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Crash and churn: Crypto story far from over despite falling prices

Crash and churn: Crypto story far from over despite falling prices
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In July 2017, I published an article entitled, “The Coming Cryptocurrency Crash — And Why It’s A Good Thing.” The article asserted there will be crashes and that cryptocurrencies would eventually become essential parts of the global financial system. 

Proposing a possible crash doesn’t mean you don’t get the crypto-wisdom. Yes, crypto currencies are potentially transformative for economic and political systems, but volatility arises precisely because transformation begets uncertainty. In a field as overheated as cryptos, there will be a crash, perhaps many.

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Many observers equate our current craze to the tulip mania of 17th-century Holland. This is a false analogy. Yes, the current craze could horribly collapse, but there’s an essential difference. Tulips aren’t good for much beyond decoration. Distributed ledger methodologies enabling cryptocurrencies have numerous potential applications. That’s the long-term game (if not the near-term trade). No one knows how it will play out, though we do have clues. 

 

What’s going on?

This month, cryptos crashed. Yes, they’re recovering, but in most markets a rapid 50-percent drop in market capitalization is a good, old-fashioned crash. Crashes don’t have to mean demise. During the crash of 2007-09, the S&P 500 collapsed 57 percent from peak to trough. Cryptos might recover — I’d say most will this time — and so did the S&P. 

The recent crypto downdraft could just be a continuation of past dynamics. Bitcoin has dropped many times before, only to recover to higher levels. But this could also be the beginning of a shakeout. The Korean and Chinese governments recently signaled potential restrictions on trading and exchanges.

They appear to be trying hard to avoid throttling these markets, but also see the need to exert regulatory control. How they proceed — and how investors interpret government pronouncements and rumors — will have great impact on this nascent market.

Meanwhile, bitcoin futures introduced in December by the CBOE and CME provide another factor. Futures traders thrive on volatility, not on assets that continually rise. Expect that bitcoin futures will trade within a wide range for a while, up and down, rather than signaling a continued meteoric rise.

Who wants to be on the wrong end of that futures contract? Futures contracts both reflect and impact market perceptions of value, and in the crypto case, perception is the operative word. 

All markets operate on sentiment, but in the early days of any asset class, sentiment and awareness represent much of what defines value. As the hype cycle accelerated in 2017, crypto markets surged. By contrast, traditional equities markets mostly value based on earnings.

While equities rise and fall with investor emotions, equities are ultimately tied to the performance of underlying companies. Few cryptocurrencies can point to proven business value beyond trading. And unlike equities, cryptos don’t typically include a claim on an underlying company. They’re more like buying into a community or concept. Many have great stories (some sensible, even visionary), but it’s tough to value stories. 

What’s next?

If crypto markets recover from current levels, what might we see? Perhaps more of the past rise to new levels followed by additional steep drops. We’ll also likely see churn. Investor interest oscillating between enthusiasm for new offerings versus preference for established coins.

Earlier this month, as bitcoin and other "alt-coins" like Ripple (XRP) were descending, Ethereum (ETH) surged to over $1,400 before its recent decline. Some of this activity might have been due to investor hesitance to convert into traditional currencies, such as the U.S. dollar — to avoid getting out of the game or confronting tax implications — while seeking the relative safety of Ethereum, even while bitcoin was falling.

Despite being the early leader, it’s impossible to know for sure if bitcoin will be one of the long-term winners. I vote no, given the issues around energy requirements and transaction speed. (Though I own one just in case.) Developers are working on fixes, but the question will be if alt-coins overtake bitcoin before these enhancements succeed. Perhaps it will become the Napster of the crypto era.

Casinos, startups, religions

Consider analogues. The current craze resembles casinos, startups and religions. Casinos have no value without people willing to play them. And like casinos, crypto markets are at risk of manipulation, either by the house or by others.

This is especially true for coins with limited float, as researchers recently asserted in the Journal of Monetary Economics regarding bitcoin’s early days.

Today’s cryptos are also similar to the numerous startups that rapidly received funding during the dot-com boom of the late 1990s. Most burned bright and flamed out. Some persisted. During the dot-com crash of 2000, most startups failed. A few like eBay and Amazon persevered and transformed the global marketplace.

Like early-stage venture capital, it’s tough to pick long-term winners at the earliest stages. It’s impossible to know for sure who will become the eBay or the Pets.com (an infamous disaster) of the crypto revolution. For clues look for those that propose — and demonstrate — they can solve real business problems. 

For some, crypto resembles a religion, i.e., the faith that this time is truly different, that we know a truth others fail or refuse to recognize. So-called HODLs ("hang on for dear lifers") have been a ballast for cryptos through ups and downs. While so far, reality has rewarded belief, the overly-faithful, veterans or newbies, are the ones bearing the most risk of a widespread crash. 

Anyone who tells you they know what will happen is either naïve or a liar. This open, distributed-ledger phenomenon will change our world; we just don’t know when or how. If you’ve invested, make sure you follow multiple perspectives for insights.

If you’re a skeptic, recognize that short-term setbacks do not alone invalidate new technologies. Market froth enables wide experimentation. Many will fail, a few will prevail. 

Assume we’ll have a crash and we don’t know when. If you’ve made money, take some off the table. If a general crash never happens and you forwent some gains, you can still be proud of being in early. If a crash does happen, you won’t have been the greater fool.

Robert Wolcott is co-founder and executive director of the Kellogg Innovation Network (KIN) and a clinical professor of innovation and entrepreneurship in executive education at the Kellogg School of Management, Northwestern University.