Why is Crypto Crashing?: Everything to Know
By Beluga Research September 25, 2023
- "Why is crypto crashing?" is a question investors ask when there is a dip in the market or a coin or platform suffers a severe attack
- The question "why is crypto crashing?" prompts investors to investigate factors such as market sentiment, regulatory actions and investor behavior
- Reasons for crashes include investor speculation, restrictive or overreaching regulation, security breaches, market manipulation and technological challenges like congestion
- Cryptocurrencies are volatile because they are new, lack intrinsic value and are affected by still-developing government regulations
"Why is crypto crashing?" is a question that investors ask when there is a dip in the market or a coin or platform suffers a severe attack. Investors attempt to understand the reasons for the crash and institute safeguards to prevent more crashes in the future. Some crashes are predictable, such as those that follow a hack after the platform did not build in enough security.
Other crashes are unpredictable, such as a devaluation of a cryptocurrency after a new government regulation severely restricts the use of the coin without warning. Examining crashes that involve bitcoin, the first-introduced and most popular cryptocurrency, suggest how to investigate and prevent crashes of other coins.
A Brief History
Understanding how Bitcoin underwent a significant crash soon after it was introduced explains why other coins experience crashes. Bitcoin's early years saw limited adoption and the development of a niche community of enthusiasts. As the coin's potential became more widely recognized, it gained traction and attracted significant investment.
By 2014, Mt. Gox, an exchange platform, engaged in over 70% of all bitcoin transactions. The exchange suffered a serious cyber attack that year and subsequently suspended trading. At this point, market speculation led to a dip in Bitcoin's value. Yet by 2017, the coin had recovered.
The key factors in Bitcoin's 2014 crash were poor performance and security practices by a major exchange. Reasons for bitcoin dropping in value in subsequent years have included congestion and concerns about how it negatively affects the environment. This is because bitcoin utilizes the proof-of-work (PoW) consensus mechanism, which requires a high amount of energy consumption. Despite these issues, bitcoin remains the most widely-used coin.
Why is Crypto Crashing?: Everything to Know
- Market Speculation and Investor Sentiment. The volatile nature of the market attracts traders and investors seeking quick profits. This speculative behavior can cause rapid price fluctuations. This leads to a series of upward rallies followed by sharp downturns. Fears of a market bubble and concerns about overvaluation can trigger widespread selling. The result is usually a market crash.
- Regulatory Actions. News of potential bans, restrictions and unfavorable regulations by governments and traditional financial institutions like banks causes investors to lose confidence. If the actions are more serious than initially indicated, investors tend to panic. In particular, regulatory crackdowns on exchanges and initial coin offerings (ICOs) contribute to market downturns. The lack of clear and consistent regulations adds to market volatility.
- Security Breaches and Hacks. High-profile security breaches and hacks erode investor confidence and trigger significant sell-offs. Exchange hacks like the Mt. Gox incident typically involve the theft of large amounts of funds. Historically, they have led to market downturns.
- Market Manipulation. The relatively small size and lack of liquidity in the cryptocurrency market make it susceptible to manipulation. Whales are entities that hold large amounts of a particular cryptocurrency. They influence prices by strategically buying or selling significant volumes. Pump and dump schemes that involve a group artificially inflating the price of a cryptocurrency before selling it can contribute to market crashes. Manipulative practices such as these exploit the market's lack of regulation. They result in substantial losses for new, inexperienced or unsuspecting investors.
- Technological Challenges. Scalability issues, slow transaction speeds and high fees are persistent concerns for many blockchain networks. These issues impact investor confidence when they become apparent or limit the utility of a particular cryptocurrency. Vulnerabilities in the underlying technology of a cryptocurrency also cause panic and trigger sell-offs.
- Engage in analysis to understand the weaknesses of a coin. An investor curious as to why crypto is crashing should look at the vulnerabilities of their own holdings. They can review whitepapers on the coin's website, comments in web forums and government and institutional regulations regarding the coin.
- Determine whether the coin is a good long-term investment. The investor should ask themselves whether they want to hold onto the coin. They may think it will recover or develop strategies to generate a profit even if the coin continues to lose value.
- Recognize that concerns which affect a popular coin like bitcoin will influence the rest of the crypto ecosystem. Problems in one area of the crypto ecosystem, such as a serious and sudden devaluation of bitcoin, have the potential to affect other coins. Investors should recognize this so they are not surprised by ripple effects.
- Relatively new. The fact that the crypto ecosystem is relatively new makes it prone to sudden shifts in sentiment and market dynamics. The newness of this market explains why governments and financial institutions are still developing regulations.
- Small market size. The crypto market can be influenced by a small number of participants, especially if they acquire large amounts of a coin. This makes the market vulnerable to significant price swings.
- Lack intrinsic value. The fact that cryptocurrencies lack intrinsic value adds to their volatility. Cryptocurrencies differ from traditional assets like stocks and commodities that derive their value from underlying assets or income streams. Cryptocurrencies derive their value mainly from investor sentiment and market demand. This makes the crypto market highly speculative. Prices can be influenced by factors unrelated to fundamental value.
- Presence of a vibrant and active community of retail investors. This community, referred to as the "crypto community," plays a significant role in shaping market sentiment and driving price movements. The community's enthusiasm and the ease of access to crypto markets through various platforms amplifies positive and negative market trends. When sentiment turns negative, it can trigger a cascade of selling.
- Exposed to a wide range of geopolitical, economic and regulatory factors. The global, 24-7 trade of cryptocurrencies means that news and specific types of events, such as changes in national governments, have a profound impact on the crypto market. Government regulations, bans and restrictions on cryptocurrencies foster uncertainty and tend to negatively affect investor sentiment. Macroeconomic factors influence the market. These include inflation, interest rates and geopolitical tensions.
- Potential to make a profit. Investors who have bet that a coin or the market will see a downturn may be able to make a profit during a crash.
- Potential to recover. The crypto market tends to recover quickly after a crash, especially if platforms take measures to improve security and prevent scams.
- Advocate for better technological practices and regulations. A downturn showcases an opportunity for a platform to take actions such as switch its consensus mechanism or find ways to relieve congestion.
- Potential to explain concerns. Understanding why a crash occurred helps educate investors.
- Develop better investment practices. A crash teaches investors to diversify and develop new strategies.
- Exposure of malicious actors. A downturn can push platforms to reveal the identities and actions of scam artists who have contributed to a problem. This helps investors gain awareness and other platforms to ban these actors.
- Weeds out exchanges and platforms that do not perform well. A downturn eliminates platforms that have not built in adequate security or found methods to compensate investors in the event of losses.
- Losses for investors. Any downturn is likely to result in losses for investors.
- Discouragement of investor activity. A downturn usually does not motivate investors to engage with the crypto ecosystem or inspire new platforms to launch different offerings.
- Invites further regulation. Downturns attract the attention of governments and financial institutions. These entities cite dips as reasons to further restrict the crypto ecosystem through regulation.
- Can encourage centralization. Security hacks can motivate investors to place too much trust in custodians and platforms that promise more security or compensation. This can contribute to centralization of the crypto ecosystem.