Macro Bytes Podcast_Cryptocurrencies
SPEAKERS
Jonathan Hobbs, Paul Diggle, Luke Bartholomew
Luke Bartholomew 00:06
Hello and welcome to Macro Bytes the economics and politics podcast series from abrdn. My name is Luke Bartholomew, and today my co-host Paul Diggle and I are joined by Jonathan Hobbs to discuss developments in the crypto asset space. Jonathan is an analyst at Finimize where he specialises in crypto. He's written two books on the topic, The 'Crypto Portfolio' and 'Digital Assets'. John started out in the traditional finance world, but he's also managed investments for a long/short crypto fund. So he is the ideal person to help us understand the important but, dare I say, complicated events that are going on in crypto at the moment. So John, thanks so much for joining us today.
Jonathan Hobbs 00:48
Thanks. Good to be here.
Luke Bartholomew 00:50
So, the context for this conversation is the recent collapse of a large crypto asset project, crypto coin and a related stablecoin, which is having large knock on effects in the wider crypto market. But we also wanted to use this opportunity today to not only talk about those developments, but also more generally about what's happening around crypto regulation, other crypto assets, and what this might mean for traditional finance, and investors. But before we get into that, John, I think it would be really helpful to just start off with some quick background questions to make sure we're all on the same page and understanding of what I said it can at times be a rather complicated market. So perhaps most fundamentally, of all, why don't you start by explaining what even is a crypto currency or crypto asset?
Jonathan Hobbs 01:38
Yeah, so I think the best way to do that is to start off with the first one that was ever created, and then kind of branch off from there, and how things go. So, you know, Bitcoin was the first digital asset ever created the first cryptocurrency and simply put Bitcoin is a payment system. So you can send bitcoin from point A to point B, except it doesn't have to go through a bank. There's no middleman involved in the transaction. So if I send you money to your bank account, that's fine. The banks will talk to each other and process it. But the blockchain does the same thing. Except it doesn't have a bank in the middle. It's got miners who effectively work together to make sure that this transaction is validated and secured. Now, the way that works is with every blockchain and I'm using Bitcoin as an example. But with every blockchain, you need to have something called consensus of the ledger. That is a public ledger that everyone can see, you can go to blockchain.com, and look it up to see which address owns which coins. And to get that consensus, you've got these miners who are effectively competing with each other. They're using mining software, and in this case, a lot of electricity, to solve these really complex cryptographic puzzles. And that updates the blockchain every 10 minutes, it updates the ledger. So you have this consensus. In return for doing that, for their work, it's called 'proof of work', they receive new Bitcoins, which is how new coins are also created and bought into the supply for Bitcoin. The miners will also receive transaction fees and all of the transaction fees of all the transactions that were in the block. So obviously technical stuff that we could go into in a really deep dive but obviously, we don't have that much time. But the most important thing to realise with all crypto assets effectively in blockchains, is that they use game theory to achieve consensus, there's a number of ways you can do that. But the obvious thing is that, you know, with Bitcoin, for example, to try and attack the blockchain, you'd have to have more mining resources and mining power than the entire blockchain or mining network combined, which is obviously very, very expensive. So, it wouldn't make financial sense to try and attack it. It's much better to do what's better for everyone in the network, by just mining the way the network intended. So that's proof of work, you've then got 'proof of stake', which is slightly different, but uses different mechanisms to achieve consensus where effectively you've got validators instead of miners, and validators will basically stake up their own crypto collateral. And in exchange, they'll earn those fees and new coins, and they will validate transactions. If they do it wrong, game theory comes into play again, and they lose this stake. So, it's all based on game theory. And that's kind of how it works. And that's the simplest, you know, you have simple transactions where you're sending from point A to point B, but you can also get more complicated transactions, which is where Ethereum comes in, for example, where you have smart contracts. Now, if you look at the ICO boom of 2017, where we were raising a lot of money for these initial coin offerings. That all worked on Ethereum smart contracts. So effectively, if I wanted to invest in token X, I would send Ethereum to the smart contract address, and a very complex deal would go down on the blockchain, and I would then get sent back the token, depending on the launch and all the conditions, programmed and so that's so obviously, you know, the market imploded, but it proved the concept that you could do these complex transactions on the blockchain. Fast forward to today, we are basically at a place where you have decentralised finance, which is a whole bunch of different financial transactions that are complicated. That can all be done with smart contracts. You also have blockchain players in games, minting and trading of NFTs as well as even buying and selling virtual land in the metaverse. So, there's a lot of ways this has branched out through the technology, but of course, it all started with Bitcoin and blockchain.
