Understanding The Crypto Market Collapse

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Fueled by fiscal stimulus and fear of inflation, cryptocurrency markets peaked at just over $3 trillion in November 2021. Since then, the entire crypto market has come crashing down nearly 70% to under $950 billion today.

Even investors in blue-chip cryptocurrencies like Bitcoin and Ethereum are feeling the pain, as the coins have fallen 69% and 77% respectively. As long-term holders gear up for another “crypto winter,” it is important to understand what has led to this significant correction.

Crypto and the stock market   

Historically, crypto markets have had little correlation with stocks. Prone to volatility and hype cycles, early buyers sought out Bitcoin for its independence from other asset classes.

In recent years, however, growing demand from retail and institutional investors, and even corporations, has driven a reversal in this trend. As such, the correction in equities and risk assets has resulted in significant outflows from crypto. Altcoins and more speculative investments like digital real estate have been hit the hardest. 

As central banks across the globe tighten fiscal policies to battle inflation, cash flow rather than growth-based investments have returned to prominence. This shift comes at the expense of venture capital-backed companies and cryptocurrencies. Further, increased borrowing costs have largely washed leveraged traders and speculators out of the system.

Given that cryptocurrency has never existed in a quantitative tightening environment, these macroeconomic factors are hard to ignore. But they are far from the only contributing factors to crypto’s latest downturn.

The fall of Terra Luna 

As the stock market corrected and interest rates rose rapidly for the first time in years, crypto continued to tumble week after week throughout April and into May.

At this precarious time, the de-peg of stablecoin Terra created a sudden and unexpected financial loss of more than $40 billion. Understanding the lasting impact of this event requires an understanding of stablecoins and investor expectations.

Stablecoins alleviate a few problems in crypto including transaction fees, capital gains tax, and volatility. As the name implies, stablecoins are intended to remain stable, always equal in value to a given asset. In the case of Terra, this peg was 1 U.S. dollar.

However, unlike other stablecoins which are backed with reserve assets like gold or actual dollars, Terra was backed algorithmically by an asset known as Luna. In the case of falling demand for Terra, the protocol would sell Luna to support the price at exactly $1.00. To attract investors to the ecosystem, Terra paid a staggering 20% interest rate to all holders of the stablecoin. These tokenomics reduced sell pressure and propelled the price of Luna, until they didn’t.

After a few large, aggressive, and potentially deliberate sales of Terra, the stablecoin broke. Its value suddenly fell far below $1.00 and instead of arbitraging the difference, investors fled for the exits. This bank run led to a massive unwind with the value of Luna falling from $86 to a fraction of a penny in less than a week.

The wealth destruction from this event has had a lasting psychological impact on the cryptocurrency market. Terra’s collapse struck fear in a number of other stablecoins, such as Tether and DEI. The reduced trust and available capital is expected to prolong and intensify the bear market that crypto is currently experiencing.

Unfortunately, Terra Luna was only the first domino to fall.

Celsius pauses withdrawals

Celsius is a crypto exchange that allows users to deposit their cryptocurrency and receive interest payments in return. In 2021, the company reported 1.7 million users and roughly $20 billion in assets under management.

Recently, Celcius announced it would be suspending all withdrawals for an indefinite period of time, sparking rumors of insolvency. Like traditional banks, Celcius was created with the premise of gathering customer deposits, and leveraging and reinvesting those deposits to generate a return.

Like other investors, the company’s crypto investments are down bad. With significant losses from hacks, Ethereum, and potentially Terra Luna, Celcius appears unable to meet customer withdrawal demands.

Regardless of how the Celsius situation is resolved, investor trust is once again shaken, which has rippling effects throughout the cryptocurrency markets. As losses lead to distrust which lead to further losses and more distrust, crypto experts are beginning to expect the contagion to spread. In fact, rumors have already begun to swirl that hedge fund Three Arrows Capital is facing financial challenges.

Keeping up with crypto

Although the losses are piling up, crypto is not dead. The market has faced numerous crypto winters before, and this will likely not be the last.

To stay up to date on the latest developments, many crypto newsletters cover the inflows of talent and investment that the ecosystem continues to see.

If history is any guide, crypto will eventually bounce back from this cleansing period stronger, and safer stores of wealth like Bitcoin are likely to lead the resurgence.

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