Cryptos’ Meltdown

Ingenuism 49

We’re sorry.  Since our last newsletter the S&P500 has fallen over 20%.  The Nasdaq is down 27%.  Bitcoin has plummeted 55%.  Even Treasury Bonds are down 15%.  Clearly Ingenuism was the only thing holding up a slew of teetering markets!

Our writing pause was unavoidable - a health issue in Robert’s family and a job opportunity for Don meant we couldn’t continue propping up asset markets.  But enough is enough so we are back, hoping to staunch the bleeding.  Not investing advice!

And our topic is markets - WTF happened?  Has that much really changed in 3.5 months?  What is going on in the markets?

To understand, we need a realistic model of how market prices are set, in particular for volatile assets.  So, this essay considers - “How did cryptocurrency prices spike so high and then fall so fast?” and “Do these wild swings mean that market prices are mostly random?” 

Sure, inflation, rising interest rates and recession fears could explain crypto prices dropping, perhaps comparable to the Nasdaq – but why is crypto down more than twice that?  Gold is up for the year – why has digital gold, Bitcoin, plummeted?

Well-functioning markets are Ingenuism on steroids, connecting people, enabling experimentation, and providing feedback.  New product?  The market will tell you if you’ve created a home run.  New investment strategy?  The market will show you very quickly if it works.  This phenomenon is called price discovery and it is a critical ingredient for progress.

In the very early stages of price formation a market’s discovery mechanism can have an Achilles heel – and then you get the wild price movements that we’ve seen in crypto lately (but are as old as markets themselves).  Swings that are not driven by fundamentals – crypto’s long-term prospects haven’t changed vastly in recent months any more than dot-com companies suddenly reversed between March and May of 2000 – swings that happen as the market moves from one pricing equilibrium to another.

Market prices represent an equilibrium.  Transactions create market prices – the price of Bitcoin is the price where at any moment some people are happy buying Bitcoin while others are happy selling it.  If everyone wants to buy (sell) Bitcoin, the price rises (falls) until there are both buyers and sellers.  Market prices find a happy medium not where people agree – remember someone is buying because they view the price as low while another is selling because they view the price as high – but where people are split and balanced.

Novel things, whether they are internet stocks or cryptocurrencies, are subject to wide uncertainty and significant disagreement over what they are really worth.  This creates a unique market dynamic.  Prices still move to where there are willing buyers and sellers, but who those buyers and sellers are can matter a lot.  And when who they are shifts, prices can move drastically without a clear change in fundamentals or even any resolution of eventual value.

Let’s use Bitcoin as an example.  We could use any novel sector but there isn’t a better example than crypto.  To make things simple we will have the world divided up into five camps based on their level of enthusiasm for Bitcoin’s prospects.  There are Bitcoin evangelists (Michael Saylor at MicroStrategy might fall in this category), Bitcoin believers (Elon Musk might fall in this category), Bitcoin curious (you might fall in this category), Bitcoin skeptics (I fall in this category) and Bitcoin haters. 

People can move to adjacent categories (and Bitcoin’s rise happened as more people evolved into Believers and Evangelists) and will move if Bitcoin’s prospects clearly change.  To keep things simple, let’s assume new information and people’s enthusiasm for Bitcoin both tend to evolve (both up and down) slowly – that is, neither information nor investor emotions are causing prices to jump or tumble.  So, despite wild price swings over the past year, Bitcoin remains Bitcoin and Evangelists/Believers are not throwing in the towel – how can prices change so rapidly?

Let’s say that Bitcoin evangelists are happy to trade Bitcoin around $60,000 – that is some Evangelists are eager to buy Bitcoin and some are reluctantly willing to sell.  No Believers are buying at this level (if they were, they would be Evangelists) but they are not necessarily selling (for various reasons including taxes).  Nobody else is trading Bitcoin or likely even holding it (to them the $60k price seems crazy).  Evangelists happily trade Bitcoin back and forth at prices ranging from $55-65k.  This is Oct/Nov 2021.

But as time passes Evangelists get less interested in buying Bitcoin at $60k and more interested in selling.  Why would this happen, given that they are Evangelists?  In this model it wouldn’t if the crypto world were static, maintaining scarcity.  Bitcoin is designed to be scarce but crypto as a whole is not – to the contrary constantly creating and experimenting with various crypto protocols is part of the ecosystem’s DNA (and what makes it special).

