Bitcoin dives 10% in a single day, continuing a rough start to the year for crypto investors.
What is behind this crash and why is the market so volatile?
At market close on Friday January 21st, bitcoin (BTC) was valued at 36,396 USD—down more than 10% in 24 hours. The world’s biggest cryptocurrency has now lost almost one quarter of its dollar value since January 1st. We have seen even more severe losses in many major alt coins, leaving many with the question—what is driving these dramatic falls?
US Market Uncertainty
The US stock market has just endured its worst week in nearly two years. Traditionally, the value of bitcoin was seen as unrelated to the performance of the stock market, however this is no longer the case. Prior to Friday’s crash, the 100-day correlation between BTC and the S&P 500 was the highest it had been since 2011. Given that the two are now clearly linked, it is unsurprising that bitcoin and the general crypto market has also suffered.
The stock market sell-off is predominantly due to a policy change from the US Federal Reserve, the central bank of the USA. Over the past two years we have seen the ‘Fed’ injecting money into the economy at unprecedented rates in response to the negative economic impacts of the coronavirus pandemic. With so much new cash entering the markets, and interest rates kept low, investor confidence has been high. The stock market has performed well, with the S&P 500 reaching successive all-time-high levels in 2021.
An unwanted side effect of this policy has been inflation, with the consumer price index (CPI) measured 7% in December 2021—the highest rate we’ve seen in 40 years. This essentially represents a 7% reduction in the ‘real terms’ value of the dollar over a one-year period. To combat this, the Fed has announced plans to ‘taper’ the amount of cash being pumped into the economy, and simultaneously start to raise interest rates.
Ever since these announcements, the US stock market has begun to falter. Raised interest rates lead to higher borrowing costs and better returns from keeping money in savings or government bonds. As such, money is generally drawn away from the investment market. When combined with the prospect of decreasing economic stimulus in the US, plus global concerns relating to tensions in Eastern Europe and the ongoing fallout in the Chinese markets from the Evergrande crisis, 2022 has created the perfect storm for a stock market sell off.
Regulation
In an uncertain market, investors typically offload their highest risk assets first. For most investors, crypto tops the ‘high risk’ category. The news of the Russian central bank proposing a ban on the use and mining of cryptocurrencies this week has served as a pertinent reminder of the impending regulatory action in the US. It is reported that the Biden administration will release a government-wide crypto strategy as soon as February. This is unlikely to be anywhere near as extreme as what has been suggested in Russia, but the exact scope of the bill remains unknown, and markets hate uncertainty!
Liquidation Cascades
The crypto market is notoriously volatile. One key factor behind this is the huge amount of leverage trading that exists in the crypto space. Leverage trading is essentially trading using borrowed money on top of your initial investment, with the goal of multiplying potential returns. This is not unique to the crypto markets, however in traditional finance this area is highly regulated, with limits on who can trade and how much leverage can be used. In comparison, many crypto exchanges are ‘offshore’ and completely unregulated, with some offering up to 100x leverage to pretty much anyone able to set up an account!
When trading with leverage, it is not only potential gains that are multiplied, but also potential losses. A leveraged trade will be ‘liquidated’ if the price of the asset falls below a certain level, meaning that all of the assets in the trade are sold off at market rate in order to repay the initial loan taken out. In the case of liquidation, the investor loses the entirety of their investment, and the large amount of the asset being sold can also act to decrease the market price of the asset itself. ‘Liquidation cascades’ can occur when this decrease in asset price triggers more and more liquidations, thus pushing the price down further in a deadly spiral. This was evident in Friday’s price action, with over 987 million dollars of bitcoin trades liquidated in 24 hours. Essentially, whatever is going on in the market, the amount of leverage exacerbates the change and causes dramatic price movements.
It is likely that in the short term, the price action of bitcoin will rely heavily on the fate of the US markets. Some analysts have suggested that the market correction is only just beginning, and if this happens in conjunction with harsh crypto regulation in the US, crypto could be in for a rough ride. This remains to be seen, but if there are further dramatic price drops, you can be sure that the amount of leverage trading out there is playing a key part!
