In the 2000s, the central belief was that home prices could not come down nationwide. This supported a boom in subprime mortgages, which drove up house prices and made homeowners look wealthier, attracting more investors and encouraging more lending on increasingly precarious terms. The increase in prices led to an increase in supply, which led to a stabilization and then a decline in prices. When this happened, the risks of subprime loans became apparent, undermining demand and further weakening prices. Investors fled and counterparties demanded more collateral, triggering failures and further undermining trust until the entire interconnected constellation of financial intermediaries was on the brink of collapse.
In crypto, the belief was that this new market would continue to grow until it replaced traditional finance. Consider tokens issued by crypto exchanges (including FTX), offering discounts on fees: their value depended on continued growth in trading volumes. Trade depended on continued confidence in growth, which in turn depended on more transactions. But as soon as something faltered – the so-called “stablecoin” Terra loses its peg, or the bank-like entity Celsius stiffens its customers – the confidence and enthusiasm dissipated. The failures of some firms have weakened others, in a dynamic that has now consumed FTX, which until recently appeared to be among the strongest. And the failure of FTX will undoubtedly further weaken the crypto industry.
So what can a comparison to the 2008 crisis tell us about what’s next for crypto?
First, the bloodshed is not over. In 2008, central banks and governments restored confidence by providing emergency liquidity and recapitalizing financial institutions. But crypto has no central bank – no lender or market maker of last resort with adequate resources – and governments (rightly) don’t see it as important enough to save. So while there may be lulls and even recoveries, as there were back then, nothing is stopping much of the market – including exchanges and other intermediaries – from sinking.
Second, regulation is coming. Among other things, the 2008 crisis spawned the Dodd Frank Act, the Consumer Financial Protection Bureau, bank stress tests, and a complete overhaul of how derivatives are traded. Crypto customers will demand protections similar to those in traditional finance, and the pressure on regulators to act will increase as the number of people harmed grows.
Third, certain business models will survive and thrive. Credit derivatives, which played a big role in the 2008 crisis, remain a robust, albeit reformed, market. Similarly, Ethereum’s shift to a new, more efficient model of transaction processing could give it resilience, allowing for increased throughput and lower transaction costs. And now that short-term interest rates are well above zero, offering stablecoins backed by interest-bearing central bank reserves is becoming a sustainable business model, potentially offering both profits for issuers and a security for users.
The promise of decentralized finance lies not in the speculative activity associated with digital tokens, but in blockchain technology. This innovation could still prove useful in trade finance, cross-border payments, securities settlement and digital identity. So even if the mania is over, don’t count this part of the crypto-ecosystem.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Bill Dudley is a Bloomberg Opinion columnist and senior advisor to Bloomberg Economics. A senior researcher at Princeton University, he was president of the Federal Reserve Bank of New York and vice-chairman of the Federal Open Market Committee.
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