Can A Catastrophic Year Save Crypto From Itself?

Cryptocurrencies have had a disastrous year, full of hacks, bankruptcies and plummeting prices. What went wrong – and are there any bright spots to look forward to in 2023?

Crypto markets hit all-time highs in November 2021, with the price of Bitcoin peaking at $68,000, fueled by excitement around NFTs, play-and-earn games, decentralized finance (DeFi) and the amorphous concept of Web3, a vague vision of a decentralized internet it runs on the blockchain.

While crypto’s takeover of prestigious Super Bowl ad spots in early 2022 suggested the industry is on the cusp of acceptance and sustainable growth, some have already pointed to warning signs that the industry’s rise may not be as inevitable as others have made it out to be.

As inflation spiked at the start of the year and the Federal Reserve began raising interest rates, proponents argued that Bitcoin could be a reliable hedge against rising prices. Goldman Sachs even labeled it “digital gold” in January, predicting that it could displace traditional investors’ safe havens.

But the thesis was not justified and by April it became clear that the leading cryptocurrencies were sinking along with stocks, while gold actually rose in value. By early May, Bitcoin had lost more than half of its value from its all-time high a year earlier.

Then in the second week of May, the industry’s first major collapse caused a death spiral from which cryptocurrencies have yet to recover. The stablecoin Terra, whose price was supposed to be firmly tied to the dollar, began to fall in value. By the end of the week it was only worth 10 cents, and its sister coin Luna had become essentially worthless.

The failure wiped roughly $45 billion from the crypto market in a matter of days. Much of the blame lay in the risky approach taken by Terra’s founders to maintain their attachment to the dollar. While most stablecoins back their tokens with cash reserves, Terra relied on a mysterious system of algorithms and game theory meant to influence investor behavior to ensure it always traded for almost exactly one dollar.

Many criticized the plan as unfeasible in the long term, and they were proven right. People were encouraged to hold Terra by a savings scheme called Anchor, which offered 20 per cent returns, but people started pulling out after the organization decided to switch to a variable rate. Then investors sold large amounts of Terra, which led to the collapse of the house of cards.

The collapse of Terra had a cascading effect on the broader crypto market. In June, the world’s largest crypto hedge fund Three Arrows Capital (3AC) announced that it had suffered heavy losses due to Luna’s descent. It defaulted on a $670 million loan from crypto broker Voyager Digital by the end of the month, and both companies filed for bankruptcy the following month.

Poor risk management practices and the incestuous nature of crypto trading – almost every major crypto lender has made loans to 3AC – meant that the failure of this single entity sent the entire crypto industry into a tailspin. The summer saw a series of crises, with crypto exchanges and lenders freezing payouts and companies filing for bankruptcy, most notably major crypto lender Celsius Network.

In the background, an ever-growing list of hacks from some of the biggest names in the industry further dented investor confidence. In October, the consulting company Chainalysis pointed out there have already been more than 125 hacks in 2022, racking up as much as $3 billion in losses and putting the year on track to be the worst for crypto hacks on record.

The coup de grâce came in November when the leading stock exchange FTX fell from an estimated value of around $32 billion to bankruptcy in just a few days. It turns out that an affiliate trading company founded by FTX CEO Sam Bankman-Fried was effectively using FTX client deposits as collateral to invest in various crypto projects. When this came to light, people rushed to withdraw their funds, leading to a rush on the stock market that quickly depleted its reserves.

The failure of such a major player in the crypto ecosystem has pushed prices even lower and is fueling continued concerns about “contagion” as more and more companies disclose their exposure to FTX. By the end of the month, crypto lender BlockFi, which had been in talks with FTX about a possible acquisition, also backed out. All of this has left cryptocurrencies in a tailspin at the end of 2022, with some predicting further pain to follow.

But there are still a few bright spots among the wreckage of the industry.

In September, fellow cryptocurrency Ethereum implemented an ambitious update known as a merge. Blockchain currencies previously relied on a security protocol called proof-of-work. Under proof of work, people compete to solve complex mathematical puzzles to win the right to verify transactions in exchange for a cryptocurrency reward. The merger moved Ethereum to an approach called proof-of-stake, in which people put up pieces of cryptocurrency as collateral in exchange for the right of verification.

The previous approach required so-called “miners” to run thousands of high-end computer processors, consuming huge amounts of energy to confirm transactions. This has led to concerns about the environmental impact of cryptocurrencies, but proof of stake could provide a solution.

The approach is still largely untested, which is why many highlight the potential risks of the merger. But so far, the upgrade has gone smoothly, and preliminary analysis suggests that power consumption has been significantly reduced, perhaps pointing to a greener future for cryptocurrencies. Future changes may also allow Ethereum to run more transactions at a higher rate and lower cost. Additional updates are planned to roll out over the next few years, starting with the division of the Ethereum blockchain into a number of smaller databases, a process known as “sharding”, in 2023.

For all the doom and gloom, some also say that this year’s cryptocurrency crash was a much-needed corrective to all the hype that has built up around the industry and could go a long way in weeding out speculators and charlatans. Demands for regulation of the sector are also increasing, which could help it become more sustainable in the long run.

Ultimately, despite the depth of the crisis, many in traditional finance think cryptocurrencies are likely to recover in 2023, although it could be a slow and gradual recovery. Tellingly, they predict that projects, like Ethereum, that can be used to support practical real-world applications, not just financial speculation, will be the drivers of growth in the next phase of cryptocurrency.

Image credit: Shubham Dhage / Unsplash

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