Every few years, it happens again. Cryptocurrencies suddenly experience big price jumps. When the time comes again, it doesn’t take long for many people to try their luck with them. The newspaper headlines then talk about quick money, about fortunes that are created virtually overnight. Every:r knows someone who knows someone who has made a lot of money with it. This makes many people want to venture into this new field as well. And there they are already joyfully awaited – by people who develop interesting technologies for them, but also by people who are only after their money.
Once again, the high was followed by the valley of tears. The crypto market generated a phase of hype, exaggerated expectations, hope and hubris. But that can only go so well for a certain amount of time. Now, prices have once again plummeted massively, and many people have either burned their fingers or are experiencing an even worse fate.
The first domino falls
Things are already starting to crumble in the crypto market in early 2022, with prices moving away from their highs. The overall economic situation deteriorates, inflation rises. But then it all happens quite suddenly: the Terra Luna stablecoin project almost completely implodes within a few days. Billions of dollars disappear within a very short time.
Stablecoins are actually cryptocurrencies with stable prices that are based on other assets. The most common use case is a 1:1 mapping of the US dollar. This creates digital representations of the dollar on the blockchain and thus makes them usable for special trading platforms (smart contracts), for example. The crypto market simultaneously receives a stable store of value away from price speculation. In most cases, real USD currency units are stored for this purpose and the equivalent value of these is issued in a stablecoin, so that full coverage of the stablecoin is maintained as well as can be exchanged back for dollars at any time.
The broken DeFi promise
The crypto scene lives the idea of decentralization – one would think. This is expressed in the self-management of its digital assets and a skepticism toward banks, financial companies and states. Third parties, middlemen, generally (financial) intermediaries should not have to be trusted.
Instead, we rely on cryptographically verifiable truth and build the decentralized financial system or DeFi for short on it. Based on technology, an alternative to the traditional financial system shall be established. This is based on high security, transparency and a lot of mathematics. With blockchains, there is no need to trust. You organize yourself in a decentralized network, which sets the rules and guarantees the truth. “Don’t trust. Verify.” (“Don’t trust. Verify.”) is a core part of the philosophy behind cryptocurrencies.
On paper. Or maybe still, if you’re just talking about Bitcoin alone. Away from that, this mantra has become less and less important in the crypto market in recent years. It has been replaced by more and more companies that have taken up the mantra of decentralization, but in reality are hardly distinguishable from classic banks, financial companies or FinTechs. They are in fact centralized financial companies – and thus CeFi instead of DeFi.
Thus, the decentralized financial system that was supposed to be established via blockchain technology has increasingly become a market dominated by centralized companies. And while blockchain is characterized by the fact that all actions in the network can be traced by all participants – with the identities of the people behind the actions protected by cryptography – this category of companies is characterized above all by the fact that they can operate in a non-transparent manner while operating in a poorly regulated market. To interact with them, people need to trust again. And that trust has been betrayed by many of these companies.
Crypto is a complicated market
In 2021, cryptocurrencies reached their highest market capitalization ever. And while moving along the sunny side, wide shadows were cast: The high degree of self-management of assets in the crypto market, coupled with the complexity of its use, makes people who move into it an attractive target for criminals. More than $12 billion was stolen by hackers, thieves and fraudsters in 2021, according to a report by compliance firm Elliptic. The blockchain analysis company Chainalysis, on the other hand, estimates the damage from attacks on cryptocurrencies, DeFi, NFTs and Co at over 14 billion dollars. However, these figures are once again dwarfed by how many companies in the crypto market ended up in insolvency due to certain activities and a constant lack of risk management, thus dragging the assets entrusted to them down with them.
The risk that is actually associated with such companies can hardly be assessed by average users. In the meantime, one would actually have to be familiar with technology, finance, trading, law, taxes and, more recently, digital art at the same time in order to find one’s way around. Of course, such a level of understanding is only available in the rarest of cases – and even then often not enough.
The great mass of people who move into the various corners of the crypto market therefore rely on people and companies in whom they place their trust. They often trust influencers or self-proclaimed experts with questionable intentions. The trust of users is bought with beautiful websites, professional marketing and high promises of returns. About the associated. Of course, there is a lack of classic bank advisors with strict professional duties in the crypto market.
The show of the “crypto bros”
Non-transparent investments or “savings plans” with cryptocurrencies were offered with interest rates that are not even possible in the traditional financial system. Instead of wondering how these returns were achieved, crypto-bros patted themselves on the back for having found such a good investment. However, those opaque companies that have made inroads into the decentralized financial system have had to take high risks in order to generate a return on the assets they have been given that justifies offering a “savings plan” with, say, an 8 to 12 percent interest rate. In times of zero interest rates, that sounds nice, unless you know how risk and return are related. Thus humans, who wanted to save or increase simply only their money, became unintentionally unbesichterten Kreditgeber:innen of a hochriskanten speculation machinery.
Meanwhile insolvent “DeFi” companies like Celsius or Voyager Digital gave the appearance of not being fundamentally different from the philosophy of the decentralized financial system. By now we know: They were high-risk investors who either lost the users’ money themselves or – even easier – were relieved of it by hackers. Most users were unaware of this until the insolvency. All they saw was the equivalent value of their assets, displayed on the website of the alleged DeFi company. The crypto market, which functionally very often operates closer to the social sciences than to finance, ultimately collapsed because of these companies. Even cryptocurrencies, which in themselves have no reason to drop in price, cannot withstand the social forces in a panicked market. The hype phase is now followed by a long period of reflection.
The recent case of the insolvency of the world’s second largest crypto exchange FTX and its sister company Alameda Research should bring to light the loss of customer funds of probably $8 to $10 billion. Authorities are now unraveling a scheme through which more than a million user:s and 60 investor:s were fraudulently deceived. Celebrities such as American football player Tom Brady, television personality Kevin O’Leary, and fashion model Gisele Bündchen lent their credibility to FTX in order to gain people’s trust. The assets given in trust were then invested in luxury real estate in the Bahamas, among other things, or used to plug holes in the balance sheets of the – yet not as brilliant as assumed – people behind these companies, who were able to attract some of the biggest names in the traditional financial system as investors.
The full extent of the FTX bankruptcy will only become fully apparent in the coming months to years. At the same time, the reputable elements of the crypto market, as well as public institutions that are supposed to regulate them, must now rebuild the foundations. They are now bearing the consequences of this misery without being much to blame for it.
What crypto needs in the future
So the cryptocasino is now closed again for a time. In the next few years, insolvency administrators, politicians and regulators will be busy trying to figure out how to prevent such events from happening in the future. Regulation cannot solve all problems, of course, but it can create a floor that makes such activities much more difficult.
The traditional financial system is also highly regulated because a certain amount of expertise is required to invest assets. It is regulated because negative actors can do great harm to a market and the people in it. And it is highly regulated because there will always be people who want to exploit others’ lack of know-how for their own benefit. Financial education, which has been neglected in the school systems of many countries in recent decades, while actually becoming more and more important, also helps against this. The graduates of these schools now have to pay for their education out of their own savings in real life.
It is to be hoped that important lessons will be learned from these events and that, despite all the adversities, this fledgling market can one day develop into a serious economic sector that offers people better financial inclusion and more opportunities. In any case, reliance on institutions is not necessary for this to happen. What is needed is for the crypto market to be taken seriously and for more emphasis to be placed on education in the future – making it easier to separate the wheat from the chaff.