Innovation typically follows a standard evolutionary path: it starts with excitement, goes on to fever-pitch inflated expectations, then drops down into the trough of disillusionment; if anything is left standing, it goes on to plateau out into competitive jockeying, innovation by pivoting, and then into the boring plateau of productivity and commoditization. Gartner, the technology research and advisory firm, formalized this as the Gartner Hype Cycle.
The crypto markets went through the excitement during the 2009-2017 period, culminating in some feverish inflated expectations (everything on the blockchain) in the next few years. 2022 may be remembered as the trough of disillusionment with the collapse of FTX, the most notorious of all crypto scams.
FTX, the world’s largest cryptocurrency exchange, went from $32B to a freezing 32° F, ushering in a crypto winter. What is worse, if that is possible, are the people—many who should know better—who compared SBF to J. P. Morgan and Warren Buffet. Clearly, the concept of making money by first creating value is an alien concept to these people.
Other high-profile scams, scandals, and “bugs” include Celsius ($4.7B), $2B in various bugs (Nomad, Wormhole, and so on), Day of Defeat, Orfano (which tricked the BBC into covering it not once but twice!), and Quadriga (where the founder apparently died in India).
Buried under the noise of the cryptocurrency chaos is the more serious situation of conflating crypto with digital assets and believing cryptocurrency (and related smart contracts) to be the only financial instrument. Assuming that a small percentage of the ICO scams of 2016-2018 era were motivated by genuine business models, they contributed to the chaos by completely misunderstanding what constitutes a securities instrument and the role of the regulators.
Compounding the problem was the confusion over smart contracts which were supposed to power these financial instruments. Smart contracts are neither smart nor legal contracts; they are closer to simple stored procedures in traditional databases.
How to come out of this turbulence and chaos into clear and sunny skies? While the efforts to catch the crooks will continue for some time, the immediate fallout is the suspicion of the technology that powers the crypto world. There is confusion around risk, recovery, settlement, and finality of transactions. These problems are not new to blockchain; they were faced by merchants and financial institutions for about half a millennium. Many of the regulations and financial processes today are the result of considerable experimentation on how to protect all the parties involved in financial transactions. The fact that these regulations and processes are onerous and cause friction is no reason to throw them away and move to entirely untested, technology-based solutions. The cure is worse than the disease.
The process of recovery from the chaos starts with a clear understanding of the technology of blockchain, its legitimate use cases, the various types of financial instruments, and methods for managing risk.
That’s a subject for another blog.
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