Does crypto technology “magic” allow it to transcend the principles of economics?

Update November 2022

Since this post was written, FTX, one of the worlds largest crypto exchanges, has controversially and spectacularly collapsed. This provides yet more compelling evidence that the crypto boom was the result of a financial bubble, rather than a magical perpetual motion machine.

Introduction

The current crypto-economy is booming. A huge amount of money is circulating, and on the surface it appears many are gaining huge returns on their crypto investments. As one now infamous piece of crypto popular culture puts it, the line just keeps going up. Much of the rhetoric in the crypto-sphere gives a sense of a perpetual motion machine, generating self-fuelled growth which will last forever. The key question is, can it?

This analysis will unpack the idea of crypto as a financial perpetual motion machine. Drawing on the downfall of TerraUSD as a case study it examines the dynamics and sustainability of the current crypto-economy, noting some worrying similarities to financial bubbles including the one which triggered the 2008 financial crisis. Finally, we consider the best case scenario for the sustainability of a crypto-asset – widespread acceptance and diversification before the speculation bubble bursts – before laying out our prognosis as to whether the crypto-economy can continue to operate as a financial perpetual motion machine. We conclude that this is unlikely at best.

Contents

1. What does it mean to call crypto a financial perpetual motion machine?
2. TerraUSD: a case study in the impossibility of financial perpetual motion
3. Similarities between the crypto-economy and the pre-2008 financial bubble
4. The best case scenario for crypto-assets: (1) ponzi, (2) acceptance, (3) diversification, (4) permanence
5. Conclusion: crypto isn’t a magic bullet for financial perpetual motion

1. What does it mean to call crypto a financial perpetual motion machine?

A perpetual motion machine is a device that, once set in motion, continues to be in motion, with no requirement for any external source of energy to maintain it. The appeal of a perpetual motion machine is the reward of essentially limitless free energy (minus the cost of the initial input of energy to get it going). The first and second laws of thermodynamics have proven the existence of such machines to be impossible.

By analogy, we can think of a financial perpetual motion machine as something generating continuing economic returns, and perhaps even growth in returns, forever, “for free”. The term “free” here is not used as strictly as in the technical definition above; in the case of crypto, money is spent on inputs such as developer labor, and the energy used for activities such as mining. The important characteristic is that the value of any given asset increases without any economically productive activity taking place. On the understanding of the crypto-economy as a financial perpetual motion machine, my crypto-assets will keep growing in value perpetually without my doing anything (i.e. expending any inputs myself), and without this growth being attached to economically productive activity – understood as the production of goods and services which generate utility for people – as is the case with traditional investments such as stocks.

While the analogy is not perfect, the impossibility of true perpetual motion should give serious pause for thought as to the sustainability of this consistent and unproductive value growth. This skepticism can only be strengthened by observing the pattern played out time and again throughout economic history: financial perpetual motion invariably transpires to be little more than a bubble, grinding dramatically to a halt as spirits shift and the bubble bursts. Examining the dynamics of the crypto-economy in more detail, there are alarming similarities with both the pre-2008 financial system and bubbles further into the past. We will turn to this analysis in the following sections, beginning with an illustrative case study of the now defunct stablecoin Terra and its staggeringly rapid crash.

2. TerraUSD: a case study in the impossibility of financial perpetual motion

To explain why the cryptosphere is not a financial perpetual motion machine we are going to examine the mechanisms that enable the crypto market to churn out more value for investors than was deposited. We are going to use the stablecoin TerraUSD (UST) to demonstrate how these mechanisms operate and to explain why the system is unsustainable. UST is fitting to use as an example to demonstrate how all crypto-assets operate as they are fundamentally underpinned by the same mechanisms. We will explain how the crash suffered by UST is demonstrative of the systemic risk which runs throughout both DeFi and crypto-asset investments more broadly.

UST is an algorithmic stable coin which is pegged to the US dollar. Whereas fiat- or crypto-collateralized stablecoins maintain their peg by having a reserve of a fiat or crypto currency as collateral, algorithmic stablecoins such as UST maintain their peg through a system of algorithmic arbitrage. UST has a sister token, Luna. The system is designed so that each UST token is redeemable for $1 worth of Luna. Therefore, when UST is trading below $1, traders are incentivized to buy one UST and exchange it for $1 worth of Luna. As UST is burnt to mint Luna, the supply of UST is reduced and its price is pushed up. When UST is trading above $1, token holders are incentivized to exchange their Luna for UST. This increases the supply of UST, thereby reducing its price and keeping the value of UST stable at $1.

As an algorithmic stablecoin, untied from the volatility of other cryptocurrencies like bitcoin or ether, UST was presented as a safe and steady place to hold one’s money while still remaining within the crypto ecosystem. An additional motivation to potential investors of UST was the promise of staggering yields by holding their UST in a decentralized finance (DeFi) savings protocol called Anchor. The protocol, running on the Terra blockchain, promises 20% interest to those who deposit UST.

