If you had invested £100 (US$122) in the Luna cryptocurrency a month ago, you could have been quietly sure that you had made a sensible bet. But Luna’s value has fallen dramatically since then: at the time of writing, that £100 is worth around 4p.
Luna was by no means the only casualty in a week in which cryptocurrencies fell 30%. Some have recovered to some extent, but this still represents a total seven-day loss of over US$500m (£410m), raising existential questions about the future of the market.
This drop was possibly triggered by a financial “attack” on the Terra (UST) stablecoin, which is supposed to match the US dollar but is currently trading at just 18 cents. Its associated coin, Luna, subsequently crashed.
An stroke This type is extremely complex and involves multiple transactions in the crypto market in an attempt to trigger certain effects, which can provide the “attacker” with significant profits.
In this case, these trades caused Terra to drop, which in turn caused its associated currency, Luna, to drop as well. Once this was noticed, it caused a panic, which in turn led to recalls, which then led to more panic. Some (but not all) stablecoins rely heavily on perception and trust, and once this is shaken, big drops can follow.
Crucially, the recent big drops in cryptocurrencies have called into question just how stable stablecoins really are. After all, they are designed to have virtually zero volatility by maintaining a “peg” to some other underlying asset.
However, the effects seen this week rippled across the entire crypto space, to create single-day losses similar to, or possibly worse than, a “Black Wednesday” for cryptocurrencies (Black Wednesday was the day in 1992 when speculators forced a collapse in the value of the pound). Even the main stablecoin, Tether, lost its peg, down to 95 cents on the dollar, perhaps showing the need for regulation. Because if stablecoins are not stable, where is the crypto safe space?
Investor response will be key to the future of cryptocurrencies. We have already seen panic and despair, with some comparing this collapse to a traditional bank run. But with bank runs, customers tend to worry that their bank won’t be able to give them their money, rather than worry that their money is worthless.
A more accurate comparison is with stock market crashes, where investors worry that the stocks and shares they own will soon lose their value. And so far, the reaction to this cryptocurrency crash suggests that a large portion of cryptocurrency holders view their investments in a similar way.
Despite historical price volatility, there is a basic assumption that is often seen in investor behavior: that the price of the asset will rise and continue to rise. In this scenario, the investor does not want to miss out. They see the asset go up, consider it a “sure thing” and then invest.
Often buoyed by initial successes, the investor can then invest more. Combine this with social media and the fear of missing out on “inevitable” profits, and the investments continue.
Simply put, many will have invested in cryptocurrencies because they believed it would make them richer. This belief has certainly been shaken.
But another motivation for investing in cryptocurrencies may be a belief in its transformative nature, the idea that cryptocurrencies will eventually replace traditional forms of financial exchange.
For these investors, any increase in the value of a cryptocurrency is a demonstration of the growing power of cryptocurrency over traditional money. But by the same token, a significant decline in the value of cryptocurrencies isn’t simply a monetary loss, it’s an ideological loss.
At the same time, however, this ideological stance creates a group of investors that are much less likely to sell in the face of a sharp decline. And it is this group that can still provide hope for the sector.
In established stock market crashes, we speak of a return to “fundamental value.” The fundamental value of crypto is often assumed to be zero. However, perhaps there is at least some core value that is based on belief. The size of the group of investors who own cryptocurrencies because they believe in its long-term future and the promise of new money can determine the fundamental value of cryptocurrencies.
In fact, if we consider cryptocurrency investors as different groups with different motivations, we can better understand the behaviors that we are seeing. Investors can perhaps take comfort in the fact that we have seen the worst of this slump and that better times are ahead. But as any financial advisor will tell you, in crypto as in any other market, nothing is guaranteed.
This article by Gavin Brown, Associate Professor in Financial Technology, University of Liverpool; Richard Whittle, CAPE Policy Fellow, UCL, and Stuart Mills, Fellow of Behavioral Science, London School of Economics and Political Science is republished from The Conversation under a Creative Commons license. Read the original article.