Why the cryptocurrency ecosystem is a house of cards

2022 began with a free fall in main cryptocurrencies together with Bitcoin and Ethereum. At the moment, it was seen as simply a part of the ebb and stream of economic speculations. But it surely was quickly adopted by the crash of main stablecoin TerraUSD.

Stablecoins are supposedly engineered to guard traders from the excessive volatility of cryptocurrencies. But billions of actual {dollars} vanished whereas additionally taking down the Luna cryptocurrency.

The spillover impact continued with crypto-lending corporations akin to Celsius and BlockFi collapsing, crypto hedge fund Three Arrow Capital going bust, and crypto dealer Voyager buckling.

If there have been a flaw with cryptocurrencies, it isn’t technological however existential.

Certainly, the tumultuous image surrounding cryptocurrencies this yr has been alarming and sobering. And now, FTX founder Sam Bankman-Fried has been arrested within the Bahamas on a US request. 

With total cryptocurrency gamers collapsing at such breakneck velocity, it’s tough to know how this chain response occurred, leaving a pall over the way forward for cryptocurrencies. These occasions have solely amplified the talk between crypto proponents and crypto sceptics. However it’s also price contemplating whether or not the continuing debacle factors to a significant flaw in cryptocurrencies or in its ballooning ecosystem.

All cryptocurrencies are underpinned by blockchain know-how, which permits the maintenance of decentralised digital ledger of coin possession. Blockchain know-how has been scientifically studied, completely examined and validated, together with in robotic purposes past the crypto universe. At their core, blockchains facilitate the upkeep of digital ledgers with out the necessity for a centralised authority and regulators – the way in which most nationwide currencies do. This carries implications for worldwide controls, too.

But when there have been a flaw with cryptocurrencies, it isn’t technological however existential: do cryptocurrencies serve a objective, a market, or some other perform versus prevailing centralised financial techniques? This key query can also be fiercely debated by consultants and crypto proponents, the previous arguing that cryptocurrencies are intrinsically speculative property. However, cryptocurrencies, like gold, could be thought to be simply one other speculative asset within the monetary system.

No detailed map of how all these actors are linked to at least one one other is obtainable.

A case can subsequently be made that the intense challenges dealing with the crypto world lie with its ecosystem and never with the cryptocurrencies themselves. As is clear from the investigations that adopted previous crypto-dominoes falling, the crypto ecosystem constitutes a closely-knit constellation of actors – lenders, hedge funds, exchanges, wallets, stablecoins being probably the most distinguished ones. Most of those institutional actors of decentralised finance (DeFi) play a job akin to that of their conventional finance (TradFi) counterparts, they usually function in a totally centralised trend.

The heralded function of decentralisation, which is supposedly meant to afford cryptocurrencies superiority over classical currencies, is solely bypassed (funding financial institution Morgan Stanley not too long ago reported that centralisation is a pure evolution of the financialisation of cryptocurrency markets). One other necessary issue is that almost all of those crypto actors have very restricted interactions with TradFi markets. Certainly, a foot into TradFi means abiding by its regulatory framework, whereas the crypto world is aware of few and restricted rules.

Successfully, the DeFi ecosystem kinds a posh community of interdependencies, primarily amongst crypto actors themselves with a number of bridges on the margins of TradFi. Nevertheless, within the absence of systematic regulation, no detailed map of how all these actors are linked to at least one one other is obtainable: we don’t truly understand how the DeFi community appears like.

However, Community Science, a subfield of Complexity Science, may also help us perceive the broad contours of the cryptocurrency ecosystem and the dominant networks inside it. We will draw on the restricted data we are able to derive from autopsy evaluation of the current main collapses of TerraUSD and FTX as an example. These revealed an excessively excessive stage of clustering within the crypto ecosystem – a typical property in your personal social community if your pals are additionally buddies with each other. 

Though clustering in social networks can confer quite a few advantages, akin to better help when attempting to stop smoking, it may well additionally amplify the contagion of damaging results. Therefore, if the connectivity of the opposite DeFi actors nonetheless standing is much like – or overlaps with – that uncovered for the fallen actors, it might be that the crypto ecosystem is prone to proceed experiencing a systemic cascading failure.

To make certain, this doesn’t essentially imply that cryptocurrencies will themselves crash, though it’s a possible end result as traders’ confidence will certainly erode sooner or later, even for probably the most ardent crypto supporters. It thus stays to be seen how for much longer the DeFi ecosystem can proceed to defy gravity, however it’s unlikely to disobey the legal guidelines of complexity.