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12 June 2022

When it’s not Ponzi

We are at the end of a 40-year long bull market during which stocks kept rising, interrupted only by a few short-lived corrections, as in 1987, 2000 and 2008. The markets crashed again in 2020, because of the pandemic. This year’s crash is the result of rising inflation and expectations of higher interest rates. This week started with another leg of a market downturn. 

The performance of crypto stocks has been particularly abysmal. Bitcoin is down 50% this year. For many investors, this will be unrecoverable loss. The crypto boom was based on justified hopes that the technology would change our world in profound ways. Unfortunately, these hopes came with unjustified optimism about when this will happen. More importantly, the boom, and subsequent bust, reflects a generalised failure to understand crypto for what it is. Crypto-assets will bring about financial innovation in the long run. This is where the real value lies. It is not in the asset itself.

Financial innovation is surprisingly rare. Paul Volcker once joked that the cash machine was the only example of financial innovation that he saw during his lifetime. Most of what has been sold as financial innovation is just different ways to repackage credit. Remember the credit derivatives that were hailed as financial innovation at the time, but turned out to be financial Ponzi schemes? Finance is full of this stuff. The creation of central banks, and later of fiat money, were of course real financial innovations with a profound impact on our lives. But finance itself has not changed much since the days of Mediaeval money lenders. It’s credit and equity, in various combinations and wrappers.

But genuine innovation is now on the horizon, in the form of crypto 2.0, or 3.0.

Stablecoins aren't it. They are a financial derivative that guarantees a dollar value of an underlying cryptocurrency. The Luna coin's collapse is probably only the first of several. This week brought more troubles for the industry. Stablecoins are the financial equivalent of a well-known economic construct, that of a fixed exchange rate system. And we all know what happens to economies with fixed exchange rate systems that are reliant on continuous inflows of foreign direct investment. Once the flows stop, the game is up. This is how the Asian boom of the 1990s turned into a financial crisis. And it is the reason why I believe that stablecoins are Ponzi schemes. The high valuation of bitcoin is in part the result of the presence of stablecoins. 

But stablecoins are not the essence of what crypto is about. What is exciting about crypto is not the get-rich-quick stuff, but what is going on away from the public limelight.

Here are some parallels to the dotcom bubble of 1999 and 2000. Back then, investors were onto something when they realised that the internet would become the dominant technology of our age. What they got wrong were the timescales. They also didn’t pick the winners. The iPhone was another seven years away. The dotcom bubble was ultimately a bet on IBM computers and Blackberry, mixed in with the usual financial euphoria.

We are seeing something similar now. As it turned out, the crypto investors were not geniuses. There were simply long and lucky until this year. In a world with several billion people, there will always be some who beat the odds for a little bit longer than others. And then, that stops too.

As in 2000, today’s investors are on to something too. Again, they are not getting it quite right. They should focus on crypto-finance, not crypto money. The two are related. Each crypto-universe has its own coin. The social value-added doesn’t come from the appreciation of the coin’s dollar value, but from potential commercial opportunities.

What the new crypto fintech promises is an end to the monopolies of banks, shadow banks and asset managers that have been creaming off the value-added of the global economy. Crypto comes with the promise to nudge at least a part of the financial system towards more perfect competition. This is why it is also called Defi: decentralised finance where the infrastructure is not owned by anybody, where borrowers and lenders, investors and issuers of securities interact directly without a middleman. Back in 2000, Amazon was a small online bookshop. It ended up revolutionising the entire retail sector. As a business model, crypto finance falls into the Amazon category of disruptors. The economic value consists of cheaper transaction costs, speed, and the removal of friction. But beware: this is not going to happen tomorrow.

The future of fiat money, and crypto’s role in that future, is another big - very big - story. But that story is further away. My own expectation is that fiat money is doomed in the very long run, and that crypto will play a role in its demise. In the meantime, the real investment story behind crypto is finance, not money. What investors need to do is avoid the Blackberries of the crypto world - and leave the crypto fanboys to do their thing.

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