Why Does Crypto Crash? 6 Reasons

Cryptocurrencies are volatile by nature, as 2022 has proven. Here's why.

Recent cryptocurrency downturns have wiped out huge amounts of wealth.

Cryptocurrencies have had a rough start to the year. As of May 12, Bitcoin (BTC) had lost nearly 40% in value year to date, while Ethereum (ETH) and Binance Coin (BNB) were each down about 48% in that period. These are the three biggest cryptocurrencies in circulation by market capitalization – not counting stablecoins Tether (USDT) and USD Coin (USDC), which are meant to be tied to the U.S. dollar. This isn't the first time crypto has taken a big dive. From mid-May to mid-July 2021, cryptos went through another big drop, and Bitcoin fell more than 45%. Despite the volatility, many investors are still interested in cryptocurrencies. According to Vin Narayanan, vice president of strategy at Early Investing, "As crypto adoption increases, it'll become more stable." Until then, however, investors may want to know what to look for so they don't get burned by crypto crashes. Here are six reasons why cryptocurrencies crash

Crypto investors taking on too much leverage.

Crypto data firm CryptoQuant's BTC leverage ratio hit all-time highs in early January, meaning more investors were taking on risk in the crypto space. Just like in traditional markets, crypto investors will often use debt to finance purchases of futures. This can be a way for miners to hedge against future price drops in the coins they're mining. Simon Peters, senior account manager at eToro, says these amounts of leverage "could spell volatility in the near term" for cryptocurrencies. As with any asset class, Peters says, "price declines could cause liquidation of long-term positions." Then, as prices drop and futures holders start liquidating their positions, prices could fall even further. It's a cycle similar to what happened to the stock market in 1929 and 2008. But these kinds of crashes are particularly dangerous for markets like crypto that don't have much liquidity..

Lack of liquidity in cryptocurrency markets.

The biggest problem the crypto markets face when leveraged investors liquidate a large portion of their assets is the overall liquidity of the markets. Unlike in the stock market, there aren't always a bunch of buyers waiting to snatch up unloaded coins. This is part of the reason why crashes tend to occur over weekends for crypto. There are fewer investors tuned in to buy when a bunch of coins are sold. Narayanan says, "It's why big institutions can't trade small coins. They wind up upsetting the markets." For example, when a whale – an investor who holds a large position of any given asset – sells significant amounts of crypto, it can flood the market. The coins simply funnel into the broader market and leave a glut of supply with limited demand.

Cryptocurrency regulation.

When China banned crypto mining in June 2021, "miners had to move to other jurisdictions that were more miner-friendly," Peters says. The implications for crypto investors were that "we saw a significant decline in the network hash rate." In the crypto world, a hash rate is the number of calculations that can be performed per second. These calculations are what allow the miners to produce the coins they're mining, and they affect a coin's price. When prices decline, the hash rate declines. It's been theorized that the opposite holds true, as well. This is often because miners are paid in cryptocurrency. But this also means that when governments clamp down on mining through regulations, the overall price of cryptos can decline.

Cryptocurrency correlations with the stock market.

Part of the beauty of crypto is that it should be an uncorrelated asset. In other words, it should float freely, divorced from the rest of the market. But, as 2022 has proven, that's often not the case. "Crypto markets have become more intertwined with traditional markets due to traditional adoption over the past few years. Crypto has a high correlation to the stock market in some people's views," says Peters. Crypto, once supposedly the world's newest hedge against interest rates and inflation, is proving far more correlated to overall markets than early adopters hoped. Look no further than the crypto market's 45.3% plunge year to date through May 12 compared to the S&P 500's 17.5% decline. The fact that this plunge comes alongside rising rates doesn't help make the case that it's uncorrelated. But, as Narayanan says, "Crypto crashes are part of investing in crypto." What investors need to determine is their time frame for holding digital assets and whether they can stomach market downturns.

6 reasons why crypto crashes:

• Crypto investor taking on too much leverage.
• Lack of liquidity in cryptocurrency markets.
• Cryptocurrency regulation.
• Crypto security breaches causing fear.
• Crypto influencers causing volatility.
• Cryptocurrency correlations with the stock market.