Luke Bartholomew 05:26
Thanks Jon, I think that was a very helpful potted history of where sort of crypto emerged from and this idea of the blockchain as a database, a way of storing the history of transactions, but maybe just one other definitional issue that we should touch on is this idea of a stablecoin or sort of specific type of crypto asset, cryptocurrency, because I think they're going to play quite an important part of the story, we're going to tell about some of what's going on recently. So could you just run us through what a stablecoin is as well, please?
Jonathan Hobbs 05:54
Sure. So, I mean, a stablecoin is essentially, what it tries to do is have all the advantages of blockchain technology. So you can send it very quickly. It's permissionless, you know, low fees, and all of that, and you can do cross border payments very efficiently. So all of the advantages of blockchain technology and then the other advantage, which it's supposed to have is that it trades one for one with the fiat currency. So as a payment system, it makes a lot of sense, because if provided it's maintaining that same value, it is a very good means of payment, because it has all the efficiencies of blockchain, but yet, it's still stabilised to fiat currency. You can send these across different blockchains. So you know, I could send USDT Tether across the Ethereum blockchain, and that would work just fine. Now, there's two different kinds of stablecoins. The first is centralised, stablecoins. And the second is, which we'll talk a lot more about in probably the next question, is algorithmic stablecoins. So centralised stablecoins is just where you have a company that is responsible for backing the collateral behind the stablecoins, and they will make sure that that is pegged one to one with the dollar, for example. They're also responsible for processing subscriptions and redemptions. So if an investor wants to trade in their stablecoin, and get back the equivalent amount of fiat currency, that company will be responsible for doing that. So for those who have, you know, think of your Tether, USDT, USDC, and Binance coin are all the examples of those. So that's the one type of stablecoin. The other one is, of course, algorithmic stablecoins. Now those are decentralised, which basically means that there's no central counterparty controlling them. So it's all done through the code. And that uses some kind of mechanism or algorithm to basically incentivize the market participants to keep the peg or to keep the value of the token, pegged to a fiat currency. And that would be TerraUSD, which we'll talk about. And just before we get to that, I mean, I think there's two types of risks associated with stablecoins - depending on which type they are. Obviously, if it's a centralised, stablecoin, you've got counterparty risk, just like you would with, you know, a bank, for example, holding funds. But if it's an algorithmic stablecoin, you are looking at the risk of the code not working as it should, or just the market generally, yeah, breaking down, as we've seen.
Paul Diggle 08:13
Thanks, John. So as you've alluded to there the biggest story in crypto right now, as we record this in May, is the collapse of one of these algorithmic stablecoins - Terra. So it was meant to have a one to one peg with the dollar and its collapse to being worth a few, a few cents. Could you give us a sense of one how important this stablecoin Terra was to the crypto space? And then talk us through some of these quite complicated intricacies of why it is that this utterly collapsed in value?
Jonathan Hobbs 08:48
Sure. So I think the reason it was so important is, you know, we've had algorithmic stable coins and crypto before and they've collapsed. But the difference with this one, which is Terra/Luna, and UST is the scale of it. So the combined market value of Luna and UST, which was the stable coin, was around $60 billion, which is a lot of money. I mean, it's the same amount of money as Enron when it collapsed. So this is what really bought in a lot of media attention. And it's been really bad for the overall market. But there might be some silver linings at the end of it, which we can go into. But yeah, so basically, I mean, how it works is before I kind of explain the events the way I see it, how it happened. First, just a bit about Terra and how the blockchain works. So basically Terra, you know, as I talked before, it's a blockchain. And it's trying to always trying to create a decentralised financial system where everything could effectively run on code without a financial middleman like a bank in the middle, for example. And this revolves around the idea of a decentralised algorithmic stablecoin. It's got a few of them, it's got the Korean won, the euro, but the one we'll focus on obviously is UST, which is the dollar one, which is the one that's collapsed and gained all the attention. So the way it works is on Terra's blockchain, you've got two tokens, you've got the UST and that's backed by another token called Luna. And the algorithm uses Luna to incentivize certain people to do certain things in order to maintain the price at a dollar, and they are incentivized with profits. So basically, how it works is Luna and UST work together to stabilise the peg. When you increase the supply of one, you decrease the supply of other and the supply of UST, the stablecoin is manipulated so that the price gets back to the dollar. So you know, if UST is above $1, let's say they will create more units of UST, they'll increase the supply, they'll bring it back to a dollar but then, to do that, they'd have to decrease the supply you know so they would burn tokens and they'd get a fee in exchange. UST if it was below the dollar, which obviously happened, they'd burn more UST to bring the supply back. This decrease the supply. They would then have to increase the supply. So that's how it works. Smart contracts work behind the background with that. There's also arbitrage so if I wanted to buy a dollar's worth of Luna, quickly, if UST was trading at 98 cents swap it for two cents profit. So that's kind of the theory and how it was all supposed to work. It did work very effectively for a long time. And it had gained a lot of confidence