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Crypto Volatility: Making Sense of a Crypto Winter

The past couple of months have rocked the crypto space, leading to the collapse of some cryptocurrencies, layoffs at crypto trading platforms and a general slide in Bitcoin’s value. Many have started to refer to this period as a “crypto winter,” as cryptocurrency demand and growth cools.

But despite the latest headlines, it’s wise to keep the noise and speculation in perspective. Will the crypto winter be followed by a spring of growth? How long would that take? How do these worrying trends affect crypto and banking?

To make sense of it all, let’s look at today’s landscape and consider what experts tell us. For a broader view of crypto and banking, including thoughts on what’s next, refer to our webinar.

What Happened to Terra Luna?

Last year, Bitcoin was riding high with a market value of around $60,000. Flash forward to early 2022, and a mild dip began. Then, there was real trouble in the water with the collapse of the algorithmic stablecoin TerraUSD (UST) and its reserve cryptoasset LUNA. By roughly midsummer in 2022, Bitcoin was hovering around $23,000 in value.

The primary takeaway is that the stablecoin UST was not stable. As explored in a previous blog, most stablecoins are collateralized, meaning they represent a claim on a portfolio of physical assets (like USD) backing the coin’s value. By contrast, algorithmic stablecoins like TerraUSD use mathematic codes to artificially regulate supply and demand for two linked cryptocurrencies.

In this case, 1 UST was worth $1 of LUNA. But when regulating that supply and demand became untenable and its value dipped below its dollar peg, the market panicked. Participants sold massive amounts of UST when there was no demand for LUNA.

In other words, people could convert their deposits into ownership but couldn’t withdraw money because the “bank” didn’t own enough to cover their outstanding liabilities. Terra’s existing reserves consisted mostly of other cryptocurrencies, which they had to sell to cover the outflows.

Many had already predicted these problems months before they happened. Unlike the established and vetted cryptocurrencies like Bitcoin, Terraform Labs—the group that created the stablecoin—wasn’t following best practices.

Why is the Rest of the Crypto Market Crashing?

Terra USD’s failure calls to mind the shortcomings of previous under-collateralized stablecoins like AMP, Digital Dollar and others. It also underscores the warnings in the U.S. Federal Reserve’s January 2022 report, stating that algorithmic stablecoin pegs “may experience instability or design flaws that lead to de-pegging.”

But its collapse is only a fragment of the story, as Terra Luna represented a significant portion of the market. When the ship sank, it sucked many over-leveraged exchanges down in its wake, causing additional selling to cover margin calls as the price continued to drop. Without intervention from more stable, financially solvent exchanges, the situation could have gotten even worse.

All modern currencies, on some level, are built on trust. At least in the short term, that trust has been shaken for many. Regulators are also already using Terra as an example of why the landscape requires additional intervention.

Many different topics under the DeFi umbrella have all been lumped into this skepticism. But it’s important to remember that some digital offerings are built on firmer ground than others.

Without intervention from more stable, financially solvent exchanges, the situation could have been worse.

Why is Crypto so Volatile?

It may be tempting to see this rough patch as evidence that crypto investments are irresponsible and too volatile. But to put everything in perspective, it’s notable that the general trend in value has been upward, especially for established and vetted cryptocurrencies.

Consider Bitcoin: Despite a rocky year, its market value remains higher than two years ago. There’s no reason to think it will go down to zero anytime soon.

In some respects, this is relative, as those who invested heavily during crypto highs likely lost money, which should not be taken lightly. However, your customers should know first and foremost that crypto assets are an investment, and risks exist with every investment.

There are many factors that contribute to crypto volatility, including news events such as the above and market speculation. But volatility is also a part of most emerging spaces. Its newness, both technologically and in public sentiment, play a significant role in its perceived value.

Consider that during the 18 months from April 1999 to October 2001, Amazon lost 95% of its market value. People wrote of it as another victim of the dot-com bubble and said internet sales would never be as strong as brick-and-mortar buildings with live sales reps. The notion seems quaint in retrospect.

