The dramatic events in markets trading in crypto-assets over the past year – with tumbling values, bankruptcy scandals, and fraud charges – point to a fundamental issue: the innate instability of decentralized finance (DeFi).
At its peak, the “crypto crash” saw the value of so-called cryptocurrencies, including Bitcoin, fall by over 70%1, while major exchanges for such assets, including most notoriously FTX but also Terra and Celsius Network, collapsed in spectacular fashion.
The crash and continued volatility has shined a light on the critical role played by central authorities in maintaining the stability of traditional currency systems. The sovereign currencies issued by central banks and used around the world are generally structured for universality and robustness: they are government-backed and regulated in order to sustain credibility and trust in a national currency and to protect its value for users. The contrast with decentralized virtual assets – which are largely unregulated and standalone, and lack any kind of official backing that might protect their value – could not be sharper.
Part of the problem is that, by definition, “cryptocurrencies” are not actually currencies. A sovereign currency issued by a central bank fulfills three core functions: it’s a unit of account, a store of value, and a medium of exchange. In the case of something such as Bitcoin, the large and frequent fluctuation in its exchange rates makes it wholly unsuitable as a store of value or as a payment vehicle for everyday goods.
What recent events have also shown is that even so-called stablecoins, such as TerraUSD, Luna, and Tether, lack the credibility that a central bank gives a currency. And that is despite attempts to peg the value of stablecoins to a national currency like the US dollar or an exchange-traded commodity.