As Stocks Rise, Here's What's Behind the Latest Crypto Crash

Tuesday was generally a good day on Wall Street. Stocks were somewhat volatile, but the Dow Jones Industrial Average (^DJI -0.11%), S&P 500 (^GSPC 0.02%), and Nasdaq Composite (^IXIC 0.10%) all managed to finish higher. Investors were largely in wait-and-see mode as they look forward to the latest readings on consumer prices.

Data source: Yahoo! Finance.

Yet even as large-cap stocks posted solid gains, cryptocurrencies performed extremely poorly on Tuesday. News of yet another potential problem among crypto exchanges helped spur a major merger, but that didn't reassure anyone about the gravity of the situation.

Moreover, the latest episode raises a simple question: How many more examples of unusual circumstances involving digital assets will investors put up with before they give up en masse on cryptocurrencies once and for all? Read on to learn more about Tuesday's crypto crash and its causes.

Fall of an empire?

The most dramatic news in digital assets centered on Sam Bankman-Fried, the CEO of digital exchange FTX. Bankman-Fried also runs a cryptocurrency trading company, Alameda Research, which fell prey to concerns about a liquidity crisis.

Although Alameda was well capitalized, a substantial portion of its assets consisted of the digital asset associated with FTX, FTX Token (FTT). When rival digital-exchange giant Binance reported over the weekend that it intended to sell its holdings of FTX Token, it raised concerns about whether a resulting drop in the token's price could cause Alameda's liabilities to exceed the value of its assets.

Indeed, that's how things played out, with FTX Token falling from $22 less than 24 hours ago to as low as $3.33 in the early afternoon before recovering to around $6 by 5 p.m. ET. But there was an additional twist, in that Binance agreed to acquire FTX, thereby potentially protecting exchange members from the full brunt of any liquidity crisis that could otherwise end up embroiling Bankman-Fried's assets in contentious disputes related to Alameda.

A domino effect

When one stock plunges due to company-specific situations, it often has minimal impact on the overall stock market. But the ripples of what's happening with Bankman-Fried are still spreading across the entire digital asset landscape. Consider:

• Bitcoin (BTC -4.16%) was down more than 10% to around $18,500, after having fallen below $18,000 earlier in the day.
• Ethereum (ETH -3.76%) plunged 16% to $1,325.
• Solana (SOL -7.56%) fared even worse, dropping 23%.

The reason crypto assets are so interlinked is that when there's a financing problem that threatens a wholesale liquidation of available assets, they almost always include holdings in some of the biggest digital tokens. Indeed, many major crypto companies hold Bitcoin and Ethereum specifically to reassure creditors that they'll be able to handle any demands from customers or creditors as they arise.

Yet if the digital asset space wants to distinguish itself from other niche markets, it will eventually have to find ways to shield investors who want more-conservative exposure to the industry. That's clearly not the case when even the cryptocurrencies with the longest track records of performance can't avoid major moves lower when a single company faces a liquidity event.

There's a huge amount of innovation happening in cryptocurrencies right now, with thousands of projects aiming to find strong uses for digital assets to improve the world. When financial events like this create systemic risk, it endangers all the work those projects have done. Moreover, for some, it makes cryptocurrency essentially unworthy of an investment.