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Spring is on the way for Web 3.0 after a long, cold winter in crypto

The economy first overheats, and then Wall Street experiences winter. January was especially bad for the forward-thinking investor, and February could be even worse. According to the New York Stock Exchange’s FANG+ index, big tech stocks were down nearly 8% at the end of last month — and that was before shares of Meta Platforms Inc. (the company formerly known as Facebook) fell off a cliff last week.


The crypto winter has been even colder than usual. Bitcoin (BTC or XBT if you prefer the official ticker) has fallen 12.5 percent since the beginning of the year; despite a rally on Friday, it is still down 40 percent from its all-time high of $67,734 in November 2021. If you purchased Ethereum at the peak ($4,799 on November 9), you are down 38.5 percent. Only meme stocks such as GameStop Corp. (down 31% since the start of the year) and Robinhood Markets Inc. (down 78% in six months) have been hit as hard. Oh, and don’t forget Facebook, which has dropped 34% in the last six months.



Retro investors, on the other hand, have had a fantastic start to the year. Oil (Brent Crude) rose by 19% in January, outperforming Bitcoin. Long coal was one of the trades of 2021: if you bought Peabody Energy Corp. (BTU) a year ago, you’d be up 252 percent. That’s the end of COP26 and the Green New Deal. Long the past, short the future appears to be the winning trade of the post-pandemic era.


Because the usual suspects have been tweeting about it, you can tell it’s a bear market for crypto. (On the way up, they’re always quiet.) It doesn’t get much better than Nouriel Roubini tweeting a Business Insider storey headlined “Economist Paul Krugman says there are ‘uncomfortable parallels’ between the recent crypto slump and the subprime mortgage crisis.” Sorry, but this does not appear to be a relevant historical analogy.


That’s not to say the crypto winter won’t bring more chill, if not the polar vortex or bomb cyclone imagined by Roubini and Krugman. How much lower can Bitcoin fall? It’s worth remembering that after the price of Bitcoin peaked during its first bubble — at $1,137 on Nov. 29, 2013 — it dropped by 84% to $183 just over a year later, on Jan. 14, 2015.


This pattern was repeated four years later, when the price peaked at $19,041 on December 17, 2017 and fell to $3,204 a year later — a drop of 83 percent. If history repeats itself exactly, the price would fall to a low of $11,515 this November, 83 percent lower than its peak in November of last year.


However, such a drop appears improbable for two reasons. First, Bitcoin is a much larger asset than it was in the 2010s, with a market cap of just under a trillion dollars last year. The adoption by individuals and institutions, which I predicted in the updated edition of “Ascent of Money” in 2018, is proceeding apace. The hedge funds were the first to appear. Then there were the banks. The sovereign wealth funds, pension funds, and large endowments are now sniffing around. Sooner or later, a respectable central bank will admit to holding some Bitcoin in its reserves, and financial journalists will pay less attention to El Salvador’s bizarre experiment to make Bitcoin legal tender alongside the US dollar.


Second, while Bitcoin is still a highly speculative investment, it is less speculative than it was a decade ago, according to 30-day volatility and institutional adoption measures. Some institutional investors have long time horizons, measured in years, such as pension funds that have become limited partners in crypto hedge funds or venture funds. Crypto newcomers who bought at the peak of the market will almost certainly retreat to lick their wounds. More sophisticated players, on the other hand, will want to buy the dip.




What exactly is going on here? This is clearly more than just a crypto winter. Part of the metanarrative (sorry, couldn’t help myself) appears to be pandemic-related. People are eager to return to the real world after two years of Covid restrictions: real ballgames, real shopping, real travel, and real gyms. Companies like DoorDash Inc. (-45 percent in six months), Zoom (-64 percent), and Peloton Interactive Inc. (-80 percent) could not have expected demand for their services to remain stable as stir-crazy Americans adjusted their behaviour from pandemic to endemic conditions.


