After FTX crash, here’s what you need to know: The cryptocurrency bubble is already bursting | Charles Alexander

fFollowing the bankruptcy of one of the largest cryptocurrency exchanges in the world, FTX, the price of bitcoin (BTC) has plummeted again. It is now around $16,500, a far cry from an all-time high of $66,000 just a year ago.

Why such a big drop in value? It is because of the highly toxic combination of an exchange (an electronic platform for buying and selling) called Binance, a stablecoin (a cryptocurrency whose price is pegged 1:1 to the US dollar or other “fiat” currency) called tether, and the skilled professional traders running high frequency algorithms.

Unlike stocks, bitcoin can be traded on many different exchanges, but Binance holds over 50% of the entire cryptocurrency market and as a result, sets the price of bitcoin and other cryptocurrencies. To buy cryptocurrencies, traders need to convert fiat money into a stablecoin such as tether. Bitcoin-tether has by far the largest volume of all products on Binance, and since one dollar usually equals one tether, bitcoin-tether trading determines the dollar price of bitcoin. But when bitcoin crashes, so does the entire crypto ecosystem.

The problem is that Binance is only self-regulated, meaning it is completely unregulated by traditional market regulators like the Securities Exchange Commission in the US or the Financial Conduct Authority in the UK. This is a major attraction for professional traders because they can implement high-frequency price manipulation algorithms on Binance, which are against the law in regulated markets. These algorithms can cause rapid up and down price movements, making bitcoin extremely volatile.

Binance carries out its own clearing and settlement of trades, in the same way as all other self-regulated cryptocurrency exchanges. This means that losing counterparties – those on the other side of profitable trades – often see their positions automatically canceled without warning.

Unlike regular exchanges, self-regulated cryptocurrency exchanges are not required to raise the alarm when a trade has lost so much money that the collateral in the account needs to be topped up. Instead, traders are solely responsible for funding their accounts by continuously monitoring something called a settlement price. This is done automatically by the algorithms maintained by professional traders, but it is exhausting for ordinary players like you and me, who have to remain very vigilant whenever manipulation is used to create the volatility that professional traders use to increase their profits.

When professionals trade against each other, it is called toxic flow, because the chance of profit is more like 50-50 if their algorithms are equally fast and effective. Professional traders much prefer that their counterpart is an ordinary investor.

This is concerning because Binance has been extremely successful in attracting ordinary investors. The commissions he earns from this type of investor have funded his very rapid expansion; now it is expanding with its own stablecoin, blockchain and NFT market. Binance is consolidating its role as the Amazon of cryptocurrencies, following a very effective business model.

To some extent one can appreciate the current circumstances in the cryptocurrency markets at the bursting of the dotcom bubble in 2001-2. The venture capital that had been pouring into Internet startups in 1999-2000 suddenly dried up, as many companies went bankrupt. This year, Three Arrows Capital, one of the largest cryptocurrency hedge funds, defaulted on its loans, and major cryptocurrency lending firms Celsius and Voyager filed for bankruptcy as the bitcoin price plummeted, following some unexpected and shocking attacks on a new type of stable currency called the Earth. Following the FTX bankruptcy, many other exchanges such as Gemini and lending platforms (shadow banks) including Genesis are preventing customers from withdrawing their funds.

We will see much more of this contagion, precipitating widespread startup failures now that venture capital has dried up in the cryptocurrency sector. More exchanges and lending platforms, as well as blockchains, NFT marketplaces, data aggregators and analytics firms will all bite the dust.

Binance could emerge from this mess with a monopoly. But right now, this non-domiciled, self-regulated company still needs fee income from ordinary investors, and it needs market makers (professional traders similar to hostile stock market hucksters) to conduct its business.

The danger is that now everyone is very scared, so the only way to attract ordinary investors is to raise the price of bitcoin again. This would cause people to jump back into the cryptocurrency game, only to have their savings wiped out as the cycle of volatility continues.

Carol Alexander is a professor of finance at the University of Sussex and a consultant on cryptocurrency markets and financial risk analysis

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