Make no mistake — The recent downturn is bad news for most of our cryptocurrency portfolios. Unless you are an expert trader, you probably are not comfortable with shorting markets. With that being said, we truly believe that a significant correction in prices is positive for the cryptocurrency ecosystem in the long run. After months of what seems like prices in freefall, it is easy to understand why spirits are broken and holders are skeptical; however, the common refrain that “corrections are actually good” is not merely hopium. Let’s take an in-depth look at significant flaws in the crypto market, how they originated, and ultimately how a bear market can eradicate them.

How did we get here?

A multitude of reasons can send a market into a downtrend. Fundamental analysts cite unfavorable market conditions or fear, uncertainty, and doubt (FUD), while technical analysts point to factors like buyer exhaustion and unsustainable volume. When market capitalization increases over 30x in the course of a year like cryptocurrency did, there is often a simpler reason. Perhaps this December 2017 tweet from Charlie Lee, creator of Litecoin, that we referred to in our most recent article sums it up best:

“When crypto goes up too fast, it overshoots its real value. So a bear market to consolidate is normal. How long and how large is anyone’s guess.”

For those who do not recall, Charlie Lee announced that he sold his entire holding of Litecoin in mid-December. In a rational market environment, investors would have interpreted this news as a very bad signal. Instead, many people immersed in the euphoria of the bull market reacted angrily, calling Charlie a non-believer (and much worse) on Twitter. In the months following his statement, total market capitalization dropped from over $800 Billion in January to $250 Billion in early April. The 70% drop ultimately proved Charlie to be right. After a short-lived bounce, we find ourselves near the $250 billion mark once again. Now you must be wondering — “How on earth is this good?”

Speculative Bubbles

According to Investopedia, a speculative bubble is usually caused by “exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values.” That sounds a lot like talks of Lambos and moon, doesn’t it? As prices rose higher, more fresh money entered the market in hopes that it would continue. The average new participant in the market knew very little about the underlying fundamentals or technology of their investments. They were told that the new technology had the potential to change lives, and therefore the potential to make them a lot of money. The speculative bubble snowballed from there. Without properly researching their recent investment purchases, new participants received instant gratification upon seeing their assets appreciate. Friends and family got involved in the revolution, and more instant gratification fooled beginners into thinking they had found a rise-only market.

The lure of a profitable investment is not an evil in and of itself. You will often hear people say, “I came for the money and stayed for the technology.” In many ways, the increasing prices are the best form of advertisement for an otherwise unknown new class of assets and technology. Many have gained a deep appreciation of blockchain and the benefits it promises out of a curiosity to understand how their investments function. So when does speculation become bad?

Focusing on the Wrong Things

We can gain some insight into the rationale behind the cryptocurrency market by taking a look at a legacy market with plenty of history — the stock market. A private company’s leaders focus solely on building a profitable, sustainable business for the long term. When a company decides to go public by issuing stock in an IPO, their primary focus shifts, by law, to serving its shareholders. The company’s executives become subject to intense scrutiny by a board of directors, who have one main goal — to increase the price of the company’s stock. This narrow focus can result in short-sighted moves that favor immediate revenues and cost-savings over important long-term goals like growth, innovation, and positioning the company for long-term survival.

The pressure to satisfy the immediate demands of shareholders is often cited as the number one drawback of a company’s decision to offer their stock to the public. This minor misalignment of incentives in the stock market has been taken to an absolute extreme in cryptocurrency. For a great majority of projects, teams began to prioritize the price of their coin above all.

In stocks, quarterly earnings and yearly income statements serve as measurable performance indicators. With the absence of equivalent tangible benchmarks in cryptocurrency, the market was forced to place heavy emphasis on intangible news alone. PR and marketing teams entered a perpetual race against each other to generate hype. Market participants made it clear that they entered as speculators looking to sell at a higher price, so teams responded accordingly. The following types of events were repeatedly rewarded and reinforced by the reaction of the market:

Partnership announcements, often lacking substance

Rebrands

Exchange listings

Announcements about imminent announcements

Rumors

Getting Back to Fundamentals

Just like speculation is not inherently pure evil, neither is a team’s focus on their coin’s price. However, you usually will not read about the necessity of having an expensive coin to function in whitepapers. When a project generates more users, the natural effect should be an increase in price. This is where the bull market went awry. Projects ignored the long term goal of growing their user base, and instead they took shortcuts in the form of marketing fluff and hype. In bear markets, the same type of hype-driven news has almost no effect on price.

This property is exactly what makes bear markets healthy.

When the same old tricks lose their effect, projects have a choice. They can decide to focus on creating value and achieving their product’s initial vision, or they can give up. Many teams choose the second option. In this sense, the bear market has a way of weeding out quality. If a coin’s use case was never legitimate in the first place, the project will die when immediate gratification derived from increasing prices stops. Furthermore, the integrity and work ethic of the team members themselves are tested. Those who have confidence that their project will deliver real value persevere.

The cleansing effect of the bear market extends beyond the builders. The same new market participants that were rewarded for buying crypto despite their lack of research begin to feel the consequences. They too have a choice to quit or persevere. When the rise-only market they once knew shifts into uncertain territory, many of them cut their losses and leave. For them, it was only about quick, easy money. Who is left after they leave? The believers. Those who took the time to research their investments learned about the true potential of cryptocurrencies. This knowledge arms them with confidence that their investments will eventually turn around. The ones who never had much conviction in the first place, AKA weak hands, walk away. Strong hands stay.

When the great majority of coin supplies are held by strong hands who refuse to sell, bull runs of epic proportions are made possible once again.

A Bright Future

Cryptocurrency will continue to go through growing pains. This was not the first “bubble” pattern to affect the market, and it likely will not be the last. Markets trend toward equilibrium. Poorly designed incentive structures were repeatedly rewarded on both sides — investors and builders. Failing to do research went unpunished as nearly every coin made substantial gains. As a result, people became comfortable buying anything and everything, and scams and quick flip ICOs were allowed to succeed. When the market finally flips bullish, we can expect the base of investors to be much smarter as a result of experience.

On the other side, coins achieved 10x and even 100x multiples by generating hype with little substance. With a smarter base of market participants, coin developers and marketers will have to focus on differentiating their products/platforms based on real value. As adoption slowly progresses across the ecosystem, we expect to see these types of tangible variables drive price movements in the next bull run: