Summary.    One of the leading arguments against crypto is its volatility. In the wake of the most recent downturn, critics have doubled down on this point. But the argument misses an important insight about how crypto assets differ from those in traditional finance....

The past few months have been dark times for the crypto industry. Between April and June, Bitcoin’s value more than halved, from just over $45,000 to around $20,000; other coins have fallen even more. The Terra-UST ecosystem, which paired a crypto coin with one designed to be pegged to the dollar, collapsed in May, wiping out $60 billion worth of value and leading to cascading failures among crypto lenders. Established companies like Coinbase, a popular crypto exchange, have announced layoffs.

Amidst the turmoil, crypto skeptics have doubled down on their critiques, often with a focus on the speculative excess, and argued that the crash has revealed crypto as a Ponzi scheme. As evidence, some cite the extreme volatility. How could crypto live up to the hype if participation feels like a rollercoaster — one whose operator is opposed to safety inspections? While some of the criticism is well deserved, the focus on price volatility isn’t as strong an argument as critics might think. Rather, it reveals a misunderstanding of what different crypto assets represent.

Crypto is a young industry. Most projects are barely five years old. Eventually, different coins are meant to serve different functions, but today they all more or less act as startup equity with the distinctive properties of having liquidity and price discovery from the start. This unique attribute — enabled by the novelty of the underlying infrastructure — leads to a more benign explanation of the volatility.

Equity, Liquidity, and Volatility

Startup equity is a core concept in business. Everything from a venture capital investment in a software company to an ownership stake in your cousin’s new restaurant falls into that category. But traditional startup equity has no liquidity — you don’t invest in a restaurant with the hope of flipping your shares a month later. No liquidity means no price discovery, either. Your investment is hard to value.

Crypto is different because a token can start trading right away — sometimes even before the function the token is meant to be used for is live. This feature is enabled by crypto’s underlying infrastructure, architected for a post-digital world where data roams freely and important tasks are performed by code, not clerks. This doesn’t mean every project has to issue a token right away, but many do.

Early liquidity has benefits and drawbacks. Before analyzing them, it might help to understand why the legacy financial system doesn’t offer this option, even to those who may prefer it.

Despite becoming more digital, the architecture of the Wall Street-run system is the same as it was decades ago. It relies on opaque systems that don’t talk to each other and still require a good deal of manual processing. Trading may look hyperactive, but back-office settlement is a bottleneck, leading to access being restricted to the shares of the biggest companies. Regulations also plays a role in this gatekeeping, but infrastructure is the primary bottleneck. The startup boom of the past decade has led to the creation of bespoke markets for smaller companies, but they too are limited in scope. Most companies can’t issue liquid shares, even if they wanted to.

The natively digital design of a blockchain platforms like Ethereum empowers it to handle more assets by orders of magnitude — hundreds of thousands (and soon to be millions) of tokens that can trade around the clock. Code automates how tokens are issued, traded and transferred from one owner to the next. All assets are programmable, improving how different assets (such as a crypto coin and a fiat coin, which is pegged to traditional currency) interact, reducing errors. Fractional ownership is easily accommodated, and universal access to the infrastructure is granted to entrepreneurs and investors alike. If this were the media industry, then Ethereum would be to Wall Street what YouTube was to cable TV, for better and for worse. Better infrastructure and a lack of gatekeepers results in greater participation and innovation, but the lack of curation means more garbage, too.

These features enable cheaper to operate and more dynamic markets, and in some cases financial models that would not exist otherwise, thus why everyone from central banks to Wall Street is exploring blockchain technology. The added efficiency comes with tradeoffs, however. On the one hand, capital formation improves, and entrepreneurs can tap a larger pool of potential investors. But an unavoidable consequence of bringing such enhanced efficiency to the shares of any young project is extreme volatility.

Most startups fail, and investing in one is making a bet in a race against oblivion. From the entrepreneur’s point of view, every decision — what kind of food should a new restaurant serve — has an amplified impact. So do outside developments, like getting a liquor license. From the investor’s point of view, trying to discount the consequences of these decisions is equally daunting. The distribution of eventual outcomes for any business is widest at birth, so rational investors have no choice but to constantly overreact.

