For well over a century, no asset class has delivered a higher average annual return than the stock market. But over the past couple of years, it's cryptocurrencies that have run circles around the broader market.
Between their respective March 2020 lows and the end of 2021, the broad-based S&P 500 rose a little over 100%, while the aggregate value of all digital currencies climbed more than 1,400%!
But in recent weeks, the high-flying crypto market has hit the skids. After coming within a stone's throw of a $3 trillion aggregate market cap on Nov. 10, the crypto market briefly dipped below $1.5 trillion on Jan. 22. In a three-day stretch last week, nearly $600 billion in peak value was wiped out.
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If you're looking for answers as to why cryptocurrencies are crashing, these seven factors are all, to some degree, to blame.
1. Crypto remains a minimal utility, speculative asset
Even though select cryptocurrencies have delivered life-altering gains, it's important to note that both the blockchain technology underlying digital currencies, and the tokens themselves, have very minimal real-world application.
On one hand, a survey in January 2020 from HSB, a division of Munich Re, found that 36% of small and medium-sized businesses accepted cryptocurrency as a form of payment. Yet, data from BitInfoCharts.com shows that only around 300,000 transactions are completed daily with Bitcoin (BTC -3.94%), the most popular digital currency. This compares to over 1 billion daily credit card transactions in 2018, and doesn't even account for global cash-based transactions. The role crypto/blockchain is currently playing in the payment and nonfinancial space is quite small.
The point is this: The technology underlying cryptocurrencies may be promising, but substantive real-world application is still a ways off. Investors have a habit of overestimating the adoption of new technology, and they appear to have done it again.
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2. Select countries are cracking down on crypto
Investors should also recognize that not all governments are OK with the idea of cryptocurrency mining or use. Crypto mining is where people or businesses use high-powered computers to solve complex mathematical equations that validate groups of transactions (known as blocks) as true.
Last year, we witnessed the world's No. 2 economy, China, put its foot down on all aspects of digital currencies. It banned financial institutions from undertaking crypto transactions in May and wound up banning crypto mining a month later. China essentially banned all digital currency use in September.
China isn't alone. More than a half-dozen countries worldwide have completely banned crypto, including Egypt, Iraq, Algeria, and Bangladesh. There are also more than three dozen countries where financial institutions are banned from dealing with crypto.
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3. Cryptocurrencies haven't decoupled from the stock market
Another clear issue for cryptocurrencies is that they've been unable to decouple from the stock market.
With the U.S. money supply significantly increasing in the wake of the pandemic, crypto was viewed as a hedge against factors like inflation. Yet what we've witnessed is the stock market and digital currencies moving in unison. Last week, when equities endured their worst pullback since 2020, the crypto market tumbled in sympathy. It's quite possible the stock market could have more downside to come.
On the bright side, the stock market tends to rise far more often than it's falling. In theory, this bodes well for the crypto space. But the inability of these digital tokens to secure their own identity is concerning.
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4. Margin debt is a worry
A fourth reason cryptocurrencies are crashing is margin debt. Margin is the amount of money borrowed with interest from a brokerage to purchase or short-sell securities.
Because the crypto space encounters differing levels of regulations by country, cryptocurrency brokerages also employ varying "rules" on their respective platforms with regard to margin. While some brokerages don't allow their members to use margin to purchase digital currencies, others allow users up to 100 times leverage on what they buy. Given how volatile this space is already, leverage of 50 to 100 times the cash value of an investment could wipe users out in the blink of an eye.
For example, more than $700 million in crypto account liquidations tied to margin debt occurred on Jan. 22. This outstanding margin debt can create a cascade effect that sends the crypto market screaming lower.
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5. Innovation is hurting the "Big Two"
An under-the-radar issue that's also likely contributing to the cryptocurrency crash is the innovative dilution the "Big Two" -- Bitcoin and Ethereum (ETH -3.15%) -- are contending with.
Bitcoin and Ethereum are the unquestioned most popular digital currencies, and they've been riding their respective first-mover advantages for years. Bitcoin was the first tradable digital currency, while Ethereum was the first to introduce smart contracts -- protocols that help to verify, enforce, and facilitate an agreement between two parties.
However, there's virtually no barrier to entry in the crypto space. As a result, more than 17,000 digital currencies are now listed on CoinMarketCap.com. Some of these projects offer superior potential, be it with speed, scaling, or cost. With Bitcoin and Ethereum accounting for a combined 59% of the crypto market cap, these respective first- and second-generation cryptocurrencies could continue to be weighed down by a sea of third-generation innovation.
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6. Meme coins are faltering and killing the FOMO trade
The bubble bursting for the popular meme coins is also partly responsible for the crash in the cryptocurrency space.
Last year, investors were treated to a historic gain of around 46,000,000% (not a typo!) for Shiba Inu (SHIB -8.35%), as well as a gain of around 3,500% for Dogecoin (DOGE -6.83%). The latter happens to be inspired by the Shiba Inu dog breed as well. The fear of missing out (FOMO) associated with these massive gains drove interest in cryptocurrencies. In fact, Dogecoin and Shiba Inu were two of the four most searched digital currencies in the U.S. in 2021.
As of this past weekend, Shiba Inu had lost more than 75% of its value in under three months, whereas Dogecoin had retraced more than 80% from its all-time high, set in May. Even with large social media followings for SHIB and DOGE, the FOMO trade has taken a clear hit. That's bad news for an asset class that's been reliant on emotion and momentum to head higher.
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7. History suggests big reversions are commonplace
Finally, history has been pretty clear that life-altering gains in the cryptocurrency space are almost always followed by equally epic reversions.
In terms of aggregate crypto market valuation, we've watched the space previously deflate from north of $800 billion in early January 2018 to a low of around $100 billion just 11 months later. It happened again last year, when the total market value plunged from more than $2.5 trillion to $1.2 trillion in six months.
These reversions are seen in many of the top 100 cryptocurrencies, too. When examining the performance of payment coins and protocol tokens that had delivered life-altering gains, I found that reversions of 90% or greater were commonplace within two years (or less) after their respective peaks.
Given how far cryptocurrencies have run, a further pullback is a real possibility.
