Jerome, son of Paul: Is crypto ready for a Volcker Shock?

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TL;DR: Crypto is not one thing–it is two categories sharing the same name:

  • stores of value, of which Bitcoin is the most important
  • smart contract networks, of which DeFi is the paradigmatic example

Inflation-hedging assets are “digital gold” likely to suffer a modern-day “Volcker Shock” as the Fed raises rates. Their long-term price hinges on Jerome Powell’s (in)ability to slay the inflationary dragon.*

DeFi protocols are closer to Internet stocks after the DotCom crash, with significant traction but in search of viable revenue models, recalling the early days of today’s dominant tech platforms.

Both types of crypto are attempts to exit our ossified, central-bank-dominated financial system. Both will suffer when the Fed hikes rates this year, but their paths will soon diverge.

Special Note: This is an edited version of an earlier essay that appeared on January 25, 2022. I have nothing but thanks to the Buttonwood team and to Niall Ferguson for their comments.

Paul Volcker nominated chairman of the US Federal Reserve.

Introduction

By crippling supply chains and expanding the money supply, COVID lockdowns and Fed policy summoned the “inflationary dragon.” All manner of asset prices boomed in 2020 and 2021, from rural real estate to tech stocks to lumber.1 But crypto surged fastest of all, with Bitcoin rising 1,340% from $5,000 to $67,000. Yet signs that the Federal Reserve will raise rates and slow asset purchases have triggered a crypto winter—crypto assets are down 45% from their $2.95 trillion November all-time-high.

Is this the end of the line for crypto? Only as a blanket term that has outlived its usefulness. Cryptocurrency has ceased to be a monolithic asset class, if it ever was one. It is now clearly comprised of two distinct categories—inflation-hedging assets, such as Bitcoin, and smart-contract networks, such as Ethereum. And although they flourished together under easy money, financial history suggests that their paths will soon diverge.

Deflationary Assets: Volcker Shock Redux?

Bitcoin today is “digital gold.” (or to be more accurate, an option on digital gold). Its core value proposition, and technological innovation, is digital scarcity via a public, decentralized ledger that tracks a fixed supply of 21 million bitcoins. This stands in contrast to the potentially unlimited supply of fiat currencies, which Satoshi Nakamoto saw as a key weakness of the traditional financial system when Bitcoin was released in 2009, in the aftermath of the global financial crisis.

Opening paragraph of the Bitcoin white paper.

Bitcoin wasn’t always digital gold. For years, enthusiasts hoped that bitcoins would function as digital cash in everyday transactions. But fundamental limits on Bitcoin’s transaction throughput–a product of both the small size and infrequency of the blocks in its blockchain— forced Bitcoin-the-money to give way to Bitcoin-the-asset.2

Source: Burueau of Labor Statistics (BLS).

Gold used to play a similar role after President Richard Nixon ended the Bretton Woods system and inagurated the age of fiat money.3 In the inflationary 1970s, as the West was buffeted by the 1973 oil shocks, the price of gold rose rapidly by 463% from its 1976 lows to peak at $2,340 in 2022-dollar terms. However, at the close of 1979, President Jimmy Carter nominated Paul Volcker to chair the US Federal Reserve. Volcker recalled that “There was this feeling of malaise, to use a term (popular) at the time. There was a kind of great speculative pressure. It was the years when everybody wanted to buy collectibles from New York. The market was booming, and other markets of real things were booming, because people had got the feeling that things were inflating and there was no way you could stop it."4

Source: World Gold Council; BLS; author's calculations.

Following changes in Fed policy to limit inflation, gold dropped 61% over the next year and a half, bottoming at $912. The Fed’s measures were drastic, even for Volcker, “If you had told me… that interest rates, the prime rate would get to 21.5 percent, I probably would have crawled into a hole and cried, I suppose.”

Of course, Jerome Powell is no Paul Volcker. Nonetheless, Bitcoin will continue trading like digital gold, and its long-term price will respond to two factors: inflation expectations and the extent of its adoption as a monetary reserve asset.

Unlike his predecessor, Powell has a track-record of changing course when the going gets tough. That was happened after markets tanked near the end of 2018. Some investors are already wondering if the Fed might blink before yearend, even if (as seems likely) inflation remains stubbornly high. It is not clear how big a stock-market sell-off the Fed can handle. Any sign of weakening will be a tailwind for Bitcoin.

Bitcoin could also secure lasting relevance through inclusion in monetary reserves. Beginning in the early 18th century, Britain, then the world’s rising imperial power, led the adoption of the gold standard. But the “Bitcoin standard” seems to be spreading in reverse, with small countries like El Salvador leading the way. It is far from certain that such an approach will succeed—but then again, Bitcoin has never been for the faint of heart.

Smart Contracts: Echoes of the DotCom Crash

After digital scarcity, the second major crypto innovation was smart contracts, with Ethereum being the earliest and largest smart-contract platform. Ethereum was launched in 2015 as a “world computer” capable of executing code across a decentralized network of machines. This stands in contrast to Bitcoin, which can only store a decentralized ledger across its network.

Until 2019, however, smart contract protocols and their tokens had yet to bear fruit. All crypto assets had to offer was digital scarcity, and so their price mimicked Bitcoin’s. And while non-fungible tokens (NFTs) and meme coins are technically built and launched on top of smart contracts, their value proposition remains digital scarcity as digital collectibles or more volatile versions of Bitcoin.

Peas in a pod? Source: Bloomberg.

The most powerful and important application of smart contracts is decentralized finance (DeFi). DeFi is based on open protocols, which coordinate financial actors while minimizing or outright removing financial intermediaries. Notable inventions in this space include on-chain markets, margin lending, and automated investment strategies. Today’s DeFi tokens are not just shinier “digital precious metals”—they are part and parcel of a technological approach to finance far more radical than anything today’s fintech companies are attempting.

“Web 3” (the hip new term) is thus tracing the steps of “Web 2.” The 1990s DotCom boom resembles the crypto boom of 2017. Most Internet companies had gone public with nothing more than vague business plans and a web domain. The NASDAQ peaked at 5,060 before tumbling 78% to 1,116—not as bad as Bitcoin’s 85% drop in 2018, but close. The crash of 2000 called into question whether tech stocks could ever accrue value independently of accommodating monetary conditions. Serious people earnestly wondered if Paul Krugman might have been correct to argue that the Internet’s economic impact would be the same as the fax machine’s.5 This was a liminal moment—when DotCom was dead but Big Tech had yet to be born.

Source: Yahoo Finance.

DeFi’s trajectory will be similar. Much as in the DotCom bubble, 2016-2018 saw hundreds of initial coin offerings (ICOs) created by teams with nothing more than whitepapers. Path-independent curves, on which almost all DeFi is built, had yet to be discovered.6 DeFi’s liminal moment may have been the two years between the 2018 crash and the 2020 COVID boom, when many in the industry wondered if smart contract applications could work at all.

Today, DeFi protocols have reached significant traction but are still in search of viable revenue models, recalling the early days of today’s dominant tech platforms. These smart contracts will disrupt less efficient sectors, much as Facebook, Google, and Craigslist decimated the less efficient print advertising industry. Consider a comparison between Coinbase, the largest US crypto exchange, and Uniswap, the largest on-chain exchange protocol.

Source: Authors's calculations.

Uniswap is limited to Ethereum-based assets, so its total 24-hour volume of $2.2BN is just about half that of Coinbase’s $4.0BN. But total ETH volume on Uniswap is $1.1BN, already more than Coinbase’s $0.7BN.7 But, strikingly, Uniswap supports its protocols with a team of just 38,8 compared with over 2,700 for Coinbase.9

As a result, Uniswap fees, which totaled $2.2BN in 2021, do not accrue to the protocol or its team, but to the liquidity providers that make its markets. At most, Uniswap governance token holders could choose to take a 0.05% protocol fee on volume, which in 2021 would have amounted to $365M.10 Coinbase’s 2021 revenues of $7.3BN accrue to the firm itself. In contrast, Uniswap returns its economic surplus back to its users. Most other DeFi protocols work in this way, making them economically competitive with traditional financial intermediaries. 11

Even more remarkable is Uniswap’s permissionless nature—anyone can list a token. It currently supports 2,136 tokens and 4,245 trading pairs across its v2 and v3,12 compared to 96 tokens for Coinbase and its 81 trading pairs.13 Coinbase curates tokens much as newspapers curated content, i.e. selectively, while Uniswap is closer to Facebook, where anyone can be a content producer.

It is not hard to see that this year might be for DeFi what 2000-2 was for tech stocks—the moment after a new technology has survived an existential threat, but before its future value has been fully priced in.

Conclusion

Like Paul Volcker 40 years ago, Jerome Powell will be pressured to try and slay the inflationary dragon. Whether he succeeds or not will hinge on the electoral calculations of the Biden administration. What’s the weaker poison–falling asset prices or high inflation?

Paul Volcker. Source: Chick Harrity, AP.

The coming end of easy money recalls similar moments in 1979 and 1999. It does not spell the end of “crypto,” any more than the dotcom bust spelt the end of e-commerce. Both Bitcoin or Ethereum are attempts to exit our ossified and fragile central-bank-dominated financial system. As digital gold, Bitcoin provides a refuge from inflationary fiat currencies, as real gold did before 1979. In turn, Ethereum’s Web 3 smart contracts promise staggering efficiency in financial markets, much as Web 2 software transformed the economy after 1999.

While these two technologies have thus far shared the same market journey, they will soon begin charting their own paths. Retire the word “crypto.” But don’t sell your Bitcoin. And be long DeFi.


  1. Scott Horsley. “What The Rise And Fall Of Lumber Prices Tell Us About The Pandemic Economy.” National Public Radio. July 8, 2021. URL ↩︎

  2. The Bitcoin Cash fork, for example, emerged because a subset of the Bitcoin community believed that Bitcoin should properly be digital cash, not digital gold. Their proposed solution was to upgrade the Bitcoin codebase to have larger transaction blocks. Many other such blockchains emerged, all trying to solve the throughput issue fundamental to blockchain design by having larger and more frequent blocks. ↩︎

  3. Niall Ferguson. “50 Years After Going Off Gold, the Dollar Must Go for Crypto.” Bloomberg. August 14, 2021. URL ↩︎

  4. Paul Volcker. “Volcker at the Fed: “Slaying the Inflationary Dragon”", Public Broadcasting Service. Interview conducted September 26, 2000. URL ↩︎

  5. Paul Krugman. “Why Most Economists’ Predictions Are Wrong.” The Red Herring. 10 June 1998. ↩︎

  6. As I’ll explain in an upcoming post, path-independent curves are a way to overcome the blockchain’s information latency relative to the outside world. ↩︎

  7. Coingecko data on January 26, 2022. ↩︎

  8. Tim Fries. “With 33x Fewer Employees, Uniswap Has 77% of Coinbase’s Trading Volume.” The Tokenist. July 6, 2021. ↩︎

  9. “About Coinbase,” January 30,2022, https://www.coinbase.com/about; ↩︎

  10. Coinbase’s 2021 revenues are an average of analyst predictions, as of January 30, 2022, according to Bloomberg terminal. Uniswap 2021 fees calculate as total volume for 2021 multiplied by the most common fee rate across pools of 0.03%. Uniswap volumes from Coingecko. ↩︎

  11. Coinbase’s 2021 revenues are an average of analyst predictions, as of January 30, 2022, according to Bloomberg terminal. Uniswap 2021 fees calculate as total volume for 2021 multiplied by the most common fee rate across pools of 0.03%. Uniswap volumes from Coingecko. ↩︎

  12. Uniswap numbers found on Uniswap.org dashboard. As of January 30, 2022, v2 had 1,687 tokens and 3,153 pairs, and v3 had 449 tokens and 1,092 pairs. For v2, data found here, for v3, data found here ↩︎

  13. Coinbase asset numbers from Coinbase Pro. Coinbase trading pairs from NerdWallet. ↩︎