Can Crypto’s Disastrous Year Save It From Itself?

Cryptocurrencies have had a disastrous year littered with hacks, bankruptcies, and rapidly falling prices. What went wrong and are there any bright spots to look forward to in 2023?

Cryptocurrency markets hit an all-time high in November 2021, with the price of Bitcoin reaching a peak of $68,000, driven by enthusiasm for NFTs, play-to-earn games, decentralized finance (DeFi) and the amorphous concept of Web3, a blurry vision of a decentralized internet marketplace running on blockchain.

While the crypto takeover of the prestigious Super Bowl advertising grounds in early 2022 suggested that the industry was on the cusp of mainstream acceptance and sustained growth, some were already pointing to warning signs that the industry’s rise may not be as inevitable as others were imagining it to be.

When inflation picked up earlier in the year and the Federal Reserve started raising interest rates, proponents argued that Bitcoin could be a reliable hedge against rising prices. Goldman Sachs even labeled it “digital gold” in January, predicting it could replace the traditional safe haven for investors.

But the argument didn’t pan out, and in April, it became clear that major cryptocurrencies were sinking along with stocks, while gold was actually rising in value. By early May, Bitcoin had lost more than half of its value from its all-time high the previous year.

Then, in the second week of May, the first major crash in the sector set off a death spiral from which cryptocurrencies have yet to recover. The stablecoin Terra, whose price was supposed to be firmly pegged to the dollar, has started to lose value. By the end of the week, it was worth just 10 cents and its sister coin Luna became essentially worthless.

The bankruptcy wiped out an estimated $45 billion from the cryptocurrency market in just a few days. The risky approach Terra’s founders took to maintain its peg to the dollar was mostly to blame. While most stablecoins back their tokens with cash reserves, Terra relied on an arcane system of algorithms and game theory that was supposed to question investor behavior to ensure it always traded at almost exactly one dollar.

Many had criticized the plan as unfeasible in the long run and proved right. People were incentivized to hold Terra by a savings program called Anchor that offered 20% returns, but people started withdrawing after the organization decided to switch to a variable rate. This was followed by investors selling large amounts of land, which caused the house of cards to collapse.

The collapse of Terra has had a cascading effect on the broader cryptocurrency market. In June, the world’s largest cryptocurrency hedge fund, Three Arrows Capital (3AC), announced that it suffered heavy losses due to the Moon’s descent. By the end of the month, it defaulted on a $670 million loan from cryptocurrency broker Voyager Digital, and both companies filed for bankruptcy the following month.

Poor risk management practices and the incestuous nature of cryptocurrency trading (nearly all major cryptocurrency lenders had lent to 3AC) meant that the failure of this single entity sent ripples across the entire cryptocurrency industry. The summer saw a series of crises, with cryptocurrency exchanges and lenders halting withdrawals and companies filing for bankruptcy, most notably major crypto lender Celsius Network.

In the background, an ever-growing list of hacks on some of the biggest names in the industry was further eroding investor confidence. In October, pointed out the consulting firm Chainalysis there had already been more than 125 hacks in 2022, racking up losses of up to $3 billion and putting the year on track to be the worst for crypto hacks to date.

The coup de grace came in November, when the major FTX exchange went from a valuation of around $32 billion to bankruptcy in just a few days. An affiliated trading firm founded by FTX CEO Sam Bankman-Fried, was found to have actually used FTX customer deposits as collateral to invest in various crypto projects. When this came to light, people scrambled to withdraw their funds, resulting in a rush on the exchange that quickly depleted its reserves.

The bankruptcy of such a major player in the crypto ecosystem has driven prices even lower and is fueling ongoing “contagion” concerns as more firms disclose their exposure to FTX. By the end of the month, cryptocurrency lender BlockFi, which had been in discussions with FTX about a possible acquisition, also closed. All of this has left cryptocurrencies in a tailspin in late 2022, with some predicting more suffering to come.

But amidst the wreckage of the industry, there are still a handful of bright spots.

In September, the number two cryptocurrency Ethereum made an ambitious upgrade known as a Merge. The currency blockchain had previously relied on a security protocol called proof-of-work. Under the proof of work people compete to solve complex mathematical puzzles in order to get the right to verify transactions in exchange for a cryptocurrency reward. The merger has turned Ethereum into an approach called proof-of-stake, where people stake pieces of cryptocurrency as collateral in exchange for the right to verify.

The previous approach required so-called “miners” to run thousands of high-end computer processors, burning massive amounts of power to confirm transactions. This has led to concerns about the environmental impact of cryptocurrencies, but proof of participation could provide a solution.

The approach is still largely unproven, leading many to highlight the potential risks of the Merger. But the update has gone smoothly so far, and preliminary analysis suggests that power consumption has dropped significantly, perhaps pointing to a greener future for cryptocurrencies. Future changes could also allow Ethereum to execute more transactions at a higher rate and at a lower cost. More updates will roll out over the next few years, starting with the Ethereum blockchain splitting into a number of smaller databases, a process known as “sharding,” in 2023.

Among all the doom, some are also saying that this year’s cryptocurrency crash was a much-needed corrective to all the hype that had been building up around the sector and could go a long way in weeding out speculators and charlatans. Calls for regulation of the sector have also increased, which could help it become more sustainable in the long run.

Ultimately, despite the depth of the crisis, many in traditional finance think cryptocurrencies could rebound in 2023, even if it could be a slow and gradual recovery. Significantly, they predict that projects, such as Ethereum, that can be used to support practical real-world applications, rather than just financial speculation, will be the engines of growth in the next phase of cryptocurrencies.

Image Credit: Shubham Dhage/Unsplash

Add a Comment

Your email address will not be published. Required fields are marked *