Moving From Crypto Winter To Winter Spring: Lessons from Bear Market and When the Winter Will End
Lex Sokolin is Head Economist at major blockchain company ConsenSys.
To say the cryptocurrency market has been on a rollercoaster ride is an understatement. In January 2021, barely nine years after it began trading, the aggregate value of the cryptocurrency market reached $1 trillion (USD) – the fastest asset by many standards to reach this milestone. Ten months later, on November 10, 2021, the asset class nearly tripled to $2.9 trillion as several tokens reached all-time highs.
Rocks and pixels regularly sold for millions, profile pictures on Twitter were awash with laser eyes, and Euphoria had no limits.
However, just one month later, the market cap dropped to $2.3 trillion, a drop of -21%. By mid-June 2022, the entire market class had fallen to a market cap of $800 billion, more than -70% off its all-time high.
The takeaway? Crypto winter is here, with much of the euphoria evaporated for anguish and bafflement.
With apologies to Mark Twain, reports of Web3’s death have been greatly exaggerated. We’ve been down this volatility path in 2011, 2013, and 2018 only to bounce back. But the question isn’t so much if, but when, there will be light at the end of the tunnel.
Lessons from the crypto winter
A crucial takeaway from this latest bull run is that exaggerated narratives and the urge for high returns spurred “greed” among investors. While this is often assumed to be associated with retail investors, this cycle showed that even the most blue-blood investment firms were engaging in dangerous and unsound behavior.
Secondly, it became apparent that in the Web3 ecosystem, many of the prevailing token design principles needed to be sound. For example, tokens that rely on the network's continued growth to prop up price have been found wanting, and governance as a token's core objective function needs to be improved.
Token holders need and deserve more.
In addition, investors need to understand that crypto has yet to live up to the narrative of being an alternative asset class, as it is closely linked with traditional asset classes. For example, the crypto market cap soared as long as the Federal Reserve (Fed) kept rates near zero, similar to equities. However, as soon as the Federal Reserve telegraphed its intention to raise interest rates, valuations began to crumble.
One last failing is many protocols within the space were being created to operate as money “Lego,” deriving an unsustainable yield rather than having a real-world use case. As a result, these sorts of protocols, particularly within decentralized finance (DeFi), have disintegrated. A protocol must have a function to sustain usage and drive growth over time.
Despite highly-stressed market conditions and depressed prices, DeFi protocols (e.g., Aave, Compound, and MakerDAO) remained resilient while maintaining their loan-to-value. Investors who lent to these protocols were protected by smart contracts that automatically forced borrowers to repay their loans. This isn’t to say that DeFi protocols are 100% safe, but the risk parameters to protect investors worked as they should for at least the top lending protocols. In addition, each of these instances had a clear and valuable function, and users were drawn to them for some specific purpose.
The most important lesson is that despite the winds of winter engulfing the Web3 streets, there are no indications that developer activity or attraction to Web3 has slowed down.
Ethereum (ETH) remains one of the most robust ecosystems for developer talent and has renewed that confidence by shipping “The Merge," the most critical upgrade in blockchain history. Solana (SOL) and Cosmos (ATOM) ecosystems are also gaining incredible traction. There remains fierce competition for developer talent with new layer-one ecosystems like Aptos emerging.
When will the winter end
Of course, nobody has a crystal ball on how long the Crypto winter will last. While it is impossible to predict the future, we can glean insights from past cycles and current developments to guide the next wave of euphoria.
As noted earlier, the Web3 market is closely intertwined with traditional market cycles. Therefore, as the Fed and other central banks worldwide continue a hawkish monetary policy in response to the current economic environment, it’s safe to assume depressed prices will continue.
However, once there is stability and a reverse trajectory of three significant factors that drive asset prices – growth, inflation, and policy – we can expect an upward trajectory.
Furthermore, there needs to be a complete resolution of all the contagions from the TerraUSD and Luna collapse, as well as all of the questionable risk management decisions that accompanied it, such as Three Arrows Capital (3AC), Celcius, and Voyager. Many technicals are currently signaling seller exhaustion, but we could continue to see new bottoms without resolving these critical issues.
[Editor's note: the article was written before the collapse of the FTX crypto exchange.]
What’s next for crypto
It is inevitable that sooner or later, there will be broad-based acceptance of blockchain technology, driving up block space demand and propelling the next wave of user adoption.
Risk management in DeFi is still in the early stages of development compared to traditional finance. I expect “naive” risk management tools to be developed on top of the primitive layer of DeFi protocols.
Leading protocols in DeFi will likely continue to go through iterations to keep up with market forces and stay relevant.
Those fundamental to the ecosystem will have critical attributes such as technical innovation, high security, and trust demonstrated by the amount of capital locked in their smart contracts.
DeFi protocols will develop their multi-chain strategy or lean heavily on platforms that interconnect crypto markets across all chains to form open finance further and look for novel approaches to help strengthen their balance sheet and token price.
Diverse revenue sources will be critical to keeping up with the dynamic market cycles.
For example, Aave’s recently-approved crypto-backed stablecoin will accrue interest to its treasury, allowing it to continue funding future projects, a strategy other protocols may follow.
Crypto winters serve as a reminder that volatility is part and parcel of financial markets. Given the big vision of Web3, it is prudent to proceed cautiously. The aftermath of the dot-com bubble affirmed that innovative organizations and technologies weather storms. The story will be the same with Web3.
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