Price drops and the loss of life savings convinced many that the blockchain dream was too good to be true, and it may now struggle to reach previous highs.
You've probably observed some volatility in the bitcoin market, even if you don't live and breathe it. The instability is reflected in headlines about missing apes and collapsing stablecoins, but what exactly is going on?

What went wrong with the cryptocurrency market?

Gradually, then all at once, like with so many things. Take bitcoin, the first cryptocurrency, which accounts for almost a third of the market's value. Since the end of March, the price of a single bitcoin has been steadily declining, indicating a broader malaise in the technology sector.

That makes sense: buying bitcoin is, in some ways, a wager on the likelihood of more technological disruption, just like buying any other technology stock. With inflation cutting down post-pandemic growth on both sides of the Atlantic, and a nagging feeling that excessive optimism had led to an overvaluing of IT in general in recent years, the entire sector began to fall.

The dam finally burst in early May. It fell more in a week than it had in the previous month. Contagion from the disastrous failure of another cryptocurrency project, Terra, which was originally valued at more than $50 billion but finished the week practically worthless. 

Other coins followed Terra's demise. Investors feared that similar ventures would follow; eventually, panic overtook the larger sector, and even comparatively blue-chip tokens, such as bitcoin itself, fell.

The crisis didn't end until mid-May, and while the market has restored some stability, it shows no signs of rebounding to its previous month's highs. According to one chief executive, we may be entering a "crypto winter." And that's the upbeat view from within the industry; pessimists believe this is the start of the end.

Was the drop connected to the turbulence in the general economy?

Probably. In recent months, tech stocks have been hammered, with high inflation undermining the attraction of fast-growth, low-profit investments and a succession of devastating revelations from the major corporations raising basic questions about their future expansion boundaries.

Bitcoin supporters may portray their currency as a kind of "digital gold," with a finite supply that allows it to operate as an effective inflation hedge. In practice, though, as inflation rises, bitcoin falls in value, and as economic prospects dwindle, so does the potential of a digital revolution.

Furthermore, the crypto economy appears to be disproportionately driven by retail investors, who regard the industry as a cross between traditional day-trading (already a notoriously risky means of investing money) and pure gambling. As costs rise, those investors may be obliged to sell part of their assets, further depressing the sector's performance.

What occurred to Terra that caused it to fall apart?

Terra was a project that aimed to create a "stablecoin," which is a cryptocurrency token with a constant value of one US dollar.

Stablecoins aren't a new concept. Tether and USDC are two of the most popular in the sector, and they work similarly to banks: consumers give them money, and they receive stablecoins in return, which can be cashed in for money at any time. This "reserve-backed" concept has flaws, namely that you must trust the stablecoin's corporation to keep the money secure and accessible, rather than betting it all on red in Las Vegas to make a quick profit with other people's money.

"Just trust us" is a no-no in the cryptocurrency world, so there's been a long push for a new sort of stablecoin, one that maintains its value algorithmically rather than through the actions of banks. Terra was one of these tries: a pair of currencies, one of which, luna, is supposed to float freely while the other, terra, is supposed to always be worth $1. Luna can always be converted to terra for $1, thus if the price of terra rises too high, luna owners will be encouraged to print more. And terra may always be converted into luna for $1 if the price of terra falls too low, Terra owners are rewarded for destroying the currency in order to increase its value.

The difficulty is that the system only works if luna is worth anything. For a time, it did, thanks to a bold offer of paying 20% return on deposits held in the currency. Then, in the midst of the crash, as investors began to withdraw their funds to cover losses elsewhere, it didn't. This set off a "death spiral," in which investors converted terra to luna, lowering the price of luna, which meant the next redemption dropped the price of luna even more, and so on. The value of the luna coin dropped from $80 to about one thousandth of a cent in just a few weeks. The experiment had come to an end.

Who are the winners and losers in this scenario?

