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Inflation has hit us quite hard. In fact, it hit Singapore the hardest since 14 years ago.
With the world just recovering from the keels of COVID-19 supply chain disruptions, the Russo-Ukraine war pushing oil and commodity prices through the roof and the 'jumbo hike' of interest rates by the US Federal Reserve in 2022, economic volatility and rising property, credit card and car loans are on the horizon for the average Singaporean investor.
In these Volatile, Uncertain, Complex and Ambiguous (VUCA) times, cryptocurrencies - more specifically, decentralized finance (DeFi) - is held by many as a hedge against inflation.
However, is this really the case?
In this article we explore why inflation occurs, if DeFi is really the hedge against inflation people assume it to be, and what are the potential risks and returns for investors who want to put their faith in DeFi in these trying times.
Why is there Inflation?
Theoretically speaking, inflation occurs when purchasing power declines, which in turn means that more money must be used to exchange for goods and services. This happens in a couple of ways: demand-pull Inflation, cost-push Inflation, and bulit-in inflation.
Singapore's core inflation statistics. Image reproduced from Bloomberg.
Demand-pull inflation
It comes when demand for goods and services far exceeds the supply produced. This can be caused by a number of factors - a strong economy, a lackluster supply chain that's slow to respond to market changes, increases in money supply, and even government policies can lead to supply not being able to catch up, making demand pull prices up.
Singapore's economy is strong and demand is fast rising, but the supply chain disruptions caused by COVID-19 and the Russo-Ukraine War have shorted supplies of essential goods.
Cost-push inflation
It's the complete opposite - prices rising are pushed by a stagnant supply in the face of growing demand. The stagnant or declining supply are primarily caused by rising costs of labour and raw materials, slowing down the rate of production and pushing the cost increases onto customers.
With oil prices rising, manufacturing costs are also rising. In fact, a major part of inflation in Singapore is caused by higher shipping costs and rising fuel costs. These have been seen in price increases in transport and other commodities and essential services.
Built-in inflation
People need money to survive, so people naturally demand higher wages to cope with the cost of living. Businesses are pressured to raise wages, and to keep profitability, are also pressured to raise prices. This unfortunately leads to a spiral of non-stop wage and price increase, and is something built-in in the current economy.
Did you know that more than 6 in 10 Singaporeans are prepared to ask for a pay rise as of May 2022?
As we've explored, inflation really is caused by many different factors, and it's important for us investors to understand this to prevent ourselves from a) being too affected and make poor investment decisions and b) failing to maximise future returns on our investments.
What has this got to do with DeFi?
It is precisely because of how DeFi and Cryptocurrencies work that make a difference. Before we go further, let's talk about these differences in depth.
DeFi vs Fiat Currency (Paper Currency)
Due to the ability of central banks to print and issue new currency, increasing the money supply is a well-known cause of demand-push inflation. In fact, it's a real problem and often a major cause of historical hyperinflation in certain countries.
There are 2 characteristics of fiat currency that are worth noting:
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Its supply is regulated by a central authority who can theoretically print as much as they deem fit, and;
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There is no theoretical limit to how much can be printed or issued
That's where DeFi and Cryptocurrencies come in.
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It is impossible for anyone to regulate, EXCEPT you
DeFi technology works on the blockchain, which means that there is no central authority that 'holds' your currencies, and neither is there a magic button that anyone can press which generates more on a whim.
Your stablecoins and other cryptocurrencies are held securely in your wallet, which can only be transacted by you or anyone who has access to your wallet. Each transaction is then recorded, verified, and encrypted on the blockchain, making it very difficult, if not impossible, to edit or change these transactions.
Similarly, because issuance and transactions of cryptocurrencies are based on code and not a central authority, it's impossible for any authority to regulate yields, prices and withhold any currencies you transact.
In addition, while anyone can invest in powerful rigs and mine cryptocurrencies, there's the second big difference:
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There are Supply and Issuance Caps
Simply put, there is a limited amount of cryptocurrency that will be issued before they will never be issued again.
For example, Bitcoin (BTC) has a hard cap of 21 million, which is touted by many as an ultimate hedge against inflation, and we agree.
Ethereum, on the other hand, has no hard cap. However, as it moves to Ethereum 2.0, issuance of Ether will be severely capped, allowing supply to always remain in control and demand to always outstrip supply. This is why Eth is also poised to appreciate in value over time.
However, does it sound too good to be true?
DeFi and Cryptocurrencies' abilities are overstated
It's quite tempting to reductively state that Cryptocurrencies and Defi outperform traditional currency in every way. Here's why it's not wise to do so.
Cryptocurrencies are extremely volatile and unpredictable
Just as how BTC rose to groundbreaking heights in a couple of years, it also experienced multiple downfalls throughout the history of its minting. A simple Google search shows exactly how this panned out:
The historical price ups and downs for BTC. Image reproduced from Google.
Other popular crytocurrencies, like ETH, have not been spared this extremely unpredictable behaviour:
The historical price ups and downs for ETH. Image reproduced from Google.
Long term stores of value need to - as their name implies - consistently be valuable. This is why assets like gold continue to be popular - attaching value to tangible, valuable items is an ideal way to prevent your wealth from being eroded. Cryptocurrencies, on the other hand, have yet to display an ability to store value in the long run without potentially falling short.
Cryptocurrencies are still not as widely accepted
Even if cryptocurrencies could hold their value in the long term for some miraculous reason, the demand for it at the moment is not as high as it could be.
With governments beginning to be a little more wary about cryptocurrencies and how they affect investor behaviour, social acceptance of DeFi as a viable platform for trading has yet to take off on a public scale.
This means that the only place you can cash out your cryptocurrency wallet, or gain value from cryptocurrencies, is within your trading platform or others who have embraced the digital currency. With continuously low demand, cryptocurrencies are, in the short run, unlikely to gain enough traction to be increasingly valuable over time.
Cryptocurrencies are still based on speculation
Every stock, every trade and every share value is influenced by investor sentiment - that's true.
What sets cryptocurrencies apart from traditional financing tools, however, is the degree to which speculation affects prices. One doesn't need to look any further than Elon Musk's tweets about Dogecoin for evidence:
Elon Musk's Tweet that Dogecoin 'seemed pretty cool' sent it on a spike. Image reproduced from Forbes.
And that's the root of the problem.
Cryptocurrencies and DeFi continue to be extremely speculative without much underlying value - something we've spoken about earlier. This means what prices can change at a whim - and while it's possible to make a fortune trading using DeFi and cryptocurrencies, it's nigh impossible at this stage as an inflationary hedge for it to consistently maintain value in the long run.
There's just been not enough time
"History shows that cryptocurrency values keep rising over time!"
That's a common argument, and we can't deny it.
However, compared to other financial instruments, cryptocurrencies have only been around for about 10-12 years ever since BTC's inception in 2009. This means that the number of bear and bull market periods it has gone through is ... just too little for us to make any viable long-term forecasts about when the next crash or boon will be.
Final Thoughts: Should I still invest in Crypto and use DeFi?
You definitely should, if it fits your risk appetite and you understand how it works. We don't doubt DeFi as a viable approach to growing wealth, and history definitely has proven that it can work out for savvy investors.
However, as a hedge against inflation, DeFi still has yet to prove itself to investors as a viable hedge against inflation.
Only time will tell.
