A great financial reset is almost upon us. But to avoid disaster, we need to heed the lessons learned from the past and present.
There are more parallels between the 2008 recession and the current economic crisis than mounting debt alone. Both represent reset moments for the financial world. The great recession taught us that credit rating systems need decentralizing and highlighted inherent flaws in the financial system. And now, amid another crisis, the world is realizing there’s also a way of opting out of the system altogether: cryptocurrency.
The great recession and the current crisis came from entirely different origins. The 2008 crisis grew from unsustainable levels of debt coupled with an untenable credit rating system. This time around, economic chaos was seeded by unexpected pandemic, punctuated by the remnants of the last recession—namely debt. But while these two differ in onset, their outcomes are the same. Vast levels of unemployment, surging global debt, a global recession, and a long and likely rocky road to recovery.
Fortunately, this time, there’s an exception. We have the tools to innovate and not only expedite recovery time but ensure we do not keep falling into the same traps.
Acting as the saving grace to this economic fallout, cryptocurrencies, born out of the ashes of the last financial crisis, are seemingly coming of age in this one.
The Great Reset
In October 2008—one month after the failure of Lehman Brothers’ bank sparked the systemic collapse leading to the great recession—Satoshi Nakamoto published the bitcoin whitepaper. It told of a decentralized, peer-to-peer electronic cash system devoid of intermediaries and governmental interference. The timing couldn’t be more appropriate. Several months later, in January 2009, bitcoin’s genesis block was mined into existence. Along with the first 50 bitcoin ever to be created, came a message. Serving both as proof of bitcoin’s creation on that date as well as a veritable nod to bitcoin’s raison d’être the message read:
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”
Bitcoin, along with its decentralized principles and autonomy was arguably created as a way to opt-out of that financial system. In the time since its creation, bitcoin has spawned a teeming ecosystem of cryptocurrencies. But it’s only now, faced with a new crisis, that people—and companies—are starting to come to terms with pitfalls of the traditional financial system and the benefits of cryptocurrencies.
In May, Wall Street veteran Paul Tudor Jones made a compelling case for bitcoin. In a communique to his investors, Jones argued that Bitcoin was like gold in the ’70s, submitting that the pioneering cryptocurrency was the only viable hedge against inflation.
“At the end of the day, the best profit-maximizing strategy is to own the fastest horse,” wrote jones. “If I am forced to forecast, my bet is it will be Bitcoin.”
Several months later, MicroStrategy, the largest publicly-traded business intelligence companies in the world, went all-in on crypto—swapping out a staggering $425 million dollars for bitcoin between August and September.
Once again, the investment rationale leaned on bitcoin’s potential as an inflationary hedge. In the time since MicroStrategy’s CEO, Micheal Saylor has become a vocal proponent of bitcoin, arguing, on more than one occasion, that bitcoin represents “economic empowerment,” and “hope”—especially amid global economic chaos.
It’s hardly surprising that confidence in traditional finance is shaking. Unemployment, coupled with the unabated printing of trillions of dollars, has piled US national debt to a record $27 trillion.
For many, the argument goes that crypto—devoid of the notion of debt and immune from the interference of central governments or banks—offers a promising alternative.
An Alternative System
Decentralized finance or DeFi, a thriving, immanent sector of the cryptocurrency industry, is capitalizing on this growing desire to opt-out. The sector harnesses the advantages of cryptocurrencies—particularly their potential for value creation through staking and borrowing. As such, DeFi has grown exponentially in recent times, locking in approximately $11 billion in value as of September. While this may seem a modest valuation compared to other financial sectors, the fact that this milestone was reached within the last three years bodes well for DeFi’s future.
Pegged to become an alternative financial system in its own right, DeFi addresses the issues within conventional finance. Investor capital data passing through a highly centralized system generates enormous third-party risk and creates inefficiencies inherent in legacy operations. DeFi, however, turns the existing model on its head via decentralization, instilling the sector with the same untamperable qualities afforded to crypto assets.
However, similarly to assets in the traditional markets, not all cryptocurrencies offer liquidity and only 10% are backed with a solid ‘use case’. This being the case, sifting the wheat from the chaff has never been more critical, especially as the DeFi sector comes to full maturity.
Learning From the Past
Much like how the coronavirus-led economic struggles of 2020 have shone a light on cryptocurrency utility, the subprime mortgage crisis of 2008, highlighted the need for appropriate rating systems.
One of the central catalysts for the crisis arose within rating agencies who dolled up risky assets, such as debt obligations (CDOs) as AAA-rated securities without looking at the constituent assets. The Big Short—a book-turned blockbuster movie cataloguing the events of the subprime mortgage crisis describes the models underpinning the rating agencies as “ripe for exploitation,” and exploited they were.
The lack of investor knowledge, coupled with blind faith for an inaccurate and biased rating system, practically brought the financial system to its knees. Arguably, the crisis could have been mitigated if an accurate, trustworthy rating system had been in place.
Nevertheless, not much has changed. While the rating agencies attempt to win back favour and repute, the world remains in need of a rating methodology that is fit for purpose, unbiased, and decentralized.
A Better Method
Rating agencies have typically harnessed traditional models of pricing, including one of the most prevalent: the capital asset pricing model (CAPM). In vogue since the 1960s, the CAPM attempts to explain investor’s expectations for returns on risky assets. However, the underlying assumption for the CAPM is that investors are rational and risk-averse. This, as the 2008 crisis illustrated, is not always the case.
Last year, Professor Andros Gregoriou, co-authored a paper alongside Dr Jerome Healy, and Dr Huong Le, entitled “Prospect theory and stock returns: A seven factor pricing model.” Within the paper, they founded a new model for asset pricing that explained variations more thoroughly than CAPM. One of the primary factors in this new model was the peak-to-end rule and prospect theory.
Prospect theory—a subgroup of behavioural economics—implies that profit and loss are viewed separately. In practice, it conceptualizes that when faced with two identical investment choices, investors overwhelmingly choose the one presented in relation to its possible losses rather than potential profits.
Meanwhile, peak to end theory suggests that experience is judged based on feelings at the peak of the experience and toward its end. Translating this into an economic context, for investors estimating monthly returns, the peak returns, and end of month returns for the previous month seem to unveil the expected yields for the following month.
When applying the peak-to-end rule to prospect theory, we found remarkable evidence that the CAPM model becomes a significantly enhanced and efficient model.
Harnessing this pricing model alongside other variables such as liquidity, momentum, systematic risk, and above all else, decentralization—can provide a highly reliable rating system upon which to strategize investments.
Moreover, applying the model to cryptocurrencies could negate the growing pains within the industry, allowing mainstream investors, dipping their toes in crypto, a means of investing in an algorithmically sound and unbiased way.