If your cousin’s new restaurant had tradable shares, they’d probably be as volatile as crypto. Landing a liquor license might make them quadruple, while a bad review may make them tank. Given the uncertainty, external developments would also have an amplified impact. A new restaurant is more vulnerable to things like dining fads or bad weather than an established one.

Everything Is Bigger on Blockchain

Crypto investors grapple with a stronger version of this phenomenon because everything is borderless, and the total addressable market is huge. Unlike a new community bank, a blockchain-based lending protocol could theoretically serve hundreds of millions of people all over the world. Success could mean significant value accrual to its token, but the project could also fail. Early investors have no choice but to flail back and forth between hope and despair.

Their dilemma is compounded by the fact that most digital assets can’t be pigeonholed into traditional categories, making valuation that much harder. Traditional investors can always rely on established metrics like a stock’s price to earnings (PE) ratio for a sanity check. Crypto investors have no such option. Most digital assets are a hybrid and transition from one category to another throughout their lifecycle.

Ether, for instance, started as a security, as its coins were sold up front to fund development. But once the blockchain launched, it transitioned to being a cross between a currency and a commodity. Some people used it as a store of value or medium of exchange, while others used it to pay for transaction validation and code execution. These features distinguished it from traditional equity and commodities — you can’t pay for a cab ride with Uber stock, and you don’t save in oil. Today, it has evolved even further to a yield-bearing instrument, a collateral asset for borrowing, a reference currency for NFTs, and the means by which validators participate in consensus.

All of these attributes make it difficult to assess the value of even the most mature crypto project, never mind the thousands that have launched recently. A skeptic could argue that these challenges are the very reason why nascent projects should not have tradable equity. Indeed, access to startup investing in traditional finance is often restricted to institutional and “sophisticated” investors. But such restrictions have their own drawbacks.

Lack of access to startup investing has contributed to the growing wealth gap. Successful companies like Meta (Facebook) stayed private for as long as possible, and VC funds couldn’t — and still can’t — take retail money. Other investments like real estate or collectible art had too high an entry price for most people. Bitcoin was the lone exception, the only high-performing asset that was universally accessible and fractionally ownable from day one.

Bitcoin was still volatile during that period, but volatility isn’t always bad. Price swings communicate important information to founders and investors, particularly during the crucial adolescent stage of any startup. And restricting price discovery to periodic funding rounds negotiated with a handful of investors can be dangerous. WeWork famously raised money at a $47 billion valuation less than a year before it ended up flirting with bankruptcy; Theranos was valued at $9 billion before going bust. Despite multiple red flags for both companies, there was little price information until the bitter end. Both investments turned out to be as volatile as crypto, we just couldn’t see the volatility — and concerned investors couldn’t get out.

The Good News About Bad News

Universal access, immediate price discovery, and greater transparency also contribute to both the reality and the perception of scams and shady behavior in crypto. Like any technology that removes friction, the ease with which new projects can be launched has been a boon to con artists and fly-by-night operators, in the same way that the accessibility and efficiency of email led to a spike in supposed Nigerian princes looking for a place to park their money.

That’s not to say that the failure rate of crypto projects isn’t higher than new restaurants — new industries naturally have a lower success rate than established ones. But it is safe to assume that the rate in crypto is not as high as it seems. But total transparency makes crypto look worse than it is. Disingenuous entrepreneurs raising money from unsuspecting marks is an ancient practice in every industry. Thousands of new restaurants fail every year, and some of those failures inevitably turn out to be scams. But those investments aren’t debated on Twitter, and we can’t watch their shares collapse on a public website like FoodMarketCap.com. Crypto is unique in that even the scams are transparent, and in the long run, transparency is a powerful tool for countering shady behavior, in any industry.

The crypto industry has a lot of growing up to do, and the current downturn certainly offers some hard lessons. Understanding what volatility means in crypto markets — what signals it’s sending and responding to — in an integral step in this process. Investors and entrepreneurs are learning not only what is possible in this new ecosystem, but also what isn’t, and why some of the lessons learned by the sectors that crypto hopes to disrupt transcend technology. Money and hubris make for a bad mix, and nothing reinforces the importance of humility better than a crash. But the skeptics who constantly harp on the volatility would be well advised to not fall into a similar trap, conflating necessary growing pains with a fatal condition.