Crash and Merge: Can Crypto’s Calamitous Year Save It From Itself?

Cryptocurrencies have had a calamitous year, littered with hacks, bankruptcies, and precipitously declining 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 Bitcoin’s price peaking at $68,000, driven by excitement around NFTs, play-to-earn gaming, decentralized finance (DeFi), and the amorphous concept of Web3, a fuzzy vision of a decentralized internet running on blockchains.

While the crypto takeover of prestigious Super Bowl ad slots in early 2022 suggested the industry was on the cusp of mainstream acceptance and sustained growth, some were already pointing to warning signs that the industry’s rise might not be as inevitable as others were making it out to be.

As inflation surged at the start of the year and the Federal Reserve began hiking interest rates, proponents claimed Bitcoin could be a reliable hedge against rising prices. Goldman Sachs even labeled it “digital gold” in January, predicting it could displace the traditional investor safe haven.

But the thesis didn’t pan out, and by April, it became clear that leading cryptocurrencies were sinking alongside stocks, while gold actually went up in value. By early May, Bitcoin had lost more than half its value since its all-time high the year before.

Then in the second week of May, the industry’s first major collapse sparked a death spiral crypto has yet to recover from. The stablecoin Terra, whose price was supposed to be firmly pegged to the dollar, started dropping in value. By the end of the week, it was worth just 10 cents, and its sister coin Luna became essentially worthless.

The failure wiped roughly $45 billion off the crypto market in a matter of days. The blame lay mainly with the risky approach the founders of Terra took to maintaining its peg to the dollar. While most stablecoins back their tokens with cash reserves, Terra was relying on an arcane system of algorithms and game theory that was supposed to play off investor behavior to ensure it always traded at almost exactly one dollar.

Many had criticized the plan as unworkable in the long run, and they were proven right. People were incentivized to hold Terra by a savings scheme called Anchor that offered 20 percent returns, but people started pulling out after the organization decided to switch to a variable rate. This was followed by investors selling large amounts of Terra, which caused the house of cards to collapse.

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

Poor risk management practices and the incestuous nature of crypto trading—nearly every major crypto lender had made loans to 3AC—meant the failure of this single entity sent ripples through the entire crypto industry. The summer saw a series of crises, with crypto exchanges and lenders freezing withdrawals and companies filing for bankruptcy, most notably major crypto lender Celsius Network.

In the background, an ever-growing list of hacks on some of the industry’s biggest names were further denting investor confidence. In October, consultancy Chainalysis pointed out there had already been more than 125 hacks in 2022, racking up losses of as much as $3 billion and putting the year well on course to be the worst for crypto hacks to date.

The coup de grâce came in November when leading exchange FTX plunged from a valuation of around $32 billion to bankruptcy in just a few days. It turned out that an affiliated trading firm founded by FTX CEO Sam Bankman-Fried, had effectively been using FTX customer deposits as collateral to invest in various crypto projects. When this came to light, people rushed to withdraw their funds, leading to a run on the exchange that quickly sapped its reserves.

The failure of such a massive player in the crypto ecosystem pushed prices even lower and is driving continued concerns about “contagion” as a growing number of companies disclose their exposure to FTX. By the end of the month crypto lender BlockFi, which had been in discussions with FTX about a possible acquisition, also folded. All this has left cryptocurrencies in a tailspin at the end of 2022, with some predicting that there is further pain to come.

But amongst the wreckage of the industry, there are still a handful of bright spots.

In September, the number two cryptocurrency Ethereum carried out an ambitious update known as the Merge. The currency’s blockchain had previously relied on a security protocol called proof-of-work. Under proof-of-work people compete to solve complex mathematical puzzles in order to win the right to verify transactions in exchange for a cryptocurrency reward. The Merge switched Ethereum to an approach called proof-of-stake, in which people put up chunks of crypto as collateral in exchange for the right to verify.

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

The approach is still largely unproven, leading many to highlight the potential risks of the Merge. But so far the upgrade has gone smoothly, and preliminary analysis suggests energy usage is down significantly, perhaps pointing towards a greener future for cryptocurrencies. Future changes may also allow Ethereum to run more transactions at a higher rate and lower cost. More updates are set to roll out over the next few years, beginning with the division of the Ethereum blockchain into a series of smaller databases, a process known as “sharding,” in 2023.

Among all the doom and gloom, some are also saying that this year’s crypto crash was a much needed corrective to all the hype that had built up around the industry, and could go a long way to weeding out speculators and charlatans. It’s also increased calls for regulation of the sector, which in the long run could help it become more sustainable.

Ultimately, despite the depth of the crisis, many in traditional finance think cryptocurrencies are likely to rebound in 2023, although it may be a slow and gradual recovery. Tellingly, they are predicting that projects, like Ethereum, that can be used to support practical real-world applications, rather than just financial speculation, will be the drivers of growth in crypto’s next phase.

Image Credit: Shubham Dhage / Unsplash

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• Source: https://singularityhub.com/2022/12/26/crash-and-merge-can-cryptos-calamitous-year-save-it-from-itself/