At the same time, the tight labour market in the United States is likely to have driven up costs for technology firms more than for others. It’s difficult to find a top engineer in Silicon Valley these days. According to rumours, almost every graduating computer science major at Stanford has already accepted an offer from Meta. Finally, it’s possible that people aren’t interested in the metaverse as envisioned by Mark Zuckerberg — or that they believe they already have it (it’s called the internet).


Many thought it was a brilliant move by the Facebook founder to save his company from an oncoming army of antitrust hipsters and disgruntled politicians when he first announced it. But I don’t believe his plan was to avoid antitrust lawsuits by ceasing to be profitable. No amount of rebranding can change the fact that Facebook is out of date (ask any teenager), TikTok has eaten its lunch on viral video content, and the days of the Facebook-Google duopoly on online advertising are over.


However, if you look closely, you’ll notice that Wall Street’s winter has barely touched other major tech firms. Microsoft Corp. is up 6.8 percent from August of last year, Alphabet Inc. is up 6.0 percent, and Apple Inc. is up a whopping 17.3 percent — it’s Springtime for Tim Cook in Cupertino. So this is far more complicated than a simple shift from “growth” to “value,” or from technology to the real world.


The tightening of monetary conditions by central banks is clearly the dominant force in financial markets today. Interest rates have already risen in some countries, such as the United Kingdom. Rate hikes are almost certain in other countries, most notably the United States and the European Union, in the coming year. The stated reason for these hikes is that inflation has risen over the past year as a result of massive fiscal and monetary expansion in response to the pandemic, combined with supply-chain and labor-market disruptions that caused shortages of goods and workers (as predicted here last March).


The Federal Reserve Chairman, Jay Powell, was not the only central banker to underestimate the inflation risk, but his are the words that future historians will remember. “Frankly, we welcome slightly higher… inflation,” he said a year ago to the Financial Times. “The kind of troubling inflation that people like me grew up with appears unlikely in the domestic and global context we’ve been in for a while.”

In just 12 months, we’ve gone from “What, me worry?” to “Five rate hikes priced in.” Not to mention a much faster taper of asset purchases than in the post-global financial crisis period, as well as the real possibility of quantitative tightening, i.e. a reduction in the size of the Fed balance sheet.


Powell’s transformation from Alfred E. Neuman to Paul Volcker is the primary reason for Bitcoin’s price decline. This is because Bitcoin was very appealing when the Fed appeared to be on a recklessly inflationary path: Remember, it soared from $4,904 on March 16, 2020 — when Wall Street finally realised the magnitude of the disaster Covid would cause — to nearly 14 times higher in November of last year. (That must have been peak FOMO for the country’s professional crypto-haters in economics departments.) The long-Bitcoin trade is less appealing now that the Fed has turned hawkish on inflation.


Bitcoin is now primarily regarded as “digital gold” (or, to be more precise, an option on digital gold, as it could conceivably fall to zero if the entire era of digital finance is brought to an end by rampant cyberwarfare or China achieving “quantum supremacy”). “Bitcoin’s core value proposition, and technological innovation, is digital scarcity via a public, decentralised ledger that tracks a fixed supply of 21 million bitcoins,” my Hoover Institution colleague Manny Rincon-Cruz argued in a brilliant essay last month. Investors prefer scarcity to the potentially infinite supply of fiat currencies, as demonstrated by the pandemic.


According to Rincon-Cruz, Bitcoin today is filling the role that gold did in the 1970s. During the inflationary 1970s, the price of gold nearly tenfold from its low in 1970 ($256) to a peak of $2,348 in February 1980. However, gold plummeted following Paul Volcker’s appointment as Fed chairman in August 1979 and the rate hikes he imposed to combat inflation (the Fed funds target rate rose from 10.5 percent when Volcker took over to 20 percent seven months later). By January 1985, the price had dropped below $800 once more.


