Friday, May 13, 2022

Cryptocurrencies: why they crashed and what it could mean for their future

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If you had invested $122 in the Luna cryptocurrency a month ago, you might have felt confident that you made a sensible bet. But Luna’s value has fallen drastically since then — at the time of writing, that $122 is worth about 5 cents.

Luna was by no means the only casualty in a week that saw cryptocurrencies plummet 30%. Some have recovered to some degree, but this still represents a total loss of over $500 million in seven days, raising existential questions about the future of the market.

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

A attack This type is extremely complex and involves placing multiple trades on the crypto market in order to trigger certain effects – which can earn the “attacker” significant profits.

In this case, those trades caused Terra to fall, which in turn caused its partner coin Luna to fall as well. When this was noticed, it triggered panic, which in turn triggered market pullbacks, which then triggered further panic. Some (but not all) stablecoins rely heavily on perception and trust, and once that is shattered, big falls can occur.

Crucially, the recent sharp falls in cryptocurrencies have called into question how stable stablecoins really are. Finally, they are designed to have virtually no volatility by maintaining a “peg” to another underlying asset.

But the impact seen this week spilled over across the crypto space, resulting in single-day losses that are akin to – or arguably worse – a “Black Wednesday” for crypto (Black Wednesday was the day in 1992 when speculators forced a collapse of the crypto value of the pound). Even the leading stablecoin Tether lost its peg to 95 cents against the dollar, possibly demonstrating the need for regulation. Because if stablecoins are not stable, then where is the safe space of crypto?

How investors react will be key to the future of cryptocurrencies. We’ve already seen panic and despair, and some likened this crash to a traditional bank run. But with bank runs, customers are more concerned that their bank won’t be able to give them their money than they are worried that their money has become worthless.

A more accurate comparison is to stock market crashes, where investors worry that the stocks and shares they hold may soon be worthless. And so far, the reaction to this crypto crash suggests that a large portion of crypto holders view their investments similarly.

Regardless of historical price volatility, there is often a basic assumption 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 going up, consider it a “safe thing” and then invest.

Often inspired by initial successes, the investor can then invest more. Combine that with social media and the fear of missing out on “inevitable” gains, and the investing keeps going.

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

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

For these investors, every increase in the value of a cryptocurrency is evidence of the increasing power of cryptocurrency over traditional money. But equally, a significant loss in the value of crypto is not just a monetary loss, but an ideological one.

At the same time, however, this ideological stance creates an investor group that is much less likely to sell in the face of a sharp decline. And it is this group that could still bring hope to the industry.

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

If we look at cryptocurrency investors as different groups with different motivations, we can better understand the observed behavior. Investors may take some comfort in knowing that we have seen the worst of this crash and that better times may lie ahead. But as any financial advisor will tell you, nothing in crypto, like any other market, is guaranteed.The conversation

By Gavin Brown, Associate Professor of Financial Technology, University of Liverpool; Richard Whittle, CAPE Policy Fellow, UCLand Stuart Mills, Fellow of Behavioral Science, London School of Economics and Political Science

This article was republished by The Conversation under a Creative Commons license. Read the original article.

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