in the market. Hence its high market cap of 20 billion or so before the collapse. So what actually happened with the downfall of Terra and UST and Luna. There's lots of theories, but you read that, you'll see a lot of different theories. It's just the way the market works. Kind of like how George Soros broke the Bank of England, back in the day. So looking at the events and what actually happened, here's how I see them. So it started off at the beginning of this month in May, there is this defi protocol - decentralised finance protocol - called Anchor protocol - and this is where everyone who had UST, or most of them, would go and use this protocol. They will deposit UST and they'd earn a 20% yield on that UST. So that's a really good yield, it got people into the protocol as an introduction, but because of its high percentage, it's not that sustainable and the exchange itself (Anchor) started to worry that they wouldn't have enough cash to pay off those interest payments as they became due. So what they did is they decided to lower the interest rates and make it more variable based on demand so that it would go down one and a half percent about every month. And the idea was now that the interest rates gone down, more people are going to leave the protocol, and therefore, they would be able to afford the interest payments. Of course, that didn't actually happen. What actually happened is more people flocked to the protocol and started depositing the UST in earning that yield. So that actually was a problem because they didn't have the capital to pay off those interest payments. Now, if we were in a bull market, that would have been probably okay, in terms of it wouldn't have caused the collapse, because you wouldn't have had, the deposits wouldn't have been affected, they just wouldn't have been able to pay back the interest. But obviously, we're not in a bull market. The markets very jittery right now. Everything's risk off, stocks, crypto, you know, everything's been down. So when the market got wind of this incident with Anchor, a lot of panic started to follow, particularly with, you know, Luna and whether it was able to back UST. So the drop in Luna's price, you know, caused investors to worry and so on. And you had this negative kind of spiral of events. And then on the weekend, which is two weekends ago, a large investor sold $285 million worth of UST, on another defi protocol, and that really kind of shocked the market and set this whole thing off. And then on Monday, the following Monday, the Fed announced interest rate hike, and then on that day, stocks, crypto everything was done by a lot, and Luna started to drop a lot too. And then you had this, basically it just escalated. So you ended up having this bank run effectively on Luna and to me, it was just a blend of, you know, market losing confidence in the peg, and how the events unfolded.
Paul Diggle 14:51
So I suppose, one thing that interests me in all that Jon is that you use the words bank run, you've compared it to Soros and his attack on Sterling's membership of the Exchange Rate Mechanism in 1992 and the events around Black Wednesday. You also might draw parallels between Terra losing its peg against the dollar and money market funds in 2008, 'breaking the buck'. So these kinds of events have happened before in finance but obviously in a new and different way, tied up with the way that the algorithmic stablecoin did or didn't work. But all those previous events were in different ways spurs for regulators to get more involved in finance. Do you think this collapse of a stablecoin is also going to be a trigger for regulators to come into the crypto space and play a bigger role?
Jonathan Hobbs 16:00
Definitely. And, you know, I think regulators have always been looking to regulate crypto, but they just move a lot slower. But they are moving, we just don't see it because most of it's in the background. But with what happened with Luna, I mean, you've already seen countries calling for regulation of stablecoins. Janet Yellen made a statement that they want something by the end of the year. But here in the UK, they actually want to include stablecoins as part of the Financial Services and Market Bill. They've actually got quite a positive view on stablecoins in the UK, they believe they have widespread benefits as a payment system, obviously, provided they're stable. So that bill doesn't actually include algorithmic stablecoins - and there's a couple of reasons for that. The first, you know, which they've stated, is just a lack of price stability, which makes a lot of sense. But the second is, I think it's very, it would be very, very difficult for them to regulate an algorithmic stablecoin. Because, I mean, how do you actually do it? Because there's no central counterparty to regulate. It's all in the code. So they wouldn't have anyone to kind of blame if things went wrong. And also, for them to sign off on an algorithmic stablecoin, they would have to themselves look at the code and go, yeah, we think this is good enough, we don't think it's going to break because we've looked at the code. But of course, if it broke down, it's not going to look very good. So you know, I see it as a big challenge in how they're going to actually go about regulating algorithmic stablecoins. I think they will eventually find a way but it's going to be a challenge. But in terms of centralised stablecoins, so your Tethers you know, all of those, that are backed by central counterparty, it's very, very easy to regulate, because you've got one, one entity to regulate. You've just got to look at their reserves to make sure they've got enough reserves to backup the peg, and just as you would for a bank, for example, or anything like that. So I do see regulation coming. But it'll be probably centralised currencies first, and then they'll figure out a way to regulate the decentralised market.
Luke Bartholomew 17:58
Broadening this conversation out a little bit, Jon, in terms of the wider crypto ecosystem. How do you see - both A sort of increasing regulatory attention that you're just talking about there, and B I suppose the confidence shock from observing a collapse like this - playing out in the crypto market in general?
