- Wednesday's market meltdown was not driven by a single factor.
- A combination of jitters over China, Elon Musk, and more help explain the volatility.
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Cryptocurrency markets took a brutal pounding on Wednesday as fell over 30% to around $32,000, and other currencies, including and , fell ever further. The recent carnage means that more than $500 billion in value has been vaporized since the crypto market's peak.
Now investors are looking for answers—not surprising given that crypto holders lost more than a third of their wealth overnight. But while it's tempting to seize on a single explanation for the meltdown, the reality is that crashes of this magnitude are rarely triggered by one event but instead by multiple, overlapping factors.
With that qualification, here are five factors that explain Wednesday's horror show:
On Tuesday, global news agency Reuters published a dramatic headline suggested that China had banned cryptocurrency. The actual news, it turned out, was much less dramatic: the country's central bank and a handful of payment firms had simply restated rules limiting crypto transactions that have been in place since 2017.
This nuance was lost on social media, however, where thousands of people and other news outlets amplified Reuters' original report that implied China had dropped a bombshell even though it did not. All of this spooked many crypto investors who were already on edge from recent volatility.
The Tesla CEO has single-handedly wrecked havoc with the crypto markets in the last week, using tweets and media appearances to send the price of Dogecoin and Bitcoin up, down, and sideways. These include Musk's tweets last weekend, which suggested Tesla was dumping its $1.5 billion Bitcoin stash and triggered a wave of selling that helped touch off the broader volatility in crypto market this week.
Musk's antics—the latest of which is a bullish "diamond heads" tweet in support of Bitcoin—have also provided ample fodder for crypto bears, who say that one man's ability to swing markets underscores how the crypto industry is immature and lacks sound fundamentals to inform its value.
Leveraged positions got liquidated
Liquidations across the market didn't cause the initial sell-off but helped to exacerbate it. In plain English, what happened is that many firms had bet on Bitcoin using borrowed money (leverage)—the same way retail investors can get their brokerages to front them collateral based on the shares they already own. This is all fine and good when prices hold relatively steady or go up. But when prices drop significantly, trading houses get antsy and ask firms to post extra collateral. If the firms can't get do that, the trading houses will liquidate their positions to cover their exposure.
That's what happened on Wednesday as exchanges triggered more than $8 billion in liquidations—which resulted in a flood of sell orders into an already panicked market, which then triggered more sales. And so on.
Unease over Tether's "stablecoin" reserves
Tether has long been the go-to currency for traders who want to move in and out of different crypto tokens. In theory, Tether is a stablecoin, which means that it's a cryptocurrency that's designed to hold a steady value. Tether is pegged to the U.S. dollar, which implies that every Tether token (USDT) is backed by one U.S. dollar. The problem is that the company behind Tether has refused to prove that its cryptocurrency actually is backed by a full reserve of dollars.
Last week, Tether released a pie-chart breakdown of its reserves since 2014. What it revealed wasn't very reassuring to its critics. The chart showed the bulk of its reserves were in commercial paper and various loans—not the sort of assets that would pass muster if Tether were a regular bank. Meanwhile, Tether refuses to employ a standard auditor.
Unease over Tether is nothing new, and many say its critics are making much ado about nothing. But the timing of this week's market crash coincides with a deadline for Tether to submit new financial records to New York's Attorney General—leading to chatter on Reddit and throughout social media that the two events could be connected.
This is a more banal but also plausible explanation for at least some of the recent sell-off. Namely, May 17 was the final day to file taxes for many Americans. Those who actively traded crypto last year likely finished 2021 with a healthy profit—but also capital gains they owed the Internal Revenue Service. As such, many U.S. crypto holders may have sold of a chunk of their portfolio this week to pay Uncle Sam.
The list above is not exhaustive. The broader markets have been on edge as a result of macroeconomic factors, such as inflation warnings and the U.S. government and central bank's recent decisions to stick with loose fiscal and monetary policy (i.e. stimulus payments, deficit spending, and low interest rates).
All of this means has given rise to broad fear and uncertainty. Combine those with the events of this week, and you may just have a perfect storm for economic upheaval—and a massive crypto sell-off.
The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment, or other advice.