Just like any other financial market, cryptocurrency markets also undergo rise and fall. However, since the DeFi space has been around for only a little more than a decade, it seems that there is still a lot of pessimism attached to it.
Every new technology takes its course to adjust to going through the process of mainstream adoption. Blockchain innovation is new, and it requires a change in the existing financial infrastructure existing for centuries to change. Under these circumstances, the most important question for cryptocurrency investors is why the crash is happening.
What is Cryptocurrency?
To understand what is cryptocurrency crash the reader must first understand what it is. Cryptocurrency is the portmanteau of two parts, namely crypto and currency. Currencies are a medium of exchange.
As visible by the Whitepaper of Bitcoin, the first cryptocurrency that it is a digital replacement for paper money. Meanwhile, the first word Crypto means that there is a digital cipher attached to a cryptocurrency that prevents it from getting stolen, manipulated, or misrepresented.
Cryptocurrencies are issued by Blockchain, which are digital online ledgers to keep these financial records. Blockchains are unique in the way that they remove the need for a centralized transaction processing authority such as Bank or a financial network.
With the introduction of Bitcoin, a digital alternative for a medium of exchange or paper money became available to investors for the first time.
What is a Cryptocurrency Crash?
There are currently several types of cryptocurrencies roaming in the world that are tethered to their native blockchains. Cryptocurrencies have become the native governance tokens for each online DeFi blockchain project, such as games, artwork, lending platforms, staking protocols, liquidity pools, swaps, and others.
Every new cryptocurrency issuer tries to introduce a use case for its token to increase its value in the market. This has given rise to the cryptocurrency market, where thousands of cryptocurrency tokens are exchanged and traded.
Many people perceive cryptocurrencies as digital stocks. However, in nature, cryptocurrencies behave more like commodities or forex. These are currencies that are operating for different projects, and the investors try to hold them or exchange them to generate profits.
The ability of cryptocurrencies to generate profits through trading has established it as a separate trading marketplace. When the cryptocurrency market appreciates, it is called a Bull Run. However, when the majority of the cryptocurrency market is printing red candles, it is called a Crypto Market Crash.
Why does Cryptocurrency Market Crash?
When investors are trying to understand how to invest in the cryptocurrency markets to make profits, they perform technical analysis. However, it is also important for investors to understand the cryptocurrency market’s crash.
There is no one answer to the question because there are a lot of variables that affect the cryptocurrency markets. Here are some of the most common reasons that make cryptocurrency markets travel on a downward spiral:
Lack of Utility
The most important reason for the downfall of the cryptocurrency market is the lack of utility. If a cryptocurrency does not offer a proper use case for its investors, it means that it is not going to keep trending for long. History is filled with examples where the prices of a certain commodity were artificially inflated to unimaginable heights.
Take, for instance, the Dutch Tulip mania of the 17th Century. The people of Holland were enamored by the rarity of Tulips to the point that the price of a single Tulip bulb reached as high as 1000 guilders per unit.
However, the mania soon died down, and the people who had bought in at higher prices ended up incurring massive losses. The incident is often quoted as a classic example of a financial bubble.
On the other hand, there are commodities like gold and diamonds that are only used for ornamental purposes, and yet they have managed to remain the most valuable assets in history.
Meanwhile, there is empirical evidence that the cryptocurrencies like Bitcoin have a real use case. But at the end of the day, the value of a financial instrument is only as good as the cumulative trust of the masses.
Absence of Regulations
The absence of regulations is something that can deter institutional investors from placing big bets in any financial scheme. When the earliest banks were set up, a lot of banks ended up failing. Today, most people cannot think about such an event happening.
There are financial insurance corporations in place that prevent banks from going under and ensure the safety of their consumers.
In the same manner, the origin of stock exchanges is filled with tales of foul play and financial malice happening on account of the lack of regulatory clarity. Some cryptocurrency investors have noted that the current lack of certainty in the DeFi sector is also a result of the lack of proper regulations.
The advocates of the DeFi markets repel the implementation of regulations to prevent the control of governments on the monetary system and to save taxes. On the other hand, institutional investors demand cryptocurrency regulations make sure that their financial contracts are safe and protected under the law of the land.
