The crypto market has an Achilles heel.
Bitcoin and Ether are the titans of this market, making up over 60% of crypto’s market capitalization that dwarfs all other coins combined.
But this lack of diversification has created a concentration risk. Any steep drop in BTC and ETH’s performance has a ripple effect across the entire market.
This is why we need to build infrastructure that allows more sustainable tokens to enter the market and create a counterbalance to this dominance. This has been difficult thus far because of the reliance on centralized exchanges with some actors that have been operating in a less transparent manner. No requirements for proof of reserves, effective management of liquidity, or sufficient due diligence.
Recent events have shown what a risk this can be. To mitigate this, we need a better infrastructure that provides transparency and sustainability. Instead of FTXs and Alamedas, we need exchanges and market makers that allow token issuers to make decisions independently.
Take market making. New and innovative forms of market making have now been introduced that enable smaller tokens to enter more markets and increase diversity, reducing the concentration risk and increasing liquidity — liberating token issuers from less transparent third-parties.
BTC and ETH’s readability is a key reason behind their dominance.
Readable assets are investment instruments that can be easily understood and analyzed by investors. They capture investor interest because they have a degree of predictability and transparency, making it easier to evaluate their potential risks and returns. Because BTC and ETH have high liquidity, it is also relatively easy to trade them.
While BTC and ETH are crypto’s trusted heroes, this dominance equally makes them our Achilles heel. On the one hand, it is a good thing to have trusted digital assets that intrigue investors and have proved to be reliable investments. Yet, on the other hand, with only two assets holding more than half of the market cap, we’ve seen investors hesitant to invest in other smaller coins or assets. This leads to a vicious cycle: the lack of portfolio diversification only keeps on adding to BTC and ETH’s dominance.
This creates a concentration risk, the effects of which we have witnessed, for example, in 2022 with the FTX collapse. The danger of high concentration is that any adverse event or regulatory action that affects these cryptocurrencies has a significant impact on the entire crypto market. For instance, a sharp drop in BTC or ETH prices often has a ripple effect, causing other cryptocurrencies’ prices to plummet.
Excessive volatility, devastating effects
Although the crypto market is no stranger to volatility, the recent collapses of Terra-LUNA, FTX, Silvergate and Silicon Valley Bank have demonstrated that excessive volatility can lead to devastating first- and second-order effects, with slow recovery times. This drawn-out downside can be highly destructive.
While short-term volatility can be advantageous for profit-making, prolonged instability undermines investor confidence and the industry’s credibility. Sudden price drops, market manipulation, and systemic risks trigger punitive regulation and erode credibility. Equally, the asymmetrical impact of volatility in BTC and ETH means that prices tend to fall more quickly than they rise, further impeding market recovery.
As a result of this excessive volatility, large funds and investors are much less active and continue to hold back. This is because of the associated slippage and thinning liquidity. Additionally, the extreme volatility of cryptocurrencies makes them unsuitable for use in many traditional financial applications, such as loans, mortgages, and insurance. This limits their potential applications and prevents them from achieving mass adoption, gaining broader acceptance in the financial world.
If BTC and ETH are slow to recover and continue to be impacted by waves of volatility while still recovering, we could see a prolonged crypto winter. This is a fundamental weakness of the crypto market that needs to be addressed. Averting another liquidity crisis requires innovative market-making practices and technological improvements that create transparency and sustainability.
Diversifying for market stability
We can now see that BTC and ETH dominance is a symptom of a bigger problem: a lack of autonomous market infrastructure.
Smaller tokens have lower trading volumes. This means up-to-date information is harder to source. The ensuing lower investment levels mean fewer resources to maintain blockchain infrastructures and ensure projects’ security — resulting in lower liquidity and limiting cryptos’ usefulness. This lack of transparency and stability forces issuers to go off-chain and rely on external exchanges and market makers. This is not only an article of faith. It reduces token issuers’ control over how their tokens go to market.
We need to fix this. The current lack of regulation enables market makers and exchanges to act almost without constraints — in their own best interests, not in the token issuers’. This lets bad actors manipulate trading strategies, market prices and collateral use.
Innovative technology can take crypto markets back to the original thesis of trustlessness. For example, services that allow token issuers to monitor their own assets and trading activities in real-time, boost the readability of these assets.
It is therefore crucial to invest in technology and infrastructure that enforces transparency, autonomy and sustainability. This unlocks the potential of full-stack development that realizes the fundamental values of the technology: trust, safety, decentralization and equitable access.
Only this can drive diversification and bring market stability to crypto.
Increasing the number of tokens in the market is not in itself the solution to the problem of concentration risk, volatility and reduced liquidity. There will always be speculative and largely worthless tokens — so quality over quantity is crucial.
However, providing token projects and communities with greater visibility and agency, and allowing them to operate without intermediaries can be a game-changer. This would give opportunities for tokens to attract more investment. In the long run, they could even challenge the dominance of BTC and ETH. This would lead to a more robust and diverse cryptocurrency market, benefiting investors, the industry and ultimately everyone.