On one level, the answer is straightforward: those who sold their cryptocurrency holdings in early April are the winners, while those who sold them to are the losers. It's so frequent in the industry that there's even a rallying cry for those left standing when the music stops: "HODL" (Hold On for Dear Life) — an implied guarantee that the good times will return, and only those who don't panic and sell at the bottom will profit in the next phase of the cycle.


 

There are, however, distinctions to be made. Those who bought "shitcoins" – low-effort projects where almost everyone involved acknowledges that the goal is simply to buy low, sell high, and leave someone else picking up the pieces – have lost a lot more than those who bought blue-chip cryptocurrencies like bitcoin and ethereum, which have lost about half their value since the peak. Those who were able to cash out into one of the stablecoins that weathered the storm are in a similar position to those who were able to convert their crypto into cash. 

The same is true in other sectors of the economy: you might have problems selling a "Bored Ape" NFT for exactly what you paid for it if you got it at the pinnacle of the market, but it's still rather straightforward to resale it for more than £100,000. Not so if you paid $2.9 million for a screenshot of Jack Dorsey's first tweet on Twitter, which is now on the market for $14,000.

The corporate funders of the sector, such as venture capital funds like Andreessen Horowitz and successful startups that have produced recurrent boom/bust cycles, appear to be the biggest winners in all of this. After all, the only thing better than buying low and selling high is having the power to print something for free that everyone else is eager to buy.

Is this to say that the underlying technology is also flawed?

Everything in the cryptocurrency industry is based on a few common inventions, most notably the concept of a blockchain, which is a decentralized ledger that monitors ownership of digital assets without entrusting network control to a single person or organization.

Other common features include "proof of work," a method of securing a blockchain by requiring massive amounts of energy to be burned every second to economically deter attackers from attempting to break the system, and the use of cryptographic "wallets," which allow assets to be held in a way that prevents any transactions without the account holder's secret key.

Each of these technologies has been criticized in its own way. Proof of work, for example, is responsible for the bitcoin network's astounding carbon footprint, which is equivalent to the entire country of Thailand, while the blockchain itself is little more than a horribly slow and inefficient database for any situation where decentralisation isn't the primary benefit.

However, in particular cases, these technologies remain extremely strong. When there is no centralised agency to enforce the regulations, any situation where the government may try to halt economic activity, for example, becomes considerably more difficult to enforce. This might include campaigners seeking cash to promote democracy in countries with strict capital controls, as well as ransomware merchants extorting payments from schools and hospitals in countries where there are no extradition treaties.

Will the cryptocurrency crisis have any consequences for traditional financial institutions?

Thankfully, it appears to be improbable at the moment. Traditional financial institutions have mainly avoided the cryptocurrency sector, and when they have, they have considered it as a high-risk investment option. Even if the entire sector vanished overnight, the potential for contagion would be limited: the knock-on effect would be devastating to some traditional stocks, and investors in venture capital funds like Andreessen Horowitz's recent $4.5 billion round of cryptocurrency investments would be wiped out, but systemic effects would be unlikely.

Is it possible for cryptocurrencies to recover?

The bitcoin industry has previously weathered severe downturns. That's what spurred the newest debate over whether we're approaching a "crypto winter": yes, it's horrible, but winter comes before spring. The aim is that investors will simply have to wait for the market to warm up.

If there's a reason to be pessimistic, it's the possibility that this time will be different. In general, cryptocurrency has risen by attracting larger and larger groups of new clients. However, this most recent bust may be so large and ubiquitous that there are few new clients to be found. People who have their funds in crypto will eventually need to sell in order to pay their expenses in the real world, but they will be unable to find anyone to sell to. If everyone in the developed world lost money in the crypto meltdown or knows someone who did, the pool of ignorant cash to invest in the next round will be quite small.

However, work on consumer items continues in the meanwhile. Perhaps someone will have created a fun "play to earn" game or an NFT that millions desire to acquire. The clock is ticking in any case.