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Why bitcoin and cryptocurrency are crashing

Posted: 16 March 2018 5:15 pm
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The magic has faded. It's possible to get it back, but it's neither easy nor popular.

Cryptocurrency prices crashed in early February, after an astronomical rise in November and December 2017. Now they're crashing again, with many coins dropping back around the depths of their February lows. Bitcoin hasn't dropped quite that low, but it's getting close and struggling to replicate its enormous rises of before.

Throughout it all, a lot of cryptocurrency speculators are wondering why. Some of the previous plunges, including the big February drop, have been tied to a massive 65,000 bitcoin sell-off of coins which were previously locked up in bankruptcy proceedings.

However, this time there's no equally clear explanation for the sorry state of the markets, leaving many speculators scratching their heads. But no clear reason doesn't mean no reason, and right now there's one clear issue weighing down the cryptocurrency markets.

The magic fades

Senior analyst Clement Thibault, from Investing.com, attributes the slump to fading magic and a broken snowball effect.

"The recent under-performance in cryptocurrency markets is largely a result of the loss of belief that people can get rich quickly by buying cryptocurrencies," he said. "The price surge of late 2017 acted as a snowball, drawing more investors in and driving the price up. Now that the market has calmed down, the general population sees its profit window closing, and their interest in cryptocurrencies is fading away."

This is undoubtedly true. While major price movements are often attributed to so-called "whales", who hold enough crypto-wealth to affect market movements either deliberately or accidentally, the countless millions of main street buyers are still the main driving force in the market, and disillusionment is stalling their momentum.

One of the world's largest cryptocurrency platforms, Coinbase, made about $1 billion in revenue in 2017. But an incredible 43% of this was from December alone when cryptocurrency hype was at its peak.

Other exchanges also found themselves suddenly overwhelmed by a level of interest and more customers than they were able to handle. Throughout November and December, exchanges were forced to halt the influx of new customers just to start working on their backlog of previous applications. When the Binance exchange opened its doors again after going offline, it experienced a ludicrous wave of a quarter million new customers in one hour.

This extraordinary influx had an outsized effect on cryptocurrency prices, far beyond the amount of actual money being put into the market. For the same reason market cap is a poor measure of a cryptocurrency's actual value, a massive influx of interest can drive prices up disproportionately.

If people simply start trading coins at higher prices, such as happens during a massive influx of new buyers, then market cap might jump by billions of dollars with only a relatively small amount of actual money being put into the system.

Money from nothing

Imagine someone buying $1 million worth of "Coin A", which pushes its price upwards by 10%. Now their $1 million purchase is worth $1.1 million. They just created $100,000 of value out of thin air.

Now people are excited by Coin A going up in price, so they start putting more money into it, driving the price up even higher.

The Coin A sellers see the price going up. They don't want to sell too low and know there's a lot of interest in Coin A, so they withdraw their orders from the market to wait for the peak and start setting their prices well above the current market value for those who don't mind paying premium prices to avoid missing out.

With enough demand, those premium prices immediately become the new market value, and the price and market value takes an immediate jump without any money actually being put into it.

Pretty soon the value of Coin A is much higher than the actual amount of money that has been put into it. This is the kind of thing that was happening all around cryptocurrency markets when it made its massive climb in late 2017.

These are also the levers behind price manipulation, and how bitcoin made its first climb from $150 to $1,000 in 2013, before sagging back down in later years.

Cryptocurrency prices are much more a function of public interest rather than the amount of money being put into it. With waning interest, prices might keep dropping to start reflecting the actual amount of money involved.

Broken promises

Stoking the public interest and fuelling the hype is what's needed to move the needle on cryptocurrency prices, far more than actually putting money into it. After the December bubble and crash, that magic has faded. Perhaps only temporarily, or perhaps forever.

"Now that the initial excitement period is behind us, cryptocurrencies actually need to prove their mainstream value, and delivering is a lot harder than promising," Thibault says.

