“This time it’s different” — these are the words we were cautioned against by John Templeton, a notable investor, fund manager and financier.
In the past few months, we have seen the world of cryptocurrencies and decentralised digital finance struggle to stay afloat with one of the reasons being the burgeoning pressure placed upon them through central banks.
The U.S. Federal Reserve, the largest among those banks, has raised rates multiple times in the past year to almost 4% from close to 0%.
Stark contrast
The current monetary intervention starkly contrasts with the benign environment cryptocurrency enthusiasts enjoyed during the year 2021, when market liquidity ran high.
Moreover, the Federal Reserve has further indicated that it does not plan to withdraw from its hawkish stance anytime soon. In times like these, it is essential to look back in history to understand how such events might play out.
One of the largest cryptocurrency exchanges recently filed for bankruptcy, declaring they had a measly $1 billion in liquid assets to meet $9 billion in liabilities. Furthermore, they reported having 1 lakh creditors and $10-50 billion in assets and liabilities. Some of their assets involve the recent acquisition of another sinking cryptocurrency lender, Voyager, which ran into tough times due to the coins Luna and Terra for a figure crossing the $1-billion mark.
Additionally, the bankruptcy claims for FTX are selling for as low as 10 cents on the dollar, which means that individuals holding a dollar’s worth of claim are willing to sell it for merely 10% of what they are owed.
The largest cryptocurrency fund, the Grayscale Bitcoin Trust, is down by more than 80% since its peak in November of 2021 compared with Bitcoin’s loss of roughly 70% (at the time of writing this piece). Many cryptocurrency exchanges have exposure to this fund, whose heavy loss in valuation acts as a precursor to worse times for these firms.
The phenomenon we currently witness was aptly termed “stampede liquidation” by the late Irving Fisher, a renowned American economist.
Stampede liquidation is the act of multiple market participants wanting to withdraw their deposits at once, or willing to sell a specific asset in panic leading to a severe correction in the price. Stampede liquidation, at a large scale, generally occurs post-economic booms, with highly leveraged investments first in line. In this case, cryptocurrencies have little regulation, extreme lending, borrowing, and leveraging. Panicked investors and traders trying to withdraw all at once create a considerable disruption in the already fragile cryptocurrency exchange’s financial system. These firms lent to hedge funds which went bust such as the Singapore firm Three Arrows Capital. Hedge funds are notorious for leveraging by more than 20 times the original principal. Therefore, a withdrawal of a nominal amount has a multi-fold effect behind it.
Moreover, cryptocurrencies lack any intrinsic value deriving their utility purely from their price, meaning miners who enable transactions are not incentivised to dedicate precious resources to a dwindling asset.
Perhaps the worst part about stampede liquidation is that financially strong lenders are weakened as their capital loses value by the second, weakening their position constantly. Although FTX and other such firms have more significant issues, the slide in crypto prices could not have arrived at a worse time. It is not a surprise that these firms operated in a cartel-like way to save smaller firms, such as Voyager, trying desperately to keep their sinking boat afloat.
One can observe parallels between the infamous South Sea Bubble and the current flow of events. The South Sea Company, which barely made any revenue let alone profits, also perpetrated the narrative of an attractive way to make money without the risk of losing one’s capital. The rise in the stock price was accompanied by poor regulation and opaque practices. The proprietors of the company all too quickly realised that the only way to keep the company afloat was never to let the valuation of the stock price sink. Compared with their competitor, the East India Company, they had no profits, assets or any semblance of intrinsic value to write home about.
George Soros, the famous speculator and philanthropist, had said that humans are “fallible”.
The line between fallibility and rationality is thin and can be crossed before one realises they are on the other side. It is, therefore, in the best interest to exercise great caution when approaching investing.
There is great wisdom in heeding the advice of Warren Buffet and sticking to one’s circle of competence, not pursuing promises of extraordinary returns in place of reasonable returns.
(Anand Srinivasan is a consultant. Sashwath Swaminathan is a research assistant at Aionion Investment Services)