FUD stands for Fear, Uncertainty, and Doubt. The term is often used to describe the state of a financial market where the lack of confidence in a trading instrument has been propagated by the majority of participants.
Some meme currencies do not come with a lot of utility; it eventually leads to a lack of trust from their investors and a major price crash. On the other hand, most cryptocurrencies are also affected by the current events in the economic backdrop, such as recession, stock market decline, inflation, etc.
All of these events can create a negative herd mentality impact on the cryptocurrency investors and result in the sudden crash that happens when investors rush to dissolve their trading positions which increases the selling pressure and supply in the market.
Cryptocurrency exchanges are the foundational units of the cryptocurrency markets, just like stock exchanges are for equity trading. Outside of the blockchains, investors are only able to purchase and sell these cryptocurrencies from these exchange markets.
Therefore, when a major cryptocurrency exchange reports a hack attack that has siphoned off billions of dollars’ worth of crypto assets, it is bad news.
The ripple effect can spiral out of control, and the investors can start questioning the stability of the cryptocurrency markets and start to withdraw their assets from the market. To this end, the exchange can suffer from a lack of liquidity.
It is the same effect as when the account holders of a bank flock around it to withdraw their funds when they hear bad news about the stability of the financial enterprise. Mt. Gox, one of the earliest Bitcoin exchanges, ended up losing 850K Bitcoins which led to the 20% price crash of the flagship crypto in 2014.
A considerable amount of institutional trading interest in the cryptocurrency markets is locked in the form of leveraged trading positions. Leveraged trading positions are the accounts that happen when institutions borrow money from other financial enterprises to invest in the cryptocurrency market.
This type of trading comes under the umbrella of High-Frequency Trading or HFT trading. It is done to increase the profit percentage.
However, leveraged trading also comes with a demand to maintain a set amount of collateral in the trading account. If the prices of a cryptocurrency fall by the smallest fraction, the required value of the collateral can trigger a margin call.
So that the debtor would have to seize the trading account of the borrower and demand them to meet the minimum requirement of the collateral value. Therefore, if there are a considerable amount of collateral positions present in a cryptocurrency market, it means that it can trigger an across-the-board margin call that would result in massive accumulative losses and a lapse of trading positions subsequently.
Since leveraged positions are usually HFT, it means that they can result in a massive price drop and result in sizeable selloffs.
Technical Setbacks are another major reason that can result in massive cryptocurrency losses. Cryptocurrencies are blockchains that have digitized the stock market and other financial instruments that do not need paper-based recording anymore.
However, the trouble with digital instruments is that they are always in danger of getting hacked. There are also many instances where hackers can exploit the technical blind spots in a blockchain and end up stealing a major amount of trading currencies.
The most glaring example of such an event is the Ethereum hack of 2016. This hack attack resulted in the loss of 3.6 million ETH coins.
At the same time, it resulted in a fork of the blockchain to make sure that it was able to recover the stolen tokens. There are reportedly several hacks and exploits affecting cryptocurrency projects to date.
However, there are also blockchains like Bitcoin that have remained free from any attacks thus far. When such attacks happen, the confidence of cryptocurrency investors is shaken in the stability of their currencies, and it can lead to selloffs and market crashes.
Financial Scams are rife in the cryptocurrency markets. From Bitcoin ATMs scams to online hack attacks, investors have always been affected by scammers and threat actors.
It is important to note that when the phones were first invented, a tide of on-call scams swept the people who were installing these first-ever communication devices in their homes. This is the main reason that the word “phony” today is synonymous with scams or frauds.
This etymological inspection reveals that just about every new invention is seen as the devil’s propagation in society. However, it is impossible to imagine the e-commerce and digitally connected version of the world today without adopting telephones in the last century.
In the same manner, most people of the current generation are not aware of how blockchains work. Therefore, they are susceptible to elaborate scams and financial traps laden by tricksters.
Such scams can also lead other cryptocurrency investors to believe that it is not safe to invest and hold digital assets, and it can lead to unprecedented amounts of sell-offs and crashes.