While Terra and Luna is often described as a financial engineering experiment, for a long time it looked as though the experiment was working. According to Coingecko, at its peak in early April, the market value of all Luna exceeded $41 billion placing it in the top 10 cryptocurrencies. ¹

On May 7 2022, UST deviated from its peg, seemingly as a result of massive withdrawals from Anchor. As billions of UST were removed from Anchor and dumped on the market, the price of Terra slipped, motivating more and more people to pull their money out of Anchor and get rid of their UST. While Luna tanked, the algorithm carried on doing what it was programmed to do: the system created more and more tokens to meet the demand of UST sellers who all remained entitled to a dollar’s worth of Luna. This caused the price to plunge even more, diluting the market with Luna. By May 13, one Luna was valued at $0.00001834 and the total supply of the coin was over 6.5 trillion. At time of writing, UST is currently sitting at 10 cents.² As described by Kevin Zhou, crypto hedge fund Galois Capital founder, Luna had suffered from “hyperinflation of hyperinflation”.³

Terra provides a stark case study of the dynamics of the crypto-economy not just because of its dramatic demise, but because the mechanism by which it sustained its growth and subsequently crashed pervades the whole of the crypto-sphere. The Terra system depended entirely on Luna, a manufactured token with no intrinsic or use value. Its value was a product of artificial demand dynamics generated by overblown narratives and speculation. Almost all crypto projects share this characteristic: they are fuelled by demand for newly created tokens devoid of meaningful value beyond allowing one to participate in the project and make financial gains from speculation. The growth stemming from sheer belief that these tokens will continue to increase in value bears all the hallmarks of greater fool theory and of an economic bubble, as we outline below.

Even more worrying is the role of the Anchor platform in the case of Terra, and the prevalence of yield farming and the spate of complex financial derivatives which has sprung up around crypto-assets. As displayed by the impacts on Terra of large withdrawals from Anchor, this layering of ever more complex financial instruments on top of tokens whose value depends on belief alone builds an extremely high level of systemic risk into the system. Not only does this make it more likely that the bubble will pop, but that the impacts will be all the more dire when it does. As outlined in the next section, this bears a striking resemblance to the system which underpinned the 2008 financial crisis.

3. Similarities between the crypto-economy and the pre-2008 financial bubble

As noted above, the case of Terra is indicative of the bubble dynamics that pervade the entire crypto ecosystem. When we compare these more directly to economic bubbles throughout history, it is hard to avoid drawing parallels which bode ill for the prospect of crypto’s perpetual growth.

Economic bubbles are a market phenomenon that sees irrational pricing of an asset caused by herd mentality; people hear stories of others who bought in early and made big profits, more and more people jump in, pushing the value of the asset up and up, exceeding the intrinsic value of the asset (if the asset even has any value), until one day the mania subsides and the value of the asset plummets.

Where such assets have complex financial instruments built on top, there is risk of far reaching systemic damage. The 2008 subprime crisis provides a demonstration of what happens when a range of complex financial products are completely dependent on the cash flows of a fundamentally unstable asset. Just as a fall in house prices caused mass mortgage defaults by borrowers in precarious financial positions, and in doing so brought down the entire financial system propped up by their repackaged debt, the cautionary tale of Terra shows the very same vulnerability throughout the system of decentralized finance (DeFi), which hinges on speculation-driven token value.

In her 2022 paper ‘DeFi: Shadow Banking 2.0?’ Prof. Hilary Allen warns that the current DeFi system risks emulating the “shadow banking” services (functional equivalents for banking products which operate outside the regulated banking sphere) which contributed to the 2008 banking crisis:

“if DeFi is permitted to develop without any regulatory intervention, it will magnify the tendencies towards heightened leverage, rigidity, and runs that characterized Shadow Banking 1.0.”⁴

Commentators have raised concerns about stablecoins in particular, describing them as analogous to the money market funds (MMF) at the heart of the 2008 crisis in their potential to cause runs. Prof. Allen explains:

“If something were to shake confidence in stablecoins’ acceptance in the DeFi ecosystem (this ‘something’ could range from a hack, to a problem with the reserve of assets backing a stablecoin, to a problem with the smart contracts managing the value of a decentralized stablecoin), we could then expect holders to exchange their stablecoins for fiat currency and exchanges to seek redemption, forcing stablecoin issuers to start liquidating the reserve of assets backing the stablecoin, depressing the market value of those assets, and cutting off credit for the corporations in which MMFs usually invest through the commercial paper market.”⁵

This fragility and extreme vulnerability to the animal spirits of investors pervades the entire crypto-economy. The core mechanism – of minting tokens with no use value and who’s market price is artificially driven by speculative hype – underpins almost the whole system (with the small exception of tokens who are in some way backed by real world assets, whose value growth beyond the price of these assets still remains fuelled by speculaiton). What might appear as a recipe for perpetual growth and financial gain in fact appears highly likely to have created a speculation fuelled bubble, with the complex token derivatives which characterize DeFi akin to castles built on foundations of sand. If this analysis is correct then not only is crypto far from a financial perpetual motion machine, but an economic time bomb.

