Crypto’s Bear Market May Have a Silver Lining

The recent plunge in prices can reset investor expectations and shake out weak ventures, says NYU Stern economist Hanna Halaburda

The finance of cryptocurrencies and excange with graph analysis

The burst of cryptocurrencies into mainstream finance and public consciousness has given the latest crypto winter a particularly harsh chill. The May collapse of the Terra blockchain’s Luna cryptocurrency and associated stablecoin TerraUSD unleashed a broad shakeout. Several firms, including a prominent crypto hedge fund, a brokerage, and a crypto lending platform, have filed for bankruptcy while the overall market lost more than two- thirds of its value, or $2 trillion, before rebounding above $1 trillion in recent weeks.

The pain may be salutary if it awakens investors to the real level of risk and separates shaky ventures from useful innovation, says Hanna Halaburda, an associate professor of technology, operations, and statistics at New York University’s Leonard N. Stern School of Business.

Halaburda, who focuses much of her research on the microeconomics of the sector, believes most cryptos are high-risk investment vehicles rather than digital currencies, and they have multiplied beyond any likely sustainable number. The market shakeout also has cast light on the degree of centralization in the supposedly decentralized world of crypto, which investors and regulators need to take into account.

She spoke recently with Larissa de Lima, a senior fellow and co-lead of the Oliver Wyman Forum’s Future of Money Initiative.

What do you make of the recent volatility in the cryptocurrency market?

It’s definitely an earthquake, but it is about as surprising as an earthquake in San Francisco. We have been saying that crypto is volatile. The market did not want to listen. We knew that a lot of the algorithms and protocols were set up in a very experimental way, sort of trial and error. We knew that whenever there is a bad event, it’s going to cascade.

Even if Terra would not have fallen, the fact is we may be facing a recession, and interest rates are increasing. A lot of investors are taking money away from very risky assets and putting it in safer assets. With crypto, if investors lose confidence, there is very little fundamental value. So I am not surprised that it happened. It must be very, very painful for investors. It’s great for researchers.

What are the big questions for researchers to explore now?

We can basically stress-test vulnerabilities in the system. It will be good for our understanding and better for the market. It will be like the dot-com bust – better business models will survive, bad business models will not.

One vulnerability we haven’t seen yet, but we expect theoretically, is the potential double-spending problem for Bitcoin. It’s not impossible to change the Bitcoin ledger and spend the same coins twice, it’s just really expensive. How expensive is directly related to the cost of mining, and the cost of mining is directly related to the cost of the coin. If Bitcoin is very, very expensive, it is very, very expensive to attack. This is why crypto whales, who own a lot bitcoin, may have an incentive to make sure the price is high. If the price were to fall well below $20,000, you would have a lot of idle mining power because it wouldn’t be worth it to mine. That would make it possible, in theory, for an attacker to gain control of 51% of the network’s mining power and double spend. If we experience that, I think any trust in Bitcoin’s investment value is going to disappear.

Will the fallout lead to greater market concentration in crypto?

We like to see cryptocurrencies as a means of payment, but most are not. A means of payment is like language, and you have a tendency to move toward a winner-take-all situation because it makes trading easier. This is why you have different ones for different uses – Bitcoin for transactions, say, and Ether for smart contracts.

Most cryptocurrencies are investment vehicles. If we treat them that way, people may want to bet on the asset that seems underpriced. We are never going to have 4,000 of them being active investment vehicles, but it could be something like 2,500. As currencies, it would probably be around 20.

What about the impact on DeFi more broadly?

Before the crash we were seeing all sorts of derivatives and synthetics based on cryptocurrencies. Like in the great financial crisis, as you start creating composites of those assets, any assessment of value or pricing is not accurate, and they are more likely to fail. Once you start building whole structures on top of cryptocurrencies, those structures are subject to bank runs, whereas Bitcoin itself or Ethereum itself is not.

Regulation serves a purpose. You have a contingency plan in case something bad happens, and if you don’t and everything fails, somebody steps in and provides some help. If you innovate in a completely decentralized way outside of regulation, then structures fail spectacularly if they fail.

Are you persuaded that decentralization itself creates value in DeFi?

I do like this idea of uncurbed innovation. If you are aware of the risk, you can say let me see what people are tinkering with and what kind of problems they think they are solving.

I’m a big fan of liquidity pools where you can get liquidity from small players that aren’t able to do so in a traditional market. You can see where the value is coming from. But if the selling point of a DeFi is we can give you a higher yield and you have no idea where this yield is coming from, well, that’s shady. As long as you think it’s a casino and you take $100 and play until it’s gone, that’s fine. But if you think this is a plan for your retirement, then it’s a problem.

Does the recent turbulence demonstrate a need for regulation, and if so, what would your priorities be?

There is an obvious need for customer protection here, especially in areas like fiat-backed stablecoins and exchanges. But regulation is useful only when it can be enforced. This is a particular challenge in permissionless blockchains, where malicious agents can hide behind a protocol launched from anywhere in the world. We see many smart contracts offering Ponzi schemes that are already illegal, and front-running on decentralized exchanges. Adding more rules that will be too difficult or costly to enforce may lead to a false sense of security. A better approach would be to make crypto regulations attractive so that protocols see voluntary compliance as valuable. Of course, that would require a change of perspective from regulators.

Will permissionless blockchains like Bitcoin, where anyone can be a miner and verify transactions, prevail over permissioned systems favored by many corporations and governments?

I expect permissioned blockchains will grow much more prevalent, especially among industries dealing with non-digital goods, and governments. Permissionless blockchains have unique qualities to offer and may coexist, but they are very expensive to run in a truly decentralized way. Also, concentration in a permissionless system is less trustworthy than in a permissioned system.

What is a desirable level of centralization or decentralization in crypto?

We need to distinguish between distributed and decentralized. Whether a network is distributed or not refers to its architecture, while decentralization refers to decision making. Most big tech companies use distributed databases, but they aren’t decentralized because decisions are taken within one company.

Decentralization is not binary. Is a measure of decentralization how many parties are making decisions? How many parties can override the decision? Is it just how many, or is it their relative weight that matters? In the Bitcoin network, for example, the computational power is not evenly distributed. The issue of centralization is similar to that of concentration in any industrial market. We worry that too much concentration will give the parties excessive market power, and they will extract too much rent from the users.

What does this mean for central bank digital currencies (CBDCs) and the kind of systems central banks might want to adopt?

CBDCs have very little to do with blockchain and cryptocurrencies. They are digital currencies. They will need to have a distributed data base. If it’s going to be on a blockchain, which is not the most efficient solution, it will be permissioned. But it is always going to be centrally managed.

It’s not clear how CBDCs will be distributed to people. It’s not clear whether the benefits outweigh the costs given that people who are already banked have an abundance of access to digital currency. It’s also not clear if CBDCs are going to fix international transfers because they will still be national currencies. This is why the debate on CBDCs has been running for years, and we still are not getting a good design.

That said, all this experimentation in DeFi and crypto offers inspiration of what can be done, provides much more technical knowledge, and it tests what people are ready for. No government wants to introduce money that will not be used.