Why has cryptocurrency collapsed and what does this indicate for the crypto future?

Why has cryptocurrency collapsed and what does this indicate for the crypto future?

If you'd put £100 (US$122) into the cryptocurrency Luna a month ago, you'd be quietly sure you'd made a wise investment. However, Luna's value has subsequently plummeted; at the time of writing, that £100 is worth just 4p (5).

Luna was far from the lone loser in a week when cryptocurrencies fell by 30%. Some have recovered to some amount, but this still marks a seven-day loss of more than $500 million (£410 million), raising existential concerns about the market's survival.

This meltdown was probably caused by a financial "attack" on the stablecoin Terra (UST), which is intended to be worth the same as the US dollar but is currently worth only 18 cents. Its companion currency, Luna, afterward went bankrupt.

An assault of this type is incredibly sophisticated, including several trades in the crypto market in an attempt to trigger particular consequences - which might result in huge winnings for the "attacker."

In this scenario, the transactions led Terra to plummet, which prompted its companion currency, Luna, to decline as well. When this was discovered, it produced fear, which sparked market withdrawals, which sparked even more panic. Some (but not all) stablecoins rely heavily on perception and confidence, and when this is undermined, huge drops might occur.

Crucially, the recent significant drops in cryptocurrency prices have called into doubt the stability of stablecoins. After all, they are supposed to have virtually little volatility by remaining "pegged" to another underlying asset.

However, the repercussions observed this week spilled over into the whole crypto market, resulting in single-day losses comparable to - or maybe worse than - a "Black Wednesday" for crypto (Black Wednesday was the day in 1992 when speculators caused the value of the pound to collapse). Even Tether, the top stablecoin, lost its peg, falling to 95 cents on the dollar, highlighting the necessity for regulation. Because if stablecoins aren't stable, where is crypto's safe haven?

Crypto assurance

The reaction of investors will be critical to the future of cryptocurrencies. We've already witnessed panic and sorrow, with some equating this crisis to a conventional bank run. However, when there is a bank run, clients are more concerned that their bank will be unable to deliver them their money rather than that their money has become worthless.

A more true analogy would be stock market collapses, in which investors fear that the stocks and shares they own would soon be worthless. So far, the reaction to the crypto meltdown indicates that a sizable portion of crypto investors see their investments in a similar light.

Regardless of previous price volatility, there remains a fundamental assumption common in investor behavior: that asset prices will continue to rise. The investor does not want to miss out in this case. They observe the asset rise in value, think it's a "sure thing," and then invest.

Following early success, the investor may decide to invest more. When this is combined with social media and the fear of losing out on "inevitable" profits, the investments continue.

Simply put, many people will have invested in cryptocurrency because they thought it would make them wealthy. This conviction has undoubtedly been shaken.

However, another reason for investing in cryptocurrency might be confidence in its transformative character or the notion that cryptocurrency will eventually replace traditional modes of financial exchange.

For these investors, each gain in the value of a cryptocurrency demonstrates bitcoin's growing influence over traditional money. However, a big drop in the value of cryptocurrency is an ideological loss as well as a monetary one.

However, this ideological attitude generates an investment group that is significantly less inclined to sell in the face of a dramatic loss. And it is this group that may yet offer hope to the sector.

We talk of recovery to "fundamental value" in established stock market disasters. Crypto's basic value is commonly thought to be zero. However, there may be some underlying worth that is dependent on belief. The amount of the investment pool that owns cryptocurrencies because they trust in its long-term future and the promise of a new currency may influence the crypto's underlying worth.

Indeed, if we regard bitcoin investors as distinct groups with distinct objectives, we may better understand the observed behaviors. Investors should take heart in the fact that we may have seen the worst of this catastrophe and that better days are on the way. But, as any financial expert will tell you, nothing is certain in crypto, as in any other market.