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HOME NRI JOURNAL Takahide Kiuchi's View - Insight into World Economic Trends :
The Relentless Volatility of the Cryptocurrency Market and the Future of DeFi (Decentralized Finance)


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Takahide Kiuchi's View - Insight into World Economic Trends :
The Relentless Volatility of the Cryptocurrency Market and the Future of DeFi (Decentralized Finance)

Takahide Kiuchi, Executive Economist, Financial Technology Solution Division

#Market Analysis

#Takahide Kiuchi

Jul. 08, 2022

The volatility of the cryptocurrency (virtual currency) market refuses to abate. The value of Bitcoin—which had reached the high $60,000 range in November of last year—has recently dropped to the low $20,000 range, hitting its lowest level since the end of 2020. In addition, the total value of the cryptocurrency market has now shrunk from its peak of more than $3 trillion last November to no more than one-third of that amount. The emerging view now is that “winter has come” for the cryptocurrency market.

The collapse of the stablecoin TerraUSD was the trigger

What’s underlying this drop in the value of cryptocurrencies is the growing expectation of interest rate hikes by the US Federal Reserve Board (FRB). With ordinary transactions involving cryptocurrencies, even if one sees profits in the form of capital gains, these are merely retained like bonds and so one doesn’t earn any interest income (i.e., income gains). Therefore, when interest rates begin to rise, the relative appeal of cryptocurrencies versus bonds or other financial instruments will start to fall.
The collapse of the stablecoin TerraUSD (UST) in May which occurred amid these conditions has spurred a drop in cryptocurrency values. Stablecoins are a type of cryptocurrency whose value is pegged to some form of legal currency like the US dollar, and they were created to compensate for the drawbacks of traditional cryptocurrencies such as Bitcoin which are characterized by their high volatility.
Although UST was designed to maintain its value at $1 per coin, the loss of confidence in the currency broke its peg to the dollar, leading its value relative to the dollar to abruptly plummet down to 1/100th of that standard. Stablecoins had been regarded as secure assets in the cryptocurrency market, but now the myth of their safety has been shattered, and that’s had a massive impact on the market.
Three Arrows Capital, a dedicated cryptocurrency hedge fund that suffered tremendous losses from the collapse of UST etc., was ordered by a court at the end of June to dissolve its operations. This was because the company, which was contending with losses from the cryptocurrency market plunge, could not supply additional collateral or repay its lenders.
The American company Coinbase Global, which operates a major cryptocurrency trading platform, also announced that it was slashing its personnel numbers by 18%, even signaling that it would be revoking tentative job offers accepted by newly hired staff. Moreover, this wave of personnel cuts has begun to extend to other cryptocurrency exchanges. The cryptocurrency industry is truly showing signs of a financial crisis or a financial downturn.
The current decline in the value of the cryptocurrency market is now even being likened to the 2008 global financial crisis. There’s a growing concern being voiced that—if one were to take UST as the Bear Stearns of the cryptocurrency industry—something like the bankruptcy of Lehman Brothers might well be just around the corner. With the Lehman Brothers collapse, there were signs early on when such firms could no longer meet demands for additional margin deposits, and a similar situation seems to be developing in the cryptocurrency industry now too.

Taking on the appearance of a currency crisis

If we were to liken the relationship between UST and Bitcoin to the currency market, I believe it would closely resemble that between currencies that are dollar-pegged and relatively less reliable currencies that adhere to a floating exchange rate system.
UST is not asset-backed by the US dollar, and its peg was being maintained by means of algorithms. That proved to be a vulnerability—when this dollar peg became unsustainable, the decline in value of UST created something resembling a currency crisis. In a typical currency crisis, it’s quite rare for a currency to be adjusted to anything like 1/100th of its value, but one might argue that it’s because the intrinsic value of UST itself was unclear to begin with that the currency is now being hit with this dramatic plunge in valuation.
Meanwhile, even stablecoins like Tether that are asset-backed by the dollar are on slightly shaky ground now in terms of their link with that currency. That’s because there are doubts as to whether they’re sufficiently backed by the dollar. This situation resembles other dollar-pegged currencies for which there are doubts that the stated value of foreign currency reserves held can prop-up the currency when necessary.
Furthermore, cryptocurrencies like Bitcoin that aren’t pegged to any legal currency resemble currencies that operate under a floating exchange rate system. When major currency fluctuations occur under a floating exchange rate system, negative effects arise as that country’s trade, economy, and prices become unstable. However, it’s thought that when a floating exchange rate system is in effect, it’s hard for a anything like a currency crisis to occur. This is because exchange rate fluctuations always reflect changes in the economic fundamentals, never significantly diverging from them. Hence, there is a limit to how widely they can fluctuate in the short term.