Jerome Powell, of course, is no Paul Volcker. Markets saw him blink once before, at the end of 2018, in the face of a stock market selloff. Nonetheless, the Fed appears to be far more constrained than it was in January 2019, when Powell effectively abandoned the effort to normalise monetary policy. Inflation was non-existent at the time, whereas the most recent CPI print (7 percent) was the highest since 1982, the year Volcker’s “regime change” was successful and inflation expectations fell.


However, this does not imply that interest rates will return to 20%. This is due, in part, to the obvious fact that inflation is unlikely to reach the eye-watering levels seen in the second quarter of 1980, when it surpassed 14 percent. But there’s another, more important reason. Yale economic historian Paul Schmelzing recently argued for “supra secular stagnation” — a multi century tendency for interest rates to fall — in his seminal work on the long-run history of interest rates.

Recent debates about “secular stagnation” as an explanation for falling nominal and real interest rates, according to Schmelzing, have focused too much on the recent past — specifically, the period since Volcker’s war on inflation. Schmelzing’s reconstruction of public and private interest rates since the 14th century reveals a much longer-term trend of declining rates.


“Global real interest rates have… followed a ‘gentle,’ persistent trend decline, at a level of 1-2 basis points per annum over [five] centuries,” Schmelzing writes. Negative real interest rates, he contends, have been far from uncommon since the Renaissance. “Global real interest rates at the zero lower bound are fully consistent with deep historical trends — in the long run, interest rates over the last four decades have in fact [reverted] back to trend after reaching unusually elevated levels in the context of the oil shocks.”




Over half a millennium, whichever government was seen as providing the safest asset — typically a bond paying a fixed annual amount — could pay relatively low nominal rates and, in some cases, negative real rates.


According to Schmelzing’s research, Americans should not expect real interest rates to rise as high as they did in the early 1980s, when the 10-year rate, adjusted for inflation, reached as high as 7%. Indeed, even after five 25-basis-point Fed hikes, rates are likely to remain negative throughout the year. It would take a far greater disaster than a mishandled pandemic to sully the United States’ reputation as the issuer of the safest financial asset in a world awash with savings looking for a guaranteed return. (According to Schmelzing, the accumulation and abundance of capital is the primary force driving down rates, with destructive events such as major wars only temporarily pushing them upward.)


Of course, the cryptocurrency selloff is about more than just inflation fears. An important point to remember is that, as has been the case throughout the history of bubbles, the most speculative investors have been buying on margin, using leverage in the hope of maximising gains. As of Feb. 2, the three largest margin-lending crypto protocols — Maker, Compound, and Aave — had $9.3 billion, $3.5 billion, and $4.5 billion in outstanding margin loans, for a total of $17.3 billion. This is a decrease of 24% from the peak of $22.7 billion in early December 2021, but an increase of more than 370% from the previous year.

On the way up, margin buying works wonders. It has the potential to cause havoc on the way down, which usually begins when interest rates rise and credit conditions tighten. The crypto market correction in January triggered margin calls and collateral liquidations, prompting Maker’s founder and others to debate on Twitter how to notify a user called “7Siblings” that approximately $650 million in Ethereum was about to be liquidated if he, she, or they did not quickly post some new collateral. Another user discovered 7Siblings’ wallet on Aave and discovered that it held $75 million in stablecoins. 7Siblings finally awoke (or sobered up) and were able to salvage the majority of the situation.

You might think this is a typical crypto bro storey. However, it is not about Bitcoin, but about Ethereum. According to Rincon-Cruz, the two should no longer be grouped together under the anachronistic label “cryptocurrency.” If Bitcoin is fundamentally an inflation-hedging asset due to its guaranteed finite supply, Ethereum and its imitators (for example, Solana) provide something different: the possibility of re-engineering the financial system on the basis of “smart contracts.” According to Rincon-Cruz, Ethereum debuted in 2015 as a “world computer” capable of executing code across a decentralised network of machines. Smart contract protocols and their tokens, on the other hand, had yet to bear fruit until 2019. Because all crypto assets had to offer was digital scarcity, their prices mirrored Bitcoin’s. While non-fungible tokens (NFTs) and meme coins are built and launched on top of smart contracts, their value proposition remains digital scarcity as digital collectibles or more volatile versions of Bitcoin.

