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Cryptocrash: Virtual currencies hammered on China's rejection

Will cryptocurrencies recover — or has a bubble popped? The valuation of virtual currencies plunged yesterday, likely for a variety of reasons, and part of a trend that began eroding their standing for the last several weeks. However, a move by China against the industry yesterday provided a catalyst for major losses running into the hundreds of billions of dollars yesterday, and most have yet to stabilize this morning.

The question at hand is whether these currencies can recover, or whether a bubble has popped. The Wall Street Journal describes the roller-coaster ride yesterday but leaves the question largely unanswered:

This week’s crypto crash has helped erase almost 40% from bitcoin’s price from a peak of almost $65,000 in mid April. Some are worried that the worst is far from over. The rapid drop has forced many investors to unwind bets made with borrowed money, adding to the pressure on prices for a swath of cryptocurrencies.

The highly volatile digital coins had been in retreat for weeks before Wednesday’s meltdown, which was sparked by regulatory restrictions in China. But investors pointed to the build up of highly unstable borrowing that has shackled together the prices of different digital assets.

It could have been worse, the WSJ warns. The massive drop could have forced cryptocurrency holders to sell other assets — stocks and bonds — to cover their losses. That would have led to an infection into traditional investment areas that could have done a great deal of damage. The risk of that kind of infection has grown over the past year or more as traditional investment institutions have increased their stakes in cryptocurrencies.

Thus far, however, it appears that the damage has been limited to the cryptocurrency markets and the secondary markets that rely on crypto. The selloff did have a chain reaction but only within cryptocurrency markets, thanks to leveraging between the different currencies. Investors had created a mechanism that generated high yields, but are particularly vulnerable to reversals:

A raft of specialist lending platforms have sprung up where investors can pledge their bitcoins for a high fee, but also use them as collateral to invest borrowed funds in other crypto assets. This activity can generate yields of up to 20%, which ought to tell investors something about the level of risk involved, Mr. Smith said.

Doing this also creates a direct link between the values of different coins through leverage. “Then selling begets more selling, and you can see that” in Wednesday’s crash, he said.

It creates a house of cards, essentially, which collapses when one of the foundation cards weaken. Any reversal creates risk that becomes amplified through this leveraging, and a serious setback could — and apparently did — generate the kind of sell-off that crashed the markets.

That may have been a “healthy sign” for crypto, argues CoinShares’ chief strategy officer Meltem Demirors. By clearing out the deadwood and the leverage, the currencies can restructure more substantially than speculatively. The key, Demirors says, is that the institutional money isn’t fleeing, even if individual investors are:

Crypto bull Meltem Demirors said Wednesday she believes the recent turbulence in bitcoin and ether are positive long-term developments, contending the optimistic story around the digital assets remains intact.

“It’s been really frothy. There was a lot of leverage in the markets. Some of that got taken out in April,” the chief strategy officer at CoinShares said on CNBC’s “Fast Money.” However, she added, there “still was a lot of leverage, so this correction we’ve seen is healthy. A pullback is normal in crypto.”

Demirors’ remarks follow a particularly volatile stretch of trading in bitcoin, which is the world’s largest cryptocurrency by market value.

Well, maybe, but it’s all that fluctuation and leveraging that made China nervous in the first place. Regulators there declared that cryptos aren’t “real” and therefore “should not and cannot be used as currency in the market.” The resulting sell-off and leveraging problems more or less proved China’s point, and even Demirors’ description of the scope of the selloff as simply a removal of the “frothy” trading raises questions about reliability and stability.

Bitcoin has stopped falling today, but the other currencies are still looking for a bottom. They might be looking for a while:

Many coins continued to have a difficult day on Thursday, though less dramatically than the previous day. Ethereum was down almost 9 per cent on Thursday morning, with dogecoin losing nearly 12 per cent.

Bitcoin looked to have steadied in the wake of the difficulties. While its price fluctuated, it was largely flat over the last 24 hours. …

Even as the plunge in prices continued, trading volumes remained high, suggesting that traders could still be getting out of their positions. More than $400 billion in cryptocurrencies had been traded over the last 24 hours, according to CoinMarketCap, up almost 75 per cent.

That would suggest that the “froth” has yet to be excised from the crypto markets. The creator of the currency Ethereum, recently highlighted in profiles of NFTs in the New York Times, says that bubbles are the nature of crypto:

The crypto crash of the past few days has shocked investors around the world. Vitalik Buterin isn’t among them — even though the meltdown wiped out a huge chunk of his personal wealth. …

The nosedive may have cost Buterin, a Russian-Canadian programmer who dropped out of college, his newfound status as a crypto billionaire. The value of ether in Buterin’s closely watched public wallet stood at approximately $870 million Thursday morning, down from around $1.1 billion the morning before.

Even though he’s just 27, Buterin is a veteran of these crypto boom-bust cycles, at least as much as anyone can be.

“We’ve had at least three of these big crypto bubbles so far,” said Buterin, who co-founded Bitcoin Magazine in 2012. “And often enough, the reason the bubbles end up stopping is because some event happens that just makes it clear that the technology isn’t there yet.”

That will serve as a limiting factor, especially with nation-states with incentives to protect their own currencies. Until the bubble-and-bust nature of these markets gets resolved, they will be limited in appeal.