#CryptoExplained: Crypto Crashes Are a Feature, Not a Bug

The world of crypto is famous for bull runs and spectacular crashes. One of the reasons folks fear crypto is that it could swing to a 30 percent loss in value within the same day. Such swings are normal for crypto and so are frequent crashes where a loss of 50 percent or more of value is not unheard of. Many in the crypto community don’t see these crashes as a flaw, but as an inherent feature that signals the resilience of the system as a whole. This is because crypto is so sensitive and transparent that it is difficult to obfuscate systemic issues until it’s too late. 

In the traditional financial system, information is often opaque and many systemic issues never come to the surface and build up over time into a catastrophic failure. The 2008 financial crisis was a great example of this where the markets were artificially high due to financial products that were so complex that even rating agencies did not rate them correctly. Further, almost all these products were held in private databases owned by private banks so the broader market and even the Fed had no idea that catastrophe was looming. 

In fact, something similar is happening right now with the Fed increasing interest rates and forcing systemic issues to the surface. Silicon Valley Bank and Signature Bank are unfortunate casualties of this but there are many more systemic failures that are likely to surface as high interest rates continue. This environment of high-interest rates is here after almost 10 years of growth during which many deals, financial innovations, etc have created a system that we don’t fully understand and could break in unpredictable ways. 

Unlike the traditional financial system, crypto crashes at least once a year. This means that systemic issues and flawed financial products are brought to the surface quickly and dealt with quickly. FTX was the failure of a large centralized exchange that was caused by the collapse of the Terra Luna ecosystem and in turn caused the collapse of many other crypto entities. All of this occurred over a period of 6 months but by the start of this quarter, much of this unraveling was nearing its end. 

During this last major crypto crash, decentralized systems like Ethereum, decentralized exchanges like Uniswap, and decentralized lending platforms like Compound did not fail. They survived the stress test. And in doing so they proved that decentralized systems are more trustworthy and more resilient than their centralized counterparts. Their resilience comes from the fact that their balance sheets are transparent and visible to the entire community. Another reason is that by nature of being decentralized, there are a large group of people who are publicly involved in their governance and therefore can not make malicious or purely self-serving decisions. Many of the people involved in the governance of these decentralized systems are highly incentivized to ensure they are trustworthy. 

Finally, code is law, which means that in many cases it is impossible for these systems to perform in a way other than designed and approved by the community. This is true to the crypto goal of “Cannot Be Evil”.

Crashes in crypto can be scary but they are necessary for innovation and rapid development of the ecosystem. Ironically it’s the feature that we are most afraid of that will ultimately be the reason for its rapid evolution and success.