As new coins and protocols are introduced Bitcoin evangelists get less interested in buying Bitcoin at $60k.  They still love Bitcoin, but many of them are broad crypto enthusiasts and they naturally gravitate towards new opportunities that down the road might mimic Bitcoin’s past ascent to $60k.  That is, their evangelism doesn’t fade but it gets diluted.

With more Evangelists selling and fewer buying, you need the Believers to balance the market.  But Believers are only happy buying (and selling) Bitcoin at, say, $40k, so prices reset down.  Certainly, this drop brings back some of the Evangelists but they have only so much money and are increasingly focused on the much larger potential upside in other coins/protocols.  Note that no fundamentals change, just new coin/protocol opportunities are introduced faster than Believers are converted to Evangelists.  Bitcoin is off its highs but crypto is generally thriving as it trades among Evangelists and Believers.  The Bitcoin curious, skeptics, and haters are largely uninvolved except to the extent that some of the Curious evolve into Believers.  This is Dec 2021 through March 2022.

At this point Bitcoin prices could pop back up to Evangelist levels if enough Believers evolve into Evangelists (without their interest being diverted to other protocols) to balance buyers and sellers around $60k.  But a shock to the system could also reset prices down to the level, say $25k, where the Curious set prices.  A series of shocks might knock prices down to $15k where Skeptics are divided, willing to both buy and sell, and setting prices.  Evangelists and Believers remain in both of these cases, but they are no longer setting prices. 

This is, I believe, roughly where we are now, with the caveat that obviously there are not just five buckets to describe investors’ Bitcoin views.  The Terra/Luna collapse provided the first shock and Celsius (and other crypto lenders) are the second.  Note that in this model Bitcoin’s prospects didn’t deteriorate 70% while its price fell 70%, and that we still don’t know what price Bitcoin’s prospects truly warrant.  All of that is yet to be resolved!  Instead, we experienced rapidly shifting pricing equilibria, both up and down, with the Fall 2021 peak undercut by a growing supply of crypto projects/protocols.

Eventually Bitcoin’s true prospects will become clear and prices will settle down to reflect them.  In the meantime we can expect periodic bouts of extreme volatility interspersed with periods of seemingly calm.

Our simple model captures the core of how markets price novel things and why they often lead to booms and busts.  You can make the model richer to deal with things like why Skeptics and Haters aren’t shorting Bitcoin at $60k (it is hard, expensive and risky) and why Evangelists and Believers aren’t loading up on Bitcoin when it falls to $20k (they are capital constrained after having lost a bunch of money) but shifting pricing equilibria due to wide uncertainty and significant disagreement accounts for the booms/crashes when the next big thing emerges.  To a large extent the same thing happened to pandemic darlings like Zoom and Peloton where like crypto investor opinions differed in fundamental ways, not just the details.

So, what happens next in crypto?  Here at Ingenuism we are committed to inventing and discovering the future, not predicting it!  But discovery is not blind, and we can glean clues from history.  For crypto the late 1990s internet boom seems like a good analogy.

In the late 1990s enthusiasm for the prospects of the new internet sector corresponded to soaring stock prices and a massive influx of capital.  New internet companies were created rapidly – not at crypto’s speed but shockingly quickly.  Pets.com was founded in Nov 1998, went public 15 months later, and went bankrupt nine months after that in Nov 2000.  Full circle of life in two years!  The flood of new internet stocks in the late 1990s diluted the internet Evangelists, sparking the move to lower pricing equilibria. 

While internet companies like Google and Amazon, category dominators with enormous future opportunities, were scarce, internet companies generally were not - and it wasn’t clear who would end up the real winners.  So, everything pretty much cratered together.  As the market moved sharply down (to where internet skeptics were mainly setting prices), the earlier flood of capital dried up and the Web wheat began to separate from the Dot-Com chaff.  Only much later were the eventual victors revealed.

Based on the early internet experience, it seems good bet that after some significant pain a small number of crypto projects will end up being fantastic investments and changing the world.  Maybe they haven’t even been launched yet (Facebook wasn’t founded until Feb 2004).  The key is crypto entrepreneurs migrating the sector from speculation to value creation.  We’ll be speculating about what that might look like in future essays.