Wharton expert explains the crashing crypto market
Sarah Hammer, managing director of the Stevens Center for Innovation in Finance at the Wharton School, discusses the cryptocurrency meltdown and how more than $1 trillion in value was wiped away in a month.
The massive downturn in cryptocurrencies in the last month has cause more and more investors to exit the risky markets.
The price of two benchmark stable coins sank below $1, while the price of bitcoin dropped to its lowest level in more than a year.
The massive selloff in cryptocurrencies has wiped out more than $1 trillion of wealth in a month.
During the pandemic, a large number of Americans ventured into the virtual currencies, with 16% of Americans now owning some, up from 1% in 2015, according to a Pew Research Center survey.
Hammer talks to Penn Today about what people need to know if they are still invested in cryptocurrencies.
What happened with the crypto market and how long can this volitilty last?
In order to answer this question, it’s important to first understand what a stablecoin is. Stablecoins are a cryptocurrency whose value purports to be pegged to an asset considered to be stable, such as the U.S. dollar. There are many types of stablecoins, including reserve-backed stablecoins and algorithmic stablecoins.
Reserve-backed stablecoins offer one-to-one redemption for the U.S. dollar. For example, USDC [USD Coin] is one reserve-backed stablecoin, pegged one to one with $1. USDC is managed by a consortium that was founded by a company called Circle, based in Boston. Reserve-backed stablecoins maintain reserve assets, such as cash, T-bills, or commercial paper.
At the center of the past weeks’ crypto crash was UST [Terra]. UST is an algorithmic stablecoin, which means it was not backed by U.S. dollars. Rather, it was backed by an on-blockchain algorithm that facilitates changes in supply and demand between the stablecoin and a cryptocurrency that was created to help maintain the stablecoin peg, called a ‘native token.’ In this case, the native token of Terra was called Luna.
There are different theories about what happened with UST last week, but essentially, UST dipped below $1, and neither the Terra protocol algorithm (which maintains the mathematical relationship with Luna) nor lending out of the Luna Foundation Guard (an organization that supports Terra) could bring the value of UST back to $1.
Why are all cryptos crashing?
There are at least two important points here. First, when the Terra peg broke, Luna Foundation Guard traded 52,189 bitcoins in an effort to support the peg. This had direct downward pressure on the price of Bitcoin.
Second, Bitcoin and other cryptocurrencies have been found to be correlated to other risk assets, such as stocks. Data by Arcane Research showed the 90-day correlation between Bitcoin and the S&P 500 reached an all-time high in March.
There could be several explanations for this. First, a large amount of Bitcoin (more than 90%, by some accounts) is concentrated among the same small group of holders. This concentration could result in price volatility. Second, some assert that Bitcoin is associated with tech stocks, since many tech stocks (such as PayPal or CashApp) utilize Bitcoin. Third, if Bitcoin is considered a risk asset, rather than store of value, then it may experience high correlation with other risk assets. Therefore, as the price of stocks falls, cryptocurrency has been falling as well.
Who does this affect the most?
Analysts are still unpacking this question. Certainly, investors in Terra and other cryptocurrencies lost money. There are very serious concerns about consumer protection for those investors. Also, those involved with the Luna Foundation Guard lost money. It is estimated that over $40 billion of value was lost.
Will crypto rise again in 2022?
Blockchain technology, which powers cryptocurrency, and digital assets will continue to be important over the long run. At the Stevens Center for Innovation in Finance at Wharton, and through our Cypher Blockchain Accelerator, we have a direct perspective on the diverse applications of this technology across many industries. For example, blockchain technology is being applied to health care, education, real estate, and clean energy efforts. I am particularly interested in the potential use of digital assets to increase financial inclusion.
I do think the industry will continue to undergo rapid change. Due to the rapid growth of the space and President Biden’s Executive Order on Digital Assets, there is quite a lot of work taking place amongst policymakers in Washington, D.C. Regulatory agencies are evaluating digital assets with respect to consumer protection, financial stability, national security, and economic competitiveness, for example. More hearings are expected in the U.S. Congress on digital assets, and there is ongoing work on central bank digital currency, a digital U.S. dollar.
How can one protect their retirement funds from the crypto crash?
Without offering investment advice, I would say that from the outset, cryptocurrency may not be appropriate for individuals’ retirement funds. Whether cryptocurrency is appropriate for an investors’ portfolio depends on their profile, risk tolerance, and overall asset allocation. Digital assets are highly volatile, and depending on an individual’s details and proximity to retirement, holding highly volatile cryptocurrency in one’s 401k may not be a good idea.
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