Cryptocurrency Crash Analyzed

Adam Johnson

Many investors are selling off their cryptocurrency holdings in the wake of financial and economic insecurity. Multiple coins have seen double-digit-percentage losses in value.

On Thursday, May 12, Bitcon briefly fell below $26,000 for the first time since 2020, while cryptocurrencies overall have lost nearly $800 billion in market value in the past month. Nearly 40% of Bitcoin holders have now lost money on their investments, as the value of a single coin dipped below last year’s July low.

In response, blockchain networks have halted trade of certain currencies as they attempt to stabilize the market, which is down by 20% from last week. Investors who jumped into the cryptocurrency market after watching valuations take flight have paper losses right now.

The Federal Reserve’s hikes in interest rates have discouraged risky investments and speculative trading of historically volatile assets like digital currencies. With the Fed making it more expensive to place bets on the markets, investors are less confident that cryptocurrencies will remain a steady holding as regulators battle inflation.

Furthermore, many crypto companies are publicly traded on the stock market. As investors back away from stocks, leading to market declines, those companies’ real-time value go down as well. Sell-offs of both the currencies and the companies lead to drastic market swings.

Cryptocurrency Crash Analyzed — The Stablecoin Instability Cause 

With cryptocurrency, there are different types of value systems. For instance, Bitcoin gains its value from the limited amount of coins available in its network, the number of holders and investor confidence.

Another type of digital currency value system is the stablecoin. Stablecoins are digital tokens pegged to the value of traditional assets like the U.S. dollar and are mostly used to facilitate trading in other digital assets.

Some stablecoins use algorithms to control their supply of currency and stay consistent with the dollar’s value. This is meant to preserve some government-backed confidence in virtual markets. However, that value system is currently failing.

The TerraUSD coin, a stablecoin, and its token, LUNA, whose price moves with demand, broke its 1:1 peg to the dollar on Monday, May 9, and has since fallen to its low of $0.27. Meanwhile, LUNA has lost more than 99% of its value over the past week.

Cryptocurrency Crash Analyzed — Why Did Stablecoins Lose Value? 

The reason why the stablecoins lost their peg was due to the main trading platform for these currencies, Anchor. Anchor offered artificially high incentives for users to trade their Terra and Luna coins on its platform. Therefore, it controlled most of the supply of these coins.

The Federal Reserve announced its interest rate hike and traders withdrew their currencies. Thus, billions of dollars of value left Anchor at once. This led to further loss of confidence in the overall Terra platform. As LUNA decreased in value, so did TerraUSD.

The one type of cryptocurrency that’s never supposed to be volatile is the stablecoin. The loss of confidence in a stablecoin does not necessarily inspire confidence in other currencies. This led to the cryptocurrency crash.

Cryptocurrency Crash Analyzed — What Is the Impact on the Financial System? 

Although many investors are experiencing tremendous losses, the real danger is cryptocurrency’s effect on the wider economy. The Federal Reserve, Treasury Department and the Financial Stability Board have identified stablecoins as a potential threat to financial stability.

The Federal Reserve’s May 2022 Financial Stability Report compared the risks of stablecoins to those of the money market funds that played such a critical part in the 2008 economic crash.

Even the prospect of stablecoin not performing as expected could result in a “run” on the stablecoin. A run occurring under strained market conditions may have the potential to amplify the shock to the economy and the financial system.

Cryptocurrency Crash – – Will These Troubles Continue?

While we can not predict the future, there are two main factors that will affect crypto’s growth: how long speculative interest persists and whether customers adopt blockchain technology en masse.

Cryptocurrency has highly speculative boom-and-bust narratives. These narratives often emerge from optimism around new applications for a particular blockchain but sometimes rely on nothing beyond a tweet from entrepreneur Elon Musk.

In general, market indexes’ returns have a negative skew, which means that above-average returns are more extreme and drag down the total return over the entire period. But for the cryptocurrency market, the opposite is true. Cryptocurrency experiences more below-average returns than above-average returns, but the positive outliers are more extreme and pull up the cumulative return over a given period.

The speculative interest in a particular token has a stronger influence than steady adoption of blockchain technology. Therefore, during a recession more investors will avoid investing in speculative assets like cryptocurrency.

In January, the crypto market experienced its second-largest loss ever, wiping out more than $1 trillion. That crash was partly attributed to the same economic trends currently troubling crypto: the Federal Reserve’s comments about potential rate hikes to fight inflation, newly proposed crypto-specific regulation and investor uncertainty.

Considering that two historic crypto crashes have occurred just in the span of a few months, with similar factors driving both, it’s safe to say a major shift in the power and structure of crypto is underway.

Between economic tribulations, government and central bank crackdowns and users drifting away from the space, cryptocurrency does not seem as popular as it once was a few months ago.

Adam Johnson is an editorial intern who writes for www.stockinvestor.com.

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