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As the old wisdom says, sometimes the bigger it gets, the more it falls.
Bitcoin and other cryptocurrencies have surged during the pandemic, turning many amateur investors into millionaires, at least on paper. Bitcoin, for example, reached nearly $68,000 all-time in November.
Today, it’s trading for less than half that amount as part of a massive sell-off that has accelerated in recent weeks.
It was even worse for a region of cryptocurrencies called stablecoins, in particular a coin called TerraUSD which plummeted.
Here’s a look at what’s going on.
So why are cryptocurrencies dropping so much?
Simply put, cryptocurrencies were caught in a downward spiral that affected the broader markets.
Stocks, bonds and other assets have fallen in recent weeks as investors fear the Federal Reserve will need to raise interest rates aggressively to fight inflation, raising the possibility of a recession.
The declines in the broader markets affected the cryptocurrency, with Bitcoin dropping more than 20% in the past two weeks.
The selloff was worse for some of the newer cryptocurrencies like Dogecoin, which started as a joke and then took off in part thanks to the support of billionaire Elon Musk.
It’s a stark reversal from a few months ago, when actors like Matt Damon and Larry David were promoting crypto companies in Super Bowl commercials.
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Wasn’t Bitcoin supposed to be a hedge against inflation?
Yes, but it hasn’t turned out to be one, at least not yet.
Bitcoin was the first cryptocurrency and is still the most popular of all time.
Bitcoin proponents have long viewed the digital currency as a way to hedge against inflation, in part because there is a limited amount of it.
But bitcoin has plummeted, along with stocks.
If Bitcoin is to be seen as a true hedge against inflation, it should rise as inflation is at its highest levels in decades.
“A lot of people thought it would be an inflation hedge, but there is very little data to prove it,” says Randy Frederick, managing director at Charles Schwab that covers cryptocurrency. “Recently, it hasn’t moved higher with the market down. Had it been an inflation hedge, it could have done so.”
In fact, Bitcoin reacts just like any other riskier asset like stocks.
However, experts say the Bitcoin argument as an inflation hedge isn’t completely dead either.
Bitcoin may be the oldest cryptocurrency, but it has been around for a little over a decade.
This means that analysts do not have a lot of historical data. Frederick, for example, says that we will know a lot more about how bitcoin behaves during more market cycles.
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What about stablecoins?
Cryptocurrencies have spawned offshoots and led to more complex – or, as some regulators see it, risky – assets.
Stable coins like Tether or the US dollar are a type of cryptocurrency that is gaining in popularity.
Most stablecoins are supposed to be backed by real assets. This means that for every dollar of stable currency value, the exchange or seller will need to put the equivalent in a real fiat currency, such as a dollar, or the equivalent amount in an easy-to-trade security such as a government bond.
This is what is supposed to make them more “stable”. If a stablecoin buyer wants to withdraw their money from that virtual currency, it should be easy since the exchange is supposed to have the money on hand, similar to how bank customers expect to be able to withdraw their money at any time.
But regulators have long questioned whether exchanges actually keep such difficult assets in an account. Moreover, stablecoins have created their own affiliates.
One of them, TerraUSD, has had a major problem in recent days. TerraUSD is known as an algorithmic stablecoin because it relies on financial engineering to maintain a 1-to-1 link between the stablecoin and reserve assets.
TerraUSD is even linked to another cryptocurrency called Luna.
The stablecoin was at 14 cents as of Friday, which is well below the $1 it should fetch in theory.
Pat Chaucek, chief portfolio strategist at Ned Davis Research, says the TerraUSD issues could be part of a potential crypto screening process.
“It’s still really small,” he says of cryptocurrencies. “You know, this is still a developing area. There will be speculation. There will be booms and busts along the way, and it’s all still new.”
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So where do we go from here?
More broadly, the outlook for cryptocurrency is likely to continue to correlate with broader market sentiment.
But the declines in cryptocurrency and the collapse in the value of TerraUSD are worrying policy makers such as Treasury Secretary Janet Yellen and Securities and Exchange Commission Chairman Gary Gensler.
This could lead to more regulation of cryptocurrencies in general.
The continued declines in cryptocurrencies could cast doubts about the future of virtual money more broadly, just when there were signs that it was trying to mature, with more and more professional investors starting to trade it.
Last month, Fidelity, the largest provider of retirement plans, announced that it would allow employers to offer Bitcoin in 401(k) plans, even though the Department of Labor has warned employers not to do so.
However, the cryptocurrency also has a lot of fanatical followers who are accustomed to sharp sell-offs and reversals, many of whom believe this is a short-term decline.
Tschosik of Ned Davis Research, for example, is “optimistic about the long-term in Bitcoin,” he says. “We continue to see acceptance continuing to expand.”
He points to millennials, for example, who want to invest in cryptocurrency because it appears to be a “legitimate option.”
However, not everyone agrees with that, which makes the future of cryptocurrency uncertain.