’t have sold it to you. Its expected value has now become $25.
You wouldn’t want to be paying $50 for an item whose value you expect to be $25.
This same logic will apply, irrespective of the price you pay for the object. This could be $40, $25, and so on – all prices except $0.
The catch, here, is that you’d not be a participant in this market.
It is safe to assume that if in the world, only rational crypto investors were present, the kind specified by the information shared above; the crypto market would all but collapse. That would be because potential buyers of cryptocurrency would not place trust in potential sellers. They wouldn’t trust brokerage firms as well.
This safely reminds us of FTX, the crypto exchange that collapsed in 2022. FTX used its customer’s funds for funding its trades.
A bank run was experienced by FTX, and it fell when it had to. The commonplace perception of bank runs is the manifestation of irrational panics. Bank runs are characterized by the depositors all lining up to withdraw their funds from banks. They believe that they should be withdrawing the funds while they can.
FTX customers had experienced an Akerlof moment here, something to do with buyer’s remorse.
In the real world of cryptocurrencies, Akerlof moment began in the last two months of 2022. In line with the Akerlof dynamic, trust hit all-time lows. Transmission of asymmetric information led to the market’s collapse. This used to be a phase when trust, though declined, did not reach zero.
Now, we will look over Binance’s story, with Binance being a dominant crypto exchange. Binance used to be one of FTX’s major competitors. Investors wonder if Binance has sufficient reserves to safeguard their customers’ accounts.
Binance, in response, has released audited statements regarding its reserves. The vagueness of these statements has been hard to ignore. Does information asymmetry exist here? Akerlof’s entire theory is based on information asymmetry.
Question marks exist over the intrinsic value of cryptocurrencies through the time. The fragility of crypto markets becomes hard to question, across the long term as well.
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