Much more important than NFTs are the various open protocols known as decentralised finance, or DeFi, which include not only margin lending (as discussed above), but also on-chain markets and automated investment strategies.

Rincon-Cruz compares “Web 3” (the trendy new name for cryptocurrency) to “Web 2,” the commercialization phase of the internet. The dot-com bust of 2000 appeared to vindicate everyone who had been sceptical of e-commerce during the 1990s bubble, just as the latest crypto selloff has vindicated those who dismissed the last few years as another tulip mania.

True, many of the early DeFi experiments were little more than initial coin offerings (ICOs) accompanied by shoddy white papers. A number of them were obvious swindles or pranks. However, just as sceptics missed the beginnings of Big Tech in the aftermath of the dot-com bust, today’s crypto haters are missing the beginnings of a major financial system disruption in the form of DeFi. Rincon-Cruz uses Uniswap, the largest on-chain decentralised exchange protocol, as an example.

I agree with this argument for two reasons. First and foremost, the existing global and national financial systems are ripe for disruption. Banks, credit card companies, and money-transfer companies, for example, charge exorbitant fees to both consumers and merchants. (I speak with the resentment of someone who has to send monthly payments to family members in East Africa, a large portion of which goes to Western Union.) But there are numerous other examples, such as the usurious interest rates on credit card debt or the overdraft fees levied by banks.)

Second, DeFi appears to be a genuine financial revolution, leveraging new technological possibilities to reduce transaction costs in novel ways. Sceptics are quick to point out that Ethereum isn’t money in the traditional sense (a store of value, a unit of account, a means of payment). This completely misses the point. Let us return to financial history.

Following the Black Death in the mid-14th century, severe labour shortages weakened the feudal system in which serfs worked the land as serfs and paid rent “in kind,” with shares of what they grew. There was a shift to a more monetized economy in England and northern Italy, where an increasingly mobile workforce could insist on cash payment. The problem that plagued Europe’s mediaeval and early-modern economies was a scarcity of high-quality coinage.

The faulty monetary system of the time posed particular difficulties for merchants seeking to conduct trade over land or sea. They got around it by inventing the revolutionary financial innovation known as the bill of exchange — a simple piece of paper that extended credit from one merchant to another, usually for several months, corresponding to the time it took for an item to be transported from port A to port B: in effect, an IOU. (An example from 1398 is available here.) Bills of exchange became negotiable over time, which meant they could be sold to third parties. This credit system was founded on the signatures of merchants.

It is important to note that bills of exchange were not money in the traditional sense. Nonetheless, they constituted a type of peer-to-peer credit that was critical to the development of European commerce from the late mediaeval period to the nineteenth century. It’s also worth noting that there was no need for third-party institutions to verify or process transactions: discount houses emerged much later. In other words, at a time when cheap paper was revolutionary information technology, the system of late-mediaeval trade finance was the closest thing to decentralised finance that was possible.

Economists have been generally uninterested in cryptocurrency, if not outright hostile to it. I suspect this is because their discipline implicitly prefers that financial intermediation structures remain static in order to avoid overcomplicating the mathematical models they adore. Financial history, on the other hand, enables one to discern both long-term price trends and market revolutions. That is why I am so proud to have taught some of the next generation’s most promising financial historians, including the two scholars whose work I mentioned above.

Using financial history as a guide, I believe this crypto winter will end soon. It will be followed by a spring in which Bitcoin maintains its steady progress toward becoming more than just a volatile option on digital gold, but dependable digital gold itself; and DeFi defies the sceptics by unleashing a financial revolution as transformative as the Web 2.0 e-commerce revolution.


Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.

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