Why is crypto crashing? A Q&A on bitcoin, luna and other falling cryptocurrencies




  • In Business
  • 2022-05-13 23:28:33Z
  • By LA Times
(Jim Cooke / Los Angeles Times)
(Jim Cooke / Los Angeles Times)  

The cryptocurrency market is seeing one of its worst selloffs since a market rally in 2020, sparking panic among investors and raising questions about why crypto prices have been increasingly sensitive to gyrations in the stock market.

In particular, stablecoins are in the spotlight. That type of cryptocurrency is supposed to, as its name suggests, have a stable value because the tokens are pegged to the value of a currency such as the U.S. dollar or a commodity such as gold, providing relative insulation from extreme volatility.

Even stablecoins have crashed. What's behind all this? What's ahead for the crypto market? We talked to finance and investment experts for a broad overview.

Why are bitcoin and other cryptocurrencies crashing?

Market experts say two main factors are driving the recent slump in the cryptocurrency market: moves by the U.S. Federal Reserve to combat high inflation and stabilize markets, and the implosion of terraUSD, a type of so-called stablecoin.

  1. Macro-econ: To explain the first factor, let's start with some macroeconomics. In early 2020, the Fed cut interest rates, or the cost of borrowing, to manage the pandemic-driven economic slump, essentially pumping more money into households and businesses.

    The result down the line was inflation rising to the highest level in four decades. Another consequence: abundant liquidity drove prices up across most asset classes, including traditional stock markets and cryptocurrency markets, as traders invested their money anticipating stronger returns.

    Rising prices mean economic pain for people - as our incomes aren't, for the most part, rising in tandem with prices - and they threaten economic growth more broadly. For damage control, earlier this month the Fed raised interest rates by 50 basis points, or half a percentage point, the largest increase in about two decades. The Fed is also in the process of reducing the money supply to further curb inflation creep and will continue to hike rates in the future.

    High inflation and, in turn, interest rate hikes make investors nervous because they can crimp business growth and affect company earnings, so they can encourage sell-offs. The Standard & Poor's 500 and Nasdaq stock indexes have fallen more than 20% since the beginning of the year. Meanwhile, the market cap of the cryptocurrency market has more than halved from its peak of around $3 billion in November to $1.3 billion now, according to data gathered by CoinGecko, which analyzes the digital currency market.

    The price of bitcoin dropped below $30,000 earlier this week, for the first time since July. Bitcoin is the world's largest trading cryptocurrency and accounts for more than 40% of the market.

  2. TerraUSD: What's really caught the eye of crypto watchers now is terraUSD, known by its list name as UST, and its effect on its sister token, luna.

    These are two cryptocurrencies created by the Terra network, a blockchain project developed in South Korea.

What are luna and UST cryptos?

Stablecoins, including terraUSD and luna, were touted as a class of crypto asset that, as the name suggests, offered more stability during market volatility.

The value of the UST token is pegged to the U.S. dollar, which means that at all times the value of one UST should be $1. If the value plunges below a dollar then the coin could be "burned" and exchanged for a dollar's worth of luna.

Luna started trading in May 2019 at roughly $3 and touched an all-time high of around $116 in April, according to CoinGecko data, at a time when most other large-cap cryptocurrencies were falling.

Earlier this week, UST broke the peg against the dollar and, for the first time, the value of 1 UST fell to less than a dollar - it crashed to less than 30 cents.

What happened to luna? Why is that a big deal?

As the price of UST crashed, large luna holders cashed out, causing the supply of luna tokens to jump, and its price to crash. Luna lost 99% of its value Thursday.

According to Bloomberg Intelligence, luna's sharp value decline looked like the worst day for a financial product ever seen and it prompted cryptocurrency exchanges to delist the coin, bringing its trade to a halt as there was no liquidity in the market.

A possible reason for the severity of this crash is the particular pricing structure of the UST token, said Edward Moya, a senior market analyst at OANDA, a foreign exchange platform.

The UST operates differently from other stablecoins, such as tether, which are backed by a government-backed currency or commercial papers. It is an algorithm-based stablecoin and uses a complicated method, with the help of luna, to ensure its value is maintained against the dollar.

"Most stablecoins will hold actual assets to function but the algorithmic solution that UST had was unable to handle the market volatility that we are seeing across the bond markets. This led to a widespread panic selling," Moya said.

While terraUSD's price slumped to as low as 30 cents, the price of luna came crashing down to $0.00001655, from around $81 earlier this week. Terraform Labs said on Thursday evening that it halted the blockchain behind the cryptocurrencies and will "come up with a plan to reconstitute it."

The Fed recently flagged concerns related to stablecoins in its biannual financial stability report, saying that the rapidly growing sector, which constitutes roughly 15% of the total cryptocurrency market capitalization, is vulnerable to runs and its risks could spill into traditional markets.

Is the crypto market now moving more like the stock market?

The cryptocurrency market, like the stock market, has been seeing declines for months. It peaked in November, and with aggressive liquidity tightening signals by the Fed, all asset markets have since seen a correction.

Market experts note that the correlation between traditional markets and the cryptocurrency market is probably at an all-time high: If one plunges, the other will most likely follow suit or vice versa.

Sylvia Jablonski, chief executive and chief investment officer of Defiance ETFs, said the correlation with the Nasdaq is at 0.82, up from historical levels of below 0.5 (on a scale of 0 to 1). In similar terms, both traditional and stock markets are moving in similar directions more than ever, so there is a spillover effect in investor sentiment.

Experts are observing a stronger correlation between cryptocurrency and tech stocks, which were among the hardest-hit stocks in the recent market slump.

I thought crypto was a hedge against inflation?

Some cryptocurrencies, particularly market giant bitcoin, were touted as assets whose value would hold over time, which means they would be a good hedge against inflation.

But as inflation has surged, bitcoin's price more than halved, making it less attractive for investors during high spells of elevated prices.

Caleb Franzen, senior market analyst at Cubic Analytics, a big data analytics firm, said he thinks bitcoin will continue to act as an inflationary hedge over a longer period of time. Some modeling projects that bitcoin's value may drop to a range of $19,000 to $21,000 in the short term, he said, but in the longer span of five to ten years, it may prove to be a good hedge.

What happens next?

Is crypto headed for a Lehman moment? (Lehman Bros. is the big investment bank that went under in 2008 and was a player in the financial crisis.)

"Not yet. You can never say never, especially in cryptocurrency," OANDA's Moya said. "Though there are potential catalysts, there doesn't seem to be a systematic risk."

Franzen believes that a substantial rise in the value of bitcoin could be a precursor to a rise in inflation as happened between March 2020 and November 2021.

This story originally appeared in Los Angeles Times.

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