It was another roller coaster ride, the crypto market. Or should we say: a slide? Over the past day, Bitcoin dropped more than 8% to just above $38,000. Ethereum and other altcoins fell by a similar or greater percentage. What's going on? We list a few causes and reflect on how to put this in perspective.
The (expected) actions of the Fed
In response to high inflation numbers, the US Central Bank (the "Fed") is under pressure to raise interest rates. Although it remains to be seen whether more interest rate hikes are coming this year - corporate and government debt levels are too high to support too many interest rate hikes - the market is expecting the hikes. And that is never good for stocks - and crypto. On top of that, the Fed is tapering its practices of quantitative easing (QE). QE is the Fed's purchase of government and corporate debt, which it uses to keep markets afloat during rough economic times. As that realization dawned, stock markets fell further yesterday, after already days of price declines. In crypto, price rises and drops are always more severe, which we saw again today.
Russian central bank wants a ban on crypto
On January 20, the Central Bank of Russia released a report in which it proposes to make trading and transactions in crypto illegal, just like mining Bitcoin. Individuals would still be allowed to own crypto but institutions would not. It is well known that highly centralized and authoritarian states such as China and Russia have even more difficulty with crypto than Western governments. Partly because crypto makes it easier to fund dissidents. Not surprisingly, the Russian report raised the argument that crypto is used for illegal activities. While strictly speaking it is not a new position that the Russian Central Bank is taking here, the report is obviously not good news. The crypto market did not immediately respond with a price drop, but as mentioned, it did not help.
There was still plenty of fuel in the leveraged markets
One reason that an abundance of not-so-good news makes crypto markets vulnerable is that there is a lot of leverage trading. Price movements up or down are therefore amplified. In the past few weeks quite a few traders have gone leveraged long again, in effect gambling with borrowed money on a price rise. Looking at the data on Binance, we see that about 75% of the traders were long in the past month, i.e. speculating on a rise in crypto prices. Such an overrepresentation of longs always provokes a counter-reaction from traders who can make money by shorting the market. They wait for their moment. In the ensuing cascade, the long positions are liquidated and the price falls hard. During the current price fall, $600 million in leveraged positions in crypto were liquidated: profit for the shorters. Only when the sentiment of the average investor becomes extremely negative is the time ripe for a trend reversal. This is the paradox of this psychological warfare: there is money to be made by going against sentiment. Thus, we saw that Bitcoin's biggest price rally of 2021 began in July, after sentiment turned extremely negative.
No one knows what the crypto market will do, and obviously neither do we. Everyone seems to be in the mode of "wait and see" at the moment. Will the stock markets continue to fall? If so, that's not good news for correlated crypto markets. In times like this, it might be good to take a step back and check with yourself: do I believe in the long term of crypto? What indicators do I have on my 'dashboard' - apart from price - that help me determine if the market is still healthy? For example Bitcoins hashrate, the number of users and the number of developers in crypto. If you believe in the long term and have an investment horizon of many months or even years, this price drop is by no means a reason to panic. And for anyone with a strategy of dollar-cost-averaging (buying periodically), a drop in the market is even good news.