Will the Crypto Market Recover?

The silver lining is that the industry has a new opportunity—and incentive—to clean itself up. Out of the thousands of cryptocurrencies, scams exist and are pulling the rug out from beneath investors.

However, some are calling this moment the “medicine the bloated market needs.” Stress testing the market may create resiliency and weed out the unstable players that don’t have their act together. Some of these unsound crypto offerings have collapsed in the wake of Terra LUNA and market panic.

Ultimately, the dying out of the weaker cryptocurrencies and survival of the strong is good news. Cryptocurrencies have survived multiple bear markets already, and while we can’t be sure when it may happen, some aspects of the market will likely rebound.

Hopefully, many of the worst practices in the crypto landscape will die out. By contrast, those with best practices will probably withstand the uncertainty.

Cryptocurrencies have survived multiple bear markets already, and while we can’t be sure when it may happen, some aspects of the market will likely rebound.

Should Banks Ignore Cryptocurrency?

Even if the potential for Bitcoin’s quick rewards is temporarily questioned, don’t write off crypto yet. Most crypto-related companies are still in their infancy, and a wave of startups still seek to launch products and services that would lay the foundation for an entirely new financial system. For established institutions, this regroup is the chance to enter this space despite the market cooling.

The last crypto crash in 2018 saw immense innovation, with organizations such as Square (now Block) and PayPal heavily investing with crypto-related ancillary offerings. Similarly, exchanges like Coinbase drastically ramped up consumer-facing products and services, including payment capabilities, direct deposit incentives and even loan products.

What is the Role of Financial Institutions in the Crypto Market?

Previous blogs on cryptocurrencies and DeFi trends have made a case for why financial institutions should pay attention to the crypto market. As mentioned on CSI’s podcast, even if your institution doesn’t want to enter the crypto space, many of your customers already have. So, it’s wise to understand the market and maintain your role as a financial advisor and facilitator.

It may seem counter-intuitive, but these newsworthy events only reaffirm that banks should enter or solidify their influence in the crypto space. At the very least, they emphasize the need for vetting and guidance for consumers to avoid similar schemes.

Unlike some of the bad actors out there, established financial institutions that offer some form of a crypto custodianship solution aren’t facilitating customers getting scammed. Instead, they’re enabling them to participate in something they would ultimately choose to do through third parties.

How Does the Crypto Market Compare to the Economy Overall?

Speaking of investments, it’s worth mentioning that the crypto slide is only part of the troubling news across the market and fears of a recession. According to a recent piece in the New York Times, the value of more established cryptocurrencies like Bitcoin more closely mirrors tech stocks each day.

Then consider that Barron’s reported the tech-heavy Nasdaq losing 29.5% this year and the wider S&P 500 sliding 20.6%. It should therefore be no surprise that with stocks and 401ks down, newer assets like cryptocurrencies would be the hardest hit.

It should be no surprise that with stocks and 401ks down, newer assets like cryptocurrencies would be the hardest hit.

In all likelihood, the worthier corners of the crypto landscape will bounce back, and the value will ebb and flow just as your customers’ investments in the stock market. Many are now looking at this downturn and seeing it less as a crash but as a buying opportunity.

What Will Happen to the Crypto Market?

We can’t predict when the value will go up again. But the current winter is an opportunity for the industry to clean itself up, and may be followed by a new spring. In the meantime, there’s a clear need for regulation and better standards to prevent improper collateralization and other similar issues.

This positions banks as a safe harbor for customers already in this space or looking to enter it. If the industry moves toward an approach that uses regulated, well-collateralized partners, the landscape can emerge much healthier.

To hear more about what that future could look like, check out our webinar, Crypto Meets Banking.

WATCH THE WEBINAR

Matt Herren is the Director of Payment Strategy at CSI. With a strong focus on emerging technologies and how they apply to the financial industry, Matt has led CSI’s effort to drive innovation in the payment space. In his role, Matt has worked to enhance customer experience and helped direct innovative product offerings to increase bank profitability, allowing banks to realize industry-leading results and maximize program performance.

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