Jonathan Hobbs 18:20
Yeah. So I think, regulation, it tends to scare the retail investors in crypto. But if you're an institutional investor, you're going to want regulation, because obviously, it's very, very important to have that. So, you know, I think long term, it's going to be good for the space. So regulation will drive more institutional investors in, but in the short term, it could create a bit of volatility in the retail market,
Luke Bartholomew 18:44
Just in terms of how this collapse of, as you described it, a top 10 very large crypto asset, the impact of that in terms of people's confidence about crypto assets, and broadly the way in which they're gonna interact with other cryptocurrencies out there?
Jonathan Hobbs 18:59
Sure. So I think it's caused, obviously, the market did drop along with Luna and UST, and it definitely exacerbated the market panic that was already in play. But we are seeing some interesting things. You know, it's not all crypto assets that have had the same amount of issues and in the market for years. We are seeing some interesting things for example, with Bitcoin, if you look on chain and you look at the basically you look at the blockchain, and you can see who's buying Bitcoin and who's not buying Bitcoin. And what you have is, you can see that there's addresses which hold over 10,000 Bitcoin, which is about $300 million worth. Those addresses are actually increasing. There's more and more of them, and they've effectively increased by about 10% Since February, as the market has been going down, and especially when this collapse came along the lines of the Terra incident. You also see on the blockchain that you've got 65% of all Bitcoin addresses have been basically dormant for a year, for over a year, which means they haven't been sold, which means people are just holding their Bitcoin and they have no intention of selling it yet at these prices. So, on the one hand, you've got a lot of panic, a lot of people have panicked, but you do have this long-term conviction, probably in Bitcoin mostly, the altcoin market's taken a much bigger drop, I think. And you've also seen a lot of leverage been flushed out. So, the derivatives market with Bitcoin, for example, the open interest, which is the amount of futures open interest, that was very, very high before it dropped, meaning a lot of speculators in the market. That's all come down a lot and been flushed a bit. And so, you know, the basic thing is, you've seen a lot of speculators exit the market. And then you've seen a lot of conviction. Mostly in Bitcoin - you can see holders who are kind of unfazed by the volatility and probably used to it by now if they've been in the market for this long.
Luke Bartholomew 20:56
In terms of that risk off sentiment? I mean, I wonder how much are we learning here about the way that crypto assets might perform in different market environments? And therefore some of the diversification qualities that it might offer in that absolutely, there is, as you say, specific crypto issues that are driving some of the panic at the moment, but there is this broader risk off sentiment across all asset markets. And one of the things that you might hope for from a diversifier is that it does well when other things are doing badly, but precisely what we're seeing is that crypto assets seem to be doing badly at just the time where everything else does badly, so seems to fail, in that sense of diversification. And moreover, part of the reason that we're seeing this risk off sentiment is, of course, concerns about inflation and policy topics that we've discussed on this podcast many times, but one of the appeals of Bitcoin to some people and other cryptocurrencies is meant to be, perhaps, a hedge to inflation. So I wonder, isn't this exactly the kind of environment that we should be seeing cryptos and Bitcoin in particular, doing better? And the fact that we're not what are we learning from that?
Jonathan Hobbs 22:08
Yeah, I mean, in terms of the inflation question, I would agree with you for Bitcoin, not so much some of the other cryptocurrencies. But I mean, the problem is, we basically had this, as you say, this big risk off sentiment in the market, and that's driven by high interest rates, and what happens is investors just need cash. So they're selling everything they can. It's not just stocks that have gone down, we've also seen bonds go down, we've seen a lot of assets go down, and you have this market-wide sell off, where everything just gets highly correlated to the downside. Bitcoin has gone down along with that, and crypto assets have been a lot more risky than Bitcoin, typically, because there's much more volatility, have obviously dropped a lot more with that, too. So yeah, I mean, right now, in the short term, it seems that Bitcoin is not acting as an inflation hedge. But longer term, if you look at the underlying dynamics of how Bitcoin works, and you take away the market, you know, the way the market thinks in the short term, which we've seen, and you kind of think, more longer term, if you just look at the supply dynamics of Bitcoin, there's only ever going to be 21 million coins, only 90% of them or 90% of them have already been printed or mined. And that is increasing at a decreasing rate. So, effectively, you do have this fixed and finite supply. So the scarcity element should come in later on. But I do think you know, the market size of Bitcoin is very small compared to a lot of other assets. So it is going to be very, very volatile. And it doesn't take a lot to drop the price, given its kind of small market size.
Paul Diggle 23:47
Jonathan Hobbs, crypto analyst at Finimize, thank you very much for joining us. And thank you to you too, for listening to Macro Bytes. Don't forget to like or subscribe on your podcast platform of choice. But until next time, goodbye and good luck out there.
24:12
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