Why is Crypto Crashing? And the future of Cryptocurrency

Many crypto participants may find themselves amid the current market turmoil and ask themselves: Will crypto ever recover?

Given the current price of Bitcoin is approximately 57% lower than when 2022 started, this consideration isn’t unreasonable. However, in times of clear distress, garnering an understanding on why crypto is going down is important as it provides clarity around the future of Bitcoin and the future of cryptocurrencies as a whole.

Why is Crypto Crashing?

The performance of assets is often a clear reflection of the macroeconomic conditions at hand. Following the Global Financial Crisis, expansionary monetary policy resulted in an influx of available capital and economic growth flourished. Correspondingly, asset classes across the board appreciated in value.

Now, markets face a different reality. Rampant inflation has taken the front foot and the prospects of a recession grow. Markets are placed at the mercy of Central Banks, and the increasing interest rate environment incrementally diminishes the appeal of high-beta investments.

How Bad is it?

Importantly, the recent fall in prices was not specific to the cryptocurrency space. The S&P 500 returned -20.6% in the first half of 2022, its worst H1 performance since 1970 and the Nasdaq declined 29.5%, its worst H1 performance in 20 years. While the most recent market drawdown has been historically significant for equity markets, Bitcoin’s 71.25% drawdown from its November 2021 high isn’t uncommon. Specifically, within the last decade, Bitcoin drop scenarios have endured drawdowns of 80% or more from all-time highs, three times. 

While serving as a distinct asset class, as the institutionalisation of digital assets has advanced so has digital assets’ correlation to equities. More specifically, in the last few years, Bitcoin’s correlation with high beta equities, such as tech stocks, has gradually increased. When markets are risk-off, cryptocurrencies suffer.  

Capitulation within the digital asset class

Events within the digital asset space have acted to amplify the already heavy effects of a hawkish macroeconomic narrative. Firstly, the breakdown of the Terra ecosystem in May had a direct impact on Bitcoin’s price. Not only were numerous institutional parties exposed to Terra’s stablecoin, TerraUST, but many of these positions were also funded with debt. As the stablecoin and Luna capitulated, markets sold off and the value of collateral used to fund borrowings diminished. This eventually led to an inability to meet debt requirements. As such, the consequent liquidations acted to exaggerate price degradation.

Quietly, the contagion associated with Terra’s collapse spread through the space until early June, when its effects began to show. First, Celsius, a multi-billion dollar crypto company paused withdrawals from its platform. The risk of Celsius’ insolvency resulted in major de-risking within the space as individuals and institutions alike were exposed to heightened counterparty risk. In turn, participants moved their assets out of the credit markets, and into ‘safer’ assets such as stablecoins and Bitcoin. To compound the already tarnished sentiment, another notable institution collapsed, Three Arrows Capital (3AC). The proceeding and substantial sell-off caused further liquidations, with June 13^th hosting the largest single day crypto liquidations of 2022.   

The consequences of counterparty risk mismanagement continues. One by one, entities such as Babel Finance and even publicly listed companies such as Voyager Digital Assets, were subjects of articles concerning their significant capital complications and need for restructuring specialists. In order to survive the turmoil, companies such as Coinbase, Crypto.com and several other large players within the digital asset space have had to reduce the size of their workforce. 

Among the madness, there are important lessons for existing and new participants to consider. Firstly, working with regulated providers ensures the responsible use of capital and inherently diminishes the risk of permanent loss of funds. Secondly, minimizing counterparty risk. Contagion has plagued financial institutions for decades. Nonetheless, investors need to avoid opaque business models that possess ambiguous risk profiles and that offer unsustainable returns.

Will Crypto Recover?

Currently, prices range within the 20,000 – 25,000 range, the hawkish narrative lingers, and counterparty risk persists. However, there are a few factors that could result in price appreciation in the short term. Firstly, as a high beta asset class, digital assets are currently dependent on the monetary policy outlook. Given the scale of price depreciation across asset classes, much of the hawkish outlook has already been priced into markets. We could certainly still get some higher data prints, but Central Banks are aggressively working to get in front of inflation. Hence, investors may only need a ‘less bad’ outlook to justify positive price action in risk assets. Hence, if traditional markets are to turn around, crypto will likely follow. The interesting play here is that major crypto assets will likely outperform in this environment when compared to equities. This presents an interesting investment thesis, particularly for Bitcoin. Either Bitcoin acts as a high beta asset, and outperforms when risk turns around. Or, it ends up being bid as a hedge against inflation given its limited supply, and increasing sovereign use cases. 

A Longer Term Outlook

Digital assets present endless opportunities and even considering the recent cyclical downturn, these opportunities still exist. An immediate consideration is the chance to enter at attractive price levels. Bitcoin’s substantial drawdowns are often preceded by asymmetric gains. Whether we are at the bottom or not is unknown. However, the attractiveness of current prices is reflected in blockchain data that shows strong accumulation taking place amongst longer term crypto participants. Another important note is that the advancements that blockchain technology presents are not reliant on market cycles. While the current value of most tokens suggests otherwise, ingenuity and progress is still taking place and at a rapid pace. Coinciding with the latter, understanding why cryptocurrencies have crashed, their relationship with broader markets and the opportunity current prices present is important for any new and existing participants.

About Zerocap

Zerocap provides digital asset investment and custodial services to forward-thinking investors and institutions globally. Our investment team and Wealth Platform offer frictionless access to digital assets with industry-leading security. To learn more, contact the team at [email protected] or visit our website www.zerocap.com