The cryptocurrency market is experiencing one of its worst sell-offs since a market rally in 2020, sparking panic among investors and raising questions about why crypto prices have become increasingly sensitive to stock market fluctuations.
Stablecoins in particular are in the spotlight. That type of cryptocurrency, as the name suggests, would have a stable value because the tokens are pegged to the value of a currency such as the US dollar or a commodity such as gold, providing relative isolation from extreme volatility.
Even stablecoins have crashed. What’s behind all this? What awaits the crypto market? We spoke to finance and investment experts for a broad overview.
Why do bitcoin and other cryptocurrencies crash?
Market experts say two main factors are driving the recent collapse of the cryptocurrency market: measures by the US Federal Reserve to combat high inflation and stabilize markets, and the implosion of terraUSD, a type of so-called stablecoin.
Macro economy: 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 contain the pandemic-induced economic slump, essentially pumping more money into households and businesses.
As a result, inflation rose to its highest level in four decades. Another consequence: Abundant liquidity propelled prices in most asset classes, including traditional stock markets and cryptocurrency markets, as traders invested their money in anticipation of stronger returns.
Rising prices mean economic pain for people – since for the most part our incomes do not rise along with prices – and they threaten economic growth in general. To mitigate damage, the Fed raised interest rates by 50 basis points, or half a percentage point, earlier this month, the largest increase in about two decades. The Fed is also reducing the money supply to further curb inflation creep and will continue to raise interest rates going forward.
High inflation and, in turn, rate hikes make investors nervous because they can dampen corporate growth and affect corporate profits, encouraging sell-offs. The Standard & Poor’s 500 and Nasdaq stock indices are down more than 20% since the start of the year. Meanwhile, the market cap of the cryptocurrency market has more than halved from its peak of about $3 billion in November to $1.3 billion now, according to data collected 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 over 40% of the market.
TerraUSD: Now what really catches the attention of crypto watchers is terraUSD, known by the list name 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-assets that, as the name suggests, offered greater stability during market volatility.
The value of the UST token is pegged to the US dollar, which means that the value of one UST must be $1 at all times. If the value falls below a dollar, the coin can be “burned” and exchanged for luna worth one dollar.
Luna started trading at around $3 in May 2019 and hit 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 below a dollar – it collapsed to less than 30 cents.
What happened to Luna? Why is that bad?
When the price of UST crashed, major luna holders were paid out, causing the supply of luna tokens to increase and the price to crash. Luna lost 99% of its value on Thursday.
According to Bloomberg Intelligence, luna’s sharp fall in value looked like the worst day ever for a financial product and prompted cryptocurrency exchanges to scrap the coin, halting trading due to lack of liquidity in the market.
One possible reason for the severity of this crash is the specific price structure of the UST token, said Edward Moya, a senior market analyst at OANDA, a currency platform.
The UST works differently from other stablecoins, such as tether, which are backed by a government-backed currency or commercial paper. It is an algorithm-based stablecoin and uses a complicated method, with the help of luna, to ensure its value against the dollar is preserved.
“Most stablecoins will have actual assets to function, but the algorithmic solution UST had was unable to handle the market volatility we see in the bond markets. This led to widespread panic selling,” Moya said.
While the price of terraUSD fell to 30 cents, the price of luna collapsed to $0.00001655, from about $81 earlier this week. Terraform Labs said Thursday evening that it has shut down the blockchain behind the cryptocurrencies and will “devise a plan to put it back together”.
The Fed recently flagged concerns about stablecoins in its semi-annual financial stability report, saying that the high-growth sector, which represents about 15% of the total cryptocurrency market cap, is vulnerable to runs and its risks could spill over into traditional markets.
Is the crypto market moving more like the stock market now?
The cryptocurrency market, like the stock market, has been seeing declines for months. It peaked in November, and with aggressive signs of liquidity tightening from the Fed, all asset markets have since corrected.
Market experts note that the correlation between traditional markets and the cryptocurrency market has likely reached an all-time high: if one plunges, the other will most likely follow or vice versa.
Sylvia Jablonski, chief executive and chief investment officer of Defiance ETFs, said the correlation with the Nasdaq is 0.82, up from historical levels of less than 0.5 (on a scale of 0 to 1). In similar terms, both traditional and stock markets are moving in the same direction more than ever, so there is a spillover effect in investor sentiment.
Experts observe a stronger correlation between cryptocurrency and technology stocks, which have been among the hardest hit in the recent market slump.
I thought crypto was a hedge against inflation?
Some cryptocurrencies, most notably the giant bitcoin, were touted as assets that would hold value over time, meaning they would be a good hedge against inflation.
But as inflation has risen, the price of bitcoin has more than halved, making it less attractive to investors during high periods of high prices.
Caleb Franzen, senior market analyst at Cubic Analytics, a big data analytics firm, said he thinks bitcoin will continue to act as an inflation hedge over time. Some modeling projects that bitcoin’s value could fall to a $19,000 to $21,000 range in the short term, he said, but in the longer term of five to 10 years, it could prove to be a good hedge.
What happens now?
Is crypto heading for a Lehman moment? (Lehman Bros. is the major investment bank that went bankrupt in 2008 and was a player in the financial crisis.)
“Not yet. You can never say never, especially in cryptocurrency,” said OANDA’s Moya. “While there are potential catalysts, there doesn’t appear to be any systematic risk.”
Franzen believes that a substantial rise in the value of bitcoin could foreshadow a rise in inflation as happened between March 2020 and November 2021.