4. The best case scenario for crypto-assets: (1) ponzi, (2) acceptance, (3) diversification, (4) permanence

The above paints a bleak outlook for the crypto-economy. So, what’s the best case scenario? Is there any way that the machine can keep running and generating wealth?

The strongest case has been outlined in Bloomberg, although in a twist of irony it focuses on Terra, just days before its crash. While the piece focuses on ‘The Stability of Algorithmic Stablecoins’ it can perhaps be extended to other crypto projects also.

As the article notes, if you can keep your token based Ponzi scheme going for long enough then you may be able to reach a point of widespread acceptance. Your stablecoin, despite having no intrinsic value, is just accepted as being worth, say $1. It is this common recognition embedded in the collective psyche of the system’s participants which maintains this value rather than a reliance on an algorithmic mechanism. This is to some extent akin to the collective belief which upholds the value of fiat money, although crucially without the power of a state to enforce it should this belief waver.

The next step would be to diversify the reserves backing the peg of your stablecoin, into other more embedded cryptocurrencies more embedded in the system such as bitcoin and perhaps also non-blockchain based assets such as gold and dollars. This diversification means that the project is no longer contingent just on investor belief in your own manufactured token’s value. If that spell breaks, there are assets deriving their market value from elsewhere which can be spent to return the value of your stablecoin to $1. More and more reserve assets are purchased, until there are sufficient ‘real world’ tools ready to back up this zero value, made up asset. This ‘best case scenario’ can be summarized, then, as: “(1) Ponzi, (2) acceptance, (3) diversification, (4) permanence.”⁶

In theory this process could be adapted to function for non-stablecoin projects also. The key is the transition from dependence on [speculative] belief in the value of the project’s manufactured token to other means of securing its value: economic norms and then external assets.

Even under this best case scenario, however, the prospects for the perpetual growth of the crypto-economy as a whole remain slim. First, while this process could at least in theory work for specific crypto-assets, it cannot work for all of them. Not every crypto token can become so embedded that its value is simply accepted as a given, or become so big that it can fund the purchase of large amounts of external reserves.

Second, while other crypto-assets still make up a part of a token’s reserve assets, its value will still depend largely on the performance of the crypto-market as a whole. If, as appears plausible based on the above analysis, the great majority of this market is subject to the same speculation fuelled bubble dynamics, then vulnerabilities persist both at the level of individual projects and the broader market. This could be seen in the case of Terra, where a large proportion of initial Anchor withdrawals seemed to occur in response to general market downturns.

Third, pivoting to backing by real world assets, arguably the most likely way to ensure a crypto token can retain its value, will fundamentally undermine the dynamics giving rise to a perception of financial perpetual motion in the first place. As soon as real world assets enter the equation, so do the constraints of real world economics. Growth will become a function of the real world assets underpinning tokens, and this growth is far less likely to be propelled to dizzying rates by speculation.

5. Conclusion: crypto isn’t a magic bullet for financial perpetual motion

The above examples provide strong reason to believe that the crypto-economy cannot keep growing like this forever. The financial perpetual motion machine must at some point come to a halt, as the speculation-driven artificial demand for fundamentally valueless crypto-assets peters out. History is littered with examples of economic bubbles, all of which eventually burst. As the 2008 crash demonstrates, whole-system collapse is made both more likely and more disastrous when derivatives and other complex financial products spring up around bubble driven asset prices. This same systemic risk pervades the ‘DeFi’ system, with the case of Terra being a warning of dynamics which have the potential to cause crashes at far larger scales.

The best case scenario for individual crypto-assets – normalization and backup asset diversification – is unlikely and does little to secure the continuing growth of the entire crypto-economy. This system is occupying some of the world’s smartest minds, contributing massive carbon emissions to our atmosphere, and had, at its peak, over $3 trillion dollars invested into it. It is time we stepped back from the illusion of financial perpetual motion, before the inevitable crypto-asset crashes begin shaking the wider global economy.

Notes and references

1. CoinGecko. ‘Terra Price, Luna Chart, and Market Cap’. Accessed 17 May 2022. https://www.coingecko.com/en/coins/terra-Luna.
2. CoinMarketCap. ‘TerraUSD Price Today, UST to USD Live, Marketcap and Chart’. Accessed 18 May 2022. https://coinmarketcap.com/currencies/terrausd/.
3. Weisenthal, Joe, and Tracy Alloway. ‘Meet the Hedge-Fund Manager Who Warned of Terra’s $60 Billion Implosion’. Bloomberg.Com, 15 May 2022. https://www.bloomberg.com/news/articles/2022-05-15/Luna-crash-this-crypto-insider-warned-of-terra-ust-s-collapse.
4. Allen, Hilary J. ‘DeFi: Shadow Banking 2.0?’ SSRN Electronic Journal, 2022. https://doi.org/10.2139/ssrn.4038788.
5. Ibid.
6. Levine, Matt. ‘The Stability of Algorithmic Stablecoins’. Bloomberg.Com, 19 April 2022. https://www.bloomberg.com/opinion/articles/2022-04-19/the-stability-of-algorithmic-stablecoins.