The cryptocurrency market is always susceptible to the forces of speculation. What happens is that there are investors at the top who are aware of the market propagation, and they take up majority positions in the tokens that are likely to gain massive traction in the marketplace. The same can be said about the stock markets, where well-connected people are the first ones to take up early positions in up-and-coming projects.
Meanwhile, the retail investors who are not well-connected end up getting into the part of the action at later stages when the prices are already pumped up. Stock traders were able to inflate the prices of their portfolios using media such as newspapers and television.
Today, the world is connected in real-time with the help of social media platforms, and in this manner, creating artificial speculation about a given cryptocurrency is easier.
There are schemes like pump and dump and rug pulls, where the early investors hype up the prices of shit coins to the highest possible potential and then sell them off, taking profits and dumping the prices.
Some scandals about inside trading have come to light within the cryptocurrency sector. On the other hand, crypto whales can also hold a lot of power in the market with their major share to sink the prices at their discretion.
Another important reason that is seen as a weakness for the cryptocurrency markets is the frequent volatility for the cryptocurrency markets. In comparison to other trading instruments, the frequency of price fluctuations in the cryptocurrency sector is higher.
Therefore, investors deem them as high-risk trading options. It is another major reason that the big players and institutional investors advise the majority of their clients to refrain from taking up crypto positions.
This can lead to a lack of professional trading interest in the cryptocurrency trading market, which can result in the crash of this market instrument.
There are no such rules in the financial markets that the investors need to undertake bigger risks to make better profits. However, the majority of the world still believes in such factors. It means that the inherent quality of increased risks in the cryptocurrency markets can lead them to massive profit returns.
On the other hand, more volatility and better liquidity are some factors that are great for short-term trading techniques such as Day Trading, Scalping, and Momentum trading, etc.
An unlikely factor that can also play a role in the drowning of a cryptocurrency market is derivatives trading. Derivatives are trading certificates that allow investors to track the performance of an underlying asset without owning it directly. The derivatives can be divided into many parts, such as forwards, options, futures, DeFi swaps, etc.
In case there is a mass liquidation of leveraging derivatives positions, it can also lead to a price meltdown for a cryptocurrency such as Bitcoin.
At the same time, if the price of the aggregate number of perpetual contracts for Bitcoin increases over its spot prices, it can trigger massive selling pressure carried about by trading bots within milliseconds.
The drop happens on account of a flush of massive Bitcoin supply in the cryptocurrency markets and it means that the prices can drop suddenly leading to a crash.
How to Protect your Crypto from Crashes
Now that the right questions have been established, it is time for cryptocurrency investors to start looking for solutions. One retail investor can’t control the entire market. However, here are some preventive measures that every investor can undertake to protect their crypto portfolio from dangerous waters:
Spread the Bets
A cryptocurrency investor cannot put enough emphasis on the importance of portfolio diversification. If an investor is going to think that they are creating major profits from investing in just one currency, their chances of succeeding are near zero and even less than fractional divisions.
However, when investors can spread their trading capital in several potential cryptocurrencies, they can distribute their trading risk and mitigate them through the effect of hedging.
Cryptocurrency investors should only invest in the market the amount that they can afford to lose. It is especially true for investors who are getting started. Many people are affected by market speculation and end up creating leveraged positions without learning anything about technical and fundamental analysis of the market.
Therefore, investors must make sure that they have done their research and proceed with caution.
DCA is a method of increasing your trading position at regular intervals. It can mean that the investors can learn about the trading positions as they increase. In this manner, traders can gain greater control over their trading positions and stop in case of unexpected market movements.
It is a distortion of the world hold. For cryptocurrency investors, it means that they must adhere to their long-term cryptocurrency positions regardless of the current market changes.
There are many long-term trading strategies, such as turtle trading and others, where the investors are trained to retain their positions, in the long run, to benefit from exponential profits at the end of a 5-10 years trading period or longer.
At present, the eyes of the world are set on the DeFi and blockchain markets more than any other tech enterprise. The discussion has propagated the daily conversions, and dedicated cryptocurrency communities online are working to keep the market sentiment positive.
However, every investor should understand the factors that can lead to the crash of cryptocurrency markets and make their trading decisions in light of these events.
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