Adjustments to the cryptocurrency market are different from those in the past

While the cryptocurrency market has undergone adjustment phases a number of times in the past, unlike those occasions, the adjustment this time could well be different in its severity. With the total market value of cryptocurrencies being greater now, and with market players now more diversified, it seems that the adjustment occurring at this stage could have a major impact extending in many directions compared to what happened in previous adjustment phases.
The Financial Stability Report released by the ECB (European Central Bank) in late May indicated the risk that the rapidly growing market for cryptocurrencies could pose a risk to financial stability in the future, and it strongly advocated for the need to enhance regulations and monitoring.
That same report showed that when we look at the ownership of cryptocurrencies by households in six major European countries, the percentage of households owning cryptocurrencies is at roughly 10%. It also showed that this ownership is U-shaped in nature, with high levels of ownership by low-income households and high-income households alike, as well as by households with low financial literacy and those with high financial literacy. The fact that so many households with low incomes and low financial literacy could very well become a social problem when prices fall, and it could even be a problem from the viewpoint of protecting private investors.
Meanwhile, the percentage of European institutional investors who own a certain scale of cryptocurrencies has also risen from 45% in 2020 to 56%. Given the growing interconnectivity between traditional financial instruments and cryptocurrencies, it’s even conceivable now that the expansion of the cryptocurrency market is increasing the potential risks to the financial system.

Will DeFi (Decentralized Finance) amplify market distortions?

With the Lehman Brothers collapse, strong expectations that real estate prices would go up led the prices of real estate-related securitized instruments to rise excessively, and this greatly shook the financial system. On the other hand, in the world of cryptocurrencies, there seems to be a sense in which the system known as DeFi (Decentralized Finance) is driving speculation and creating a bubble.
Based on the DeFi (Decentralized Finance) platform “Anchor Protocol”, UST had maintained an extraordinarily high 20% APY for deposits denominated in UST. So many billions of dollars in investment capital—drawn by the promise of this high interest yield—flowed in to the platform that this sudden influx caused UST to crash.
In response to the crash of UST, the cryptocurrency lender Celsius Network was even forced to freeze all of its client accounts worth several billion USD. Although the lender had promised high rates of return to those who had deposited cryptocurrencies like Bitcoin with it, because it had used those cryptocurrency deposits for making loans, the users who had made the deposits were unable to get them back. In the case of a bank, this kind of situation would produce a bank run that would then lead to bankruptcy.
Thus, we can see how the banking business of deposits and lending and systems equivalent to equity investments under DeFi schemes have played a role in amassing capital in the cryptocurrency market and significantly driving up prices.
And as for “safety nets”, which society has adopted based on experiences with bubbles in the past, nothing of the sort was ever put in place for cryptocurrencies. It was amid these conditions that people sought high returns, ones that couldn’t easily be achieved with ordinary financial transactions, and capital came streaming into cryptocurrencies. In a way that even amounted to a kind of “evasion” of regulations.

Can stronger regulations help restore confidence in cryptocurrencies?

Acting ahead of other countries, on June 3, 2022, Japan enacted the Revised Payment Services Act, the first law to regulate stablecoins. The major aim of this revision to the law is to enhance investor protections and countermeasures against money laundering.
Meanwhile, at a meeting on June 30 with the heads of agencies including the FRB and the SEC (Securities Exchange Commission), US Treasury Secretary Janet Yellen stressed the “need to continue to constructively engage in serious legislative efforts to promptly put in place a regulatory framework for stablecoins”.
It’s now become clear that the lending and deposit systems under DeFi—relying on cryptocurrencies that aren’t covered by regulations—involve factors that threaten to seriously distort the cryptocurrency market. If introducing regulations makes it possible to restore the stability of and confidence in the cryptocurrency market, one could expect that the innovation of DeFi will be able to develop in a sound manner, contributing to greater user convenience and increased economic efficiency.
The recent upset in the cryptocurrency market may ultimately serve to propel the healthy development of DeFi. However, the question of whether that will actually be the case depends in some sense on the skillfulness of the regulations crafted by the authorities.
While this current turmoil is being hailed by some as the beginning of a “crypto winter”, the fact is that the high-quality cryptocurrencies out there will endure this culling and survive, and new regulations will bring higher confidence in the market as a whole. Given all this, there’s also reason to take a more positive outlook on things, to see this period as one of “birth pains” that will form the foundation for the long-term development of cryptocurrencies and DeFi.

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