Recession and Decentralized Finance
The US is steadily moving toward an economic recession. Looming over everything is the possibility of a default on US debt which would turn a recession into a depression, or worse. Meanwhile the world of cryptocurrencies has begun to emerge from a dreadful crypto winter that sucked as much as three-fourths of the previous value of crypto tokens. Many a DeFi business fell into dire straits or even bankruptcy. Contrary to years of crypto hype, the world of DeFi is not separate from or insulated from the larger economy. Looking ahead, how will a recession and decentralized finance work out?
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Crypto Exchanges Versus DeFi Businesses
After a four month runup in price, Bitcoin has fallen back below $30,000. Bitcoin and other cryptocurrencies follow the Nasdaq stock market, react to interest rate changes, and the economy in general. Something that we saw back during the 2022 crypto winter was that far too many DeFi businesses worked on the premise that crypto always goes up. Thus, they borrowed dollars, converted to cryptocurrencies and lent them out. When folks paid back their crypto the idea was that they would be worth more in dollars than before the transactions started. When crypto prices plummeted that was not the case and many businesses failed. Companies that survived commonly changed their crypto business plans. Large crypto exchanges have gone bankrupt because many of them followed the same business plan based on crypto always going up. The advantage for a properly governed DeFi business is that it need not be totally dependent on the value of the crypto tokens it deals in.
Decentralized Finance Business Is Not Bitcoin
DeFi businesses use Bitcoin, other tokens, and currencies like the US dollar in their businesses. However, they are not Bitcoin or any other token. A decentralized finance company has smart contracts that enable loans between people or business entities across the globe. These loans involve cryptocurrencies. Traditional banks engage in loans using dollars, euros, and other currencies. When the value of the dollar falls due to the US lowering interest rates banks commonly make less of a profit, but they do not necessarily go out of business. (They do if they mismanage their assets such as with Silicon Valley Bank.) If Bitcoin falls again in price due to a recession in the US and world economies, smart DeFi businesses will adjust, perhaps tighten their belts, and continue doing business. The health of Bitcoin in a recession might depend on Nasdaq. The health of a competently managed DeFi business will depend on their mix of assets, customers, loan portfolio, and management’s decisions.
Are We Going to Have a Recession?
When inflation becomes a problem the US Federal Reserve raises interest rates. More often than not, they fail to achieve the desired “soft landing”. A soft landing is where inflation falls to acceptable levels, employment in the economy remains strong, and businesses do not suffer extreme losses. The last time inflation was as bad as it has been this last year was more than four decades ago coming out of the inflation-driven 1970s. At that time the Federal Reserve under Paul Volcker raised rates dramatically and succeeded in breaking the back of inflation. The economy went into a recession and employment did not return to prior levels for 7 years. This time around the Fed is using a gradual approach of raising rates by a quarter or half percent at a time. They do this based on their appraisal of how the economy is doing. It remains to be seen if they can avoid a huge recession but the general consensus of economists is that we are going to have a recession. Everyone, including DeFi businesses, need to get ready.
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Originally published at https://profitableinvestingtips.com on May 10, 2023.
