Stocks are down again.
Tech stocks are down more, as you’d expect (since stocks with higher expected return tend to go down more when the market goes down).
And crypto is down as well.
This provides more support for the theory that crypto behaves like a tech stock, rather than an inflation hedge.
The crypto crash understandably has a lot of people upset.
I know these are not fun numbers, but here’s a list of US exchanges by their approximate employee count & layoff by % and size:
Gemini – 1038 (10% – 100)
BlockFi – 850 (20% – 170)
Crypto.com – 5200 (5% – 260)
Coinbase – 4900 (18% – 900)
Robinhood – 3800 (9% – 350)
Somewhat hilariously, celebrity boxer Jake Paul blamed Joe Biden for letting crypto prices fall:
Now, it’s a little bit hilarious to see people calling for government policy to support crypto prices. The whole story of Bitcoin was that it was supposed to make governments and their fiat currencies obsolete — now they’re begging the government to make their crypto worth more fiat? Comedy gold.
But the truth is that Jake Paul is probably not a hardcore Bitcoin bro — he’s just a regular guy who bought crypto because he thought it was a Thing That Goes Up. A Goer-Upper. In financial economics, we call this kind of thinking “extrapolative expectations”.
Well, harsh news: High expected returns almost always come at the price of high risk. Being a Goer-Upper in the long term means that an asset will tend to spend a decent amount of time as a Goer-Downer.
When it comes to Bitcoin and crypto in general, there are scenarios where it does go up in the long term.
One such scenario is a world where web3 figures out how to provide real value to consumers, and where Bitcoin serves as the onboarding process for people to get into web3.
I think there’s another scenario, though, where Bitcoin goes up even more in the medium term. It’s the idea that institutional money will eventually come in and buy up a ton of crypto, pumping up prices to previously-undreamt-of levels. At this point the regular folks who don’t buy into the “Bitcoin will replace fiat” origin myth are probably, on some level, hoping for this sort of institutional bailout. So it’s worth thinking about whether this will happen, and why.
The notion that institutional money will be a sort of “exit” for crypto speculators is hardly new. Sam Bankman-Fried, the founder and CEO of the crypto exchange FTX, has been going around saying this for over a year now. In a recent Bloomberg podcast, Bankman-Fried admitted that much of the “decentralized finance” that people use his platform for isn’t financing anything real, just monetizing user growth — i.e., Ponzi schemes. But he said that all would be made right when the institutional money came in and everyone who was holding any kind of crypto made out like a bandit.
This is sort of the reverse of the rosy scenario Maxis dream about; Instead of Bitcoin being an onboarding ramp to useful web3 applications, Bankman-Fried is positing that useless web3 applications are basically just disguised bets on Bitcoin. Meaning that the viability of the whole system depends on a bailout from institutional money.
What kind of institutions are we talking about here? Well, the financial services companies that manage 401(k) plans, for one. About two months ago, Fidelity Investments announced that it would allow companies to allow employees to choose to allocate some of their retirement money to Bitcoin. The Labor Department and various nonprofits like the AARP have been warning against letting crypto into 401(k) plans, but employees have been clamoring for the option. Another big pot of money would be if target-date funds invested in crypto.
Then there are pension funds, endowments, insurance companies, hedge funds, and a host of other institutions who could decide to dip their toes into the crypto waters. A Fairfax County, Virginia pension fund started investing in crypto in 2019, and in 2021 a Houston firefighters’ pension fund put money into Bitcoin and Ether. Harvard and Yale’s endowments have been investing in Bitcoin since 2019. Some insurers are entering the market too. So the wave of institutional money has already been arriving, and the question is more about whether it’ll increase significantly.
Why would institutional portfolio managers allocate their clients’ money to a hyper-volatile asset with only a short history and little obvious fundamental value beyond cybercrime and evading capital controls? Some of them might actually buy the story that Bitcoin or some other crypto will eventually replace fiat money as the currency of the land…but I doubt it.
A simple explanation is that professional fund managers themselves have extrapolative expectations — they see that Bitcoin has risen steadily in price for the past few months or years, and they conclude that it is a Goer-Upper, without thinking too hard about whether whatever is making it go up might soon stop. Some surveys have shown that professional investors are subject to extrapolative beliefs, though other research suggests they are less extrapolative than retail investors.
A third explanation is that fund managers are speculating. Some models of asset bubbles find that when a new asset gets offered to the market, rational investors will bet on the eventual size of the total market for that asset. In essence, all the money managers might conclude that in the long run, some percent of investors will hold crypto, and that they’re not too late in line to make some money.
Note that these explanations don’t end particularly well for many of the institutional investors themselves. Speculative processes where everyone is betting that everyone else is going to buy the thing eventually end up crashing when the number of new investors runs out; everyone realizes that they’re only holding it because they thought other people were going to hold it, and then there’s a stampede to get out. Similarly, buying binges based on extrapolative expectations end up crashing when the number of extrapolators runs out, prices begin to fall, and people start extrapolating in the opposite direction. And if money managers expect Bitcoin to be the future of money, they’re simply going to be disappointed.
So all of these theories end in tears for the money managers — and, by extension, for grandma’s pension plan and your 401(k). In essence, the institutional investors would simply represent the final bag-holder for a vast Ponzi, allowing early Bitcoin buyers to cash out huge and allowing those who bought in at the late 2021 peak to at least break even.
But such a crash is not inevitable. There are rosier scenarios for institutional investors, where they aren’t just the dumbest of the dumb money.
For example, demand for crypto might ultimately be sustained by the popular persistence of Bitcoin’s founding myth — the idea that Bitcoin will eventually supplant fiat currency. This is the “digital gold” hypothesis, because a popular belief that the world will revert to a gold standard is one of the things that supports the value of that yellow shiny rock. So far, Bitcoin hasn’t behaved much like an inflation hedge, but gold doesn’t always do so either. Perhaps there will be people in 2050 and 2100 who still think that someday all the governments will fall and Bitcoin will rule the Earth. That future belief, mythological or no, could provide an anchor for crypto’s value in the present.
A second possibility is that web3 will actually create a bunch of digital services that people want to use, and that Bitcoin will serve as the onboarding ramp to that world.
A third possibility is that evading capital controls might prove to be a lot more valuable than anyone realizes. With the U.S. and Europe having just demonstrated the power of financial sanctions against Russia, some countries will naturally want to insulate themselves against a similar attack. Holding some crypto might be one way to do this; if the West freezes your dollar or euro holdings, at least you can buy stuff with your Bitcoin. This is why Bitcoin boosters are trying to woo the central bankers of various developing nations and rogue states.
Finally, maybe institutional asset managers themselves will help sustain the value of Bitcoin, simply by holding it in their portfolios. Asset management tends to operate on a “bucket” principle — portfolio managers decide what the investable asset classes are, and then they allocate nonzero percentages of their money to those “buckets”. Market share is a function of mindshare. If asset managers simply collectively decide that crypto is a “bucket”, they might keep allocating money to it even if no plausible story of fundamental value ever materializes. As more people are born and the economy grows and more money flows into the coffers of institutional investors, they will allocate some of that to crypto, supporting its price simply through collective action (like a less fickle version of the noise traders who “create their own space” in a noise trader model).
First, crypto’s recent price decline might puncture its image as a Goer-Upper in the minds of extrapolative investors. Sure, Bitcoin has bubbled and crashed many times before, but this is only to be expected for a fringe asset traded by a few libertarians and tech geeks. The most recent crash — which has now lasted half a year — came after some institutional money piled in. Over $2 TRILLION of notional value has now been wiped out compared to the peak in late 2021, and the total market cap of all crypto is now estimated at less than $1 trillion. The set of investors who have seen their crypto go down is now far larger than it was in the crash of 2018 or any of the earlier crashes.
That crash will also probably make it harder to sell Bitcoin’s founding myth to the masses and thus turn Bitcoin into digital gold. People intuitively recognize that a form of money that can lose 2/3 of its value in six months is not a very useful currency; just imagine a fiat currency that experienced massive hyperinflation or hyperdeflation every year. You would not use it. (And on top of that, people can easily see that experiments with using Bitcoin as an actual currency, as in El Salvador, have not worked out.)
Second, crypto seems ever more correlated with other assets, especially tech stocks. One institutional case for crypto investing is that crypto is imperfectly correlated with other assets and can thus boost the returns of a diversified portfolio even if it isn’t a spectacular Goer-Upper. But this case is looking weaker and weaker; as more “normies” have piled into crypto, Bitcoin’s correlation with the NASDAQ has grown to 0.8. Growing correlations also raise the chance that institutional money managers will come to see crypto as just a weird tech stock instead of its own special “bucket”.
As for web3, it may eventually provide lots of real value to consumers, but right now NFTs — the most interesting and valuable web3 product — are in quite a bust. So we’ll see.
In fact, I think the most bullish event for Bitcoin is actually the Russia sanctions. The case for developing-country and rogue-state central banks to hold some Bitcoin as insurance against Western sanctions is actually legitimate. It will certainly be ironic if central banks end up being key to Bitcoin’s value, but it’ll also make a lot of sense. Cryptocurrency is, on some level, a desperate back-up method of transferring and storing value in a world of anarchy. And yet the international sphere is a world of anarchy.
So while I can’t know the minds of institutional money managers, if I were forced to guess, I’d say this crash will make them shy away from the big shift to crypto. The $1 trillion of institutional money that Sam Bankman-Fried confidently predicts will swoop in to bail out everyone in the crypto universe may eventually arrive, but I think it will now be a lot longer in coming. Developing-country and rogue-state central banks, on the other hand, seem like crypto’s likeliest savior in the short term.