The first wave of cryptocurrency interest was largely focused on bitcoin, which is still the biggest coin around, accounting for over 40% of the total cryptocurrency market cap. It promised to be the future of currency, a deflationary speculative tool of infinite value and the new monetary standard to replace gold.

It flopped on all counts. Hyper-volatility, and the nagging challenges that come with lacking any inherent value, may have tanked its chances at being the new digital gold standard. Meanwhile, issues with its dated blockchain architecture saw it very visibly become one of the most impractical payment methods the world has ever seen.

Despite consuming as much energy as a large city or small country, the bitcoin network spent most of its time running at about 7 transactions per second, with average transaction fees riding above US$20 for about a month straight, even peaking at over $50 during the zenith of bitcoin's hype.

Average bitcoin transaction fees, which broadly mirror bitcoin prices. Source

The new problem

As Thibault said, cryptocurrencies need to prove their mainstream value and usefulness in order to see great rises once again. This could be problematic.

All cryptocurrencies can be broadly shoved into two different categories.

  • Monetary tokens – These are cryptocurrencies like bitcoin, which are purely designed to contain some kind of monetary value and to be transferable. They do not have any inherent value.
  • Functional tokens – These cryptocurrencies, such as Ethereum, are designed to serve some kind of function beyond containing monetary value. They also have monetary value and are also transferrable, and depending on their function, may have some kind of inherent value.

Counter-intuitively, the useless monetary tokens are potentially worth a lot more. Cryptocurrencies that serve a purpose risk having their value capped in line with actual real world applications, while purely monetary tokens can be of potentially unlimited value.

The current cryptocurrency market is oriented largely around monetary tokens. In fact, four of the top 5 coins by market cap are purely monetary tokens, and two of them are technologically almost identical to bitcoin. These are the ones that have been making the loudest promises so far of unlimited value and untold riches for speculators, but are increasingly unable to deliver. As time passes they stand increasingly little chance of renewing the snowball effect that they depend on.

Bitcoin might be especially problematic. It's still the largest and best-known token by far, but from a practical standpoint, neither it nor its many clones are very good anymore. Bitcoin was the first blockchain cryptocurrency, but its network architecture is getting increasingly outdated. It consumes enormous amounts of energy, and the scaling solutions that are meant to prevent the network from falling apart on mass usage are looking increasingly dubious.

Its "SegWit" updates to improve transactability are seeing limited uptake and its adoption may have stalled out, while the upcoming "Lightning Network" system is running into developmental obstacles and may be incompatible with tightening regulations.

To make matters worse, quirks of its decentralised architecture, an ideologically fractured development team and inherent limitations of its original blockchain system mean it's only going to fall further behind as time passes.

But it's still synonymous with cryptocurrency. It controls the bulk of public interest, is still the most common intermediary coin in the cryptocurrency world and its rises and falls have always dictated the direction of most other coins.

This might be where cryptocurrency finds itself right now. To experience another 2017-style bullrun it needs to demonstrate real world value and practical applications. Unfortunately, all the tokens that could potentially do so are still in bitcoin's shadow, and in many cases can't even be purchased with any currency other than bitcoin.

Cryptocurrency and blockchain technology is very real and there are a lot of incredible projects happening. But cryptocurrency market prices are still driven by pixie dust and unicorn dreams. Unfortunately, everyone now knows that bitcoin is just a horse with a party hat.

New speculators need something to believe in, and right now they just can't see it, hidden away in bitcoin's shadow.


Disclosure: At the time of writing the author holds ETH, IOTA, ICX, VEN, XLM, SALT, BTC, XRB

Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific provider, service or offering. It is not a recommendation to trade. Cryptocurrencies are speculative, complex and involve significant risks – they are highly volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of future performance. Consider your own circumstances, and obtain your own advice, before relying on this information. You should also verify the nature of any product or service (including its legal status and relevant regulatory requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may have holdings in the cryptocurrencies discussed.

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