Why Does Crypto Crash? 6 Reasons

Recent cryptocurrency downturns have wiped out huge amounts of wealth.

Cryptocurrencies have had a rough start to the year. As of Jan. 26, Bitcoin (BTC) had lost about 20% in value year to date, and Ethereum (ETH) and Binance Coin (BNB) dropped about 30% and 25%, respectively, in that period, despite a late surge higher. These are the three biggest cryptocurrencies in circulation by market capitalization -- not counting the stablecoin Tether (USDT), which is tied to the U.S. dollar. This isn't the first time crypto has taken a big dive. From mid-May to mid-July 2021, cryptos went through another big drop, and Bitcoin fell more than 45%. Despite the volatility, many investors are still interested in cryptocurrencies. According to Vin Narayanan, vice president of strategy at Early Investing, "As crypto adoption increases, it'll become more stable." Until then, however, investors may want to know what to look for so they don't get burned by crypto crashes. Here are six reasons why cryptocurrencies crash.

Crypto investors taking on too much leverage.

Crypto data firm CryptoQuant's BTC leverage ratio hit all-time highs in early January, meaning more investors are taking on risk in the crypto space. Just like in traditional markets, crypto investors will often use debt to finance purchases of futures. This can be a way for miners to hedge against future price drops in the coins they're mining. Simon Peters, senior account manager at eToro, says these amounts of leverage "could spell volatility in the near term" for cryptocurrencies. As with any asset class, Peters says, "price declines could cause liquidation of long-term positions." Then, as prices drop and futures holders start liquidating their positions, prices could fall even further. It's a cycle similar to what happened to the stock market in 1929 and 2008. But these kinds of crashes are particularly dangerous for markets like crypto that don't have much liquidity.

Lack of liquidity in cryptocurrency markets.

The biggest problem the crypto markets face when leveraged investors liquidate a large portion of their assets is the overall liquidity of the markets. Unlike in the stock market, there aren't always a bunch of buyers waiting to snatch up unloaded coins. This is part of the reason why crashes tend to occur over weekends for crypto. There are fewer investors tuned in to buy when a bunch of coins are sold. Narayanan says, "It's why big institutions can't trade small coins. They wind up upsetting the markets." For example, when a whale -- an investor who holds a large position of any given asset -- sells significant amounts of crypto, it can flood the market. The coins simply funnel into the broader market and leave a glut of supply with limited demand.

Cryptocurrency regulation.

When China banned crypto mining in June 2021, "miners had to move to other jurisdictions that were more miner-friendly," Peters says. The implications for crypto investors were that "we saw a significant decline in the network hash rate." In the crypto world, a hash rate is the number of calculations that can be performed per second. These calculations are what allow the miners to produce the coins they're mining, and they affect a coin's price. When prices decline, the hash rate declines. It's been theorized that the opposite holds true, as well. This is often because miners are paid in cryptocurrency. But this also means that when governments clamp down on mining through regulations, the overall price of cryptos can decline.

Crypto security breaches causing fear.

Blockchain and network security are other factors that could cause a crypto crash, Peters says. This kind of crash would unfold similarly to regulatory disruptions from government actors. For example, if it appeared that there was a security flaw in Bitcoin, that would affect the desire to mine it, which could affect the hash rate and overall price. "This is a new asset class," Narayanan says. "There's only going to be a certain amount of Bitcoin that will ever exist." And unlike with stocks, which are supported by underlying assets, the value of most cryptocurrencies is driven purely by investor sentiment. "The challenge for investors who wish to hold cryptocurrency is to find those that have limited supply and enduring appeal," says Dan Kemp, global chief investment officer at Morningstar Investment Management.

Crypto influencers causing volatility.

When it comes to sentiment, Peters says cryptocurrency investors need to keep in mind that "crypto advocates and key influencers can tweet and cause an inflow of capital." Obviously, we've seen this happen with Elon Musk's support of Dogecoin. Tweeting can have the opposite effect, as well. This is due to the value of this asset class being based on investor sentiment and to crypto's lack of liquidity. For investors, a possible antidote to this problem is stablecoins. Traders can use this type of coin to easily move in and out of other crypto positions as the market shifts.

Cryptocurrency correlations with the stock market.

Part of the beauty of crypto is that it should be an uncorrelated asset. In other words, it should float freely, divorced from the rest of the market. But that's not always the case. "Crypto markets have become more intertwined with traditional markets due to traditional adoption over the past few years. Crypto has a high correlation to the stock market in some people's views," says Peters. Therefore, the world's newest hedge against interest rates and inflation may be more correlated to the overall markets than early adopters hoped. But, as Narayanan says, "Crypto crashes are part of investing in crypto." What investors need to determine is their time frame for holding digital assets and whether they can stomach market downturns.

6 reasons why crypto crashes:

-- Crypto investors taking on too much leverage.

-- Lack of liquidity in cryptocurrency markets.

-- Cryptocurrency regulation.

-- Crypto security breaches causing fear.

-- Crypto influencers causing volatility.

-- Cryptocurrency correlations with the stock market.