Crypto Crunch
Tue Jul 05 2022
Between May and June of 2022 we saw the biggest crypto crash in history. Bitcoin and Ethereum dropped in value by 80%, DeFi platforms and crypto hedge funds imploded. The dominos continued to fall as over-leveraged positions were liquidated.
The Setup
In the last few years, DeFi took center stage with products that yield 20-40% on stable coins. Yields at tradition finance hovers around 0.2%. Stable coins removed speculation from the equation. 20-40% yields was supposed to be risk-free until the whole system came crashing down. New customers to the crypto ecosystem stumbled into unknowingly risky and unregulated financial products without knowing which questions to ask. These products were supposed to be ‘decentralized’, ran on the ‘blockchain’, just like Bitcoin. The perceived security of Bitcoin was co-opted by dubious cryptonomics schemes.
The first 10 years of Bitcoin were extremely volatile with 20-100x bull runs and 80-90% drawdowns. In late 2020, as the prices rose, super-cycle narrative projected 200-300k BTC. The community was electrified by the possibility a 10x or more bull market. Leverage was the tool to make the most out of it. In November 2021, macro-economic pressures took over. Asset prices began to drop and so did crypto.
The Crash
Orderly and slow descend in value became chaotic in May 2022 when margin calls began. Leveraged positions became over-leveraged positions. Investors were forced to make hard choices between re-collateralizing, getting wiped out, or sell to cover the loans. Massive margined long positions on BTC exchanges were targeted for liquidation now that there was weakness in the market.
As sell pressure built, the price crashed and crashed again. Liquidations occurred across DeFi and created the perfect storm that would lead to the Terra/Luna disaster. Terra’s depegging from USD became inevitable once the amount of Luna backing it was less than the total amount of Terra. Speculative attacks took down Terra’s ecosystem in a matter of days, crashing one of the biggest DeFi platforms. The crypto crash wiped out hundreds of billions of dollars of wealth in the industry.
The Recessionary Inflation hits
The last period of high inflation and recession was from 1970-1980. In the 1970s the Federal Reserve had just gone off the gold standard and debt to GDP was at 35%. Today debt to GDP is at an all time high at 124%. Today’s 4x higher debt to GDP ratio limits the headroom for raising rates.
In a recession, equities drop in value due to lower company earnings. Bond yields fluctuate depending on interest rates set by the government and typically perform well as investors flock to risk-off assets. Real estate will see an early drop as buyer’s purchasing power is reduced, which then impacts supply as builders deal with lower returns but also lower costs. Gold value will increase as investors flock to tried and true store of value.
The Bitcoin non-Response
Bitcoin supply remains painfully inelastic in the face of recession, which means it will crash harder than anything else, but also recover faster once sentiment improves. Because Bitcoin’s supply doesn’t respond to recessions, it will behave exactly like it always has: Changes in demand drive price and cause high volatility. Because inflation of Bitcoin is lower than anything else (including Gold), the price will increase over time.
In an inflationary environment, Bitcoin will perform well. It’s a mathematical guarantee of scarcity to offset inflation. In a deflationary environment, no one needs Bitcoin as they can just hold dollars. Deflationary environments are bad for Bitcoin and bad for the economy as consumers would rather hoard their money than spend it, driving down GDP growth.
Governments will avoid deflationary environments by lowering interest rates and performing QE has it has always done. A short term deflationary environment is possible, but policy will shift the currency back to inflationary. In an Inflationary recession, Bitcoin price will see extreme downside volatility as demand dries up, but a long term upward trend as the mathematically guaranteed scarcity will continue to attract new and old investors as a hedge against inflation.