This is why you lose money

If you had invested £100 (US$122) in the cryptocurrency Luna a month ago, you would have quietly believed that you had made a wise bet. But Luna’s value has since fallen drastically – at the time of writing, that £100 is worth around 4p (5¢).

Luna was certainly not the only victim in a week when cryptocurrencies fell by 30%. Some have recovered to some degree, but this still represents a total seven-day loss of over US$500m (£410m), raising existential questions about the future of the market.

This crash may have been caused by a financial “attack” on the stablecoin Terra (UST), which is believed to be equivalent to the US dollar but currently trades at just 18 cents. Its partner coin, Luna, then collapsed.

One attack this kind is extremely complex and involves placing multiple trades on the crypto market in an attempt to trigger certain securities – which can bring the “attacker” significant profits.

In this case, these trades caused Terra to fall, which in turn also brought down his partner coin Luna. Once spotted, this sparked panic, which in turn led to market pullbacks, which then sparked further panic. Some (but not all) stablecoins rely to a great extent on perception and trust – and once this is shaken, major falls can occur.

Crucially, the recent major declines in cryptocurrencies have raised the question of how stable stablecoins really are. After all, they are designed to have virtually no volatility by maintaining a “peg” to another underlying asset.

But the effects seen this week trickled down to the entire crypto space, creating one-day losses comparable to – or arguably worse than – a “Black Wednesday” for crypto (Black Wednesday was the day in 1992). when speculators collapsed the value of the pound). Even the leading stablecoin Tether lost its peg, down to 95 cents on the dollar, perhaps showing the need for regulation. Because if stablecoins are not stable, where is the safe space of crypto?

Trust crypto

How investors react will be key to the future of cryptocurrencies. We have already seen panic and despair, with some comparing this crash to a traditional run on the banks. But in bank runs, customers are more likely to fear that their bank won’t be able to give them their money, rather than worry that their money has become worthless.

A more accurate comparison is with stock market crashes where investors worry that the stocks and shares they own may soon be worthless. And so far, the response to this crypto crash suggests that a large proportion of crypto holders view their investments in a similar way.

Despite historical price volatility, there is a basic assumption often seen in investor behavior: that the asset price will and will continue to rise. In this scenario, the investor does not want to miss anything. They see the asset rise, see it as a ‘certain thing’ and then invest.

Often supported by initial successes, the investor can then invest more. Combine this with social media and the fear of missing out on “inevitable” gains, and the investment continues.

Simply put, many will have invested in cryptocurrencies because they thought it would make them richer. This belief has undoubtedly been shaken.

But another motivation for investing in cryptocurrencies may be a belief in their transformational nature, the idea that cryptocurrencies will eventually replace traditional forms of financial exchange.

For these investors, any increase in the value of a cryptocurrency is a demonstration of the increasing power of cryptocurrency over traditional money. But similarly, a significant drop in crypto’s value isn’t just a monetary loss — it’s an ideological one.

At the same time, however, this ideological stance creates a group of investors who are much less likely to sell in a sharp decline. And it is this group that may still offer hope for the sector.

In established stock market crashes we speak of a return to “fundamental value”. It is often assumed that the fundamental value of crypto is zero. But perhaps there is at least one fundamental value based on faith. The size of the investor pool that owns cryptocurrency because they believe in the long-term future, and the promise of new money, can determine that fundamental value of crypto.

Indeed, if we view cryptocurrency investors as different groups with different motivations, we can better understand the behavior we see. Investors may take comfort in the fact that we have seen the worst of this crash and that better times may be ahead. But as any financial advisor will tell you, in crypto as in any other market nothing is guaranteed.

This article by Gavin Brown, Associate Professor of Financial Technology, University of Liverpool; Richard Whittle, CAPE Policy Fellow, UCL, and Stuart Mills, Fellow of Behavioral Science, London School of Economics and Political Science are republished from The Conversation under a Creative Commons license. Read the original article.

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