Why Is Bitcoin Down Today?

With inflation high, stock markets sinking and investors apprehensive about the Federal Reserve’s bold new monetary policy stance, you’d think this would be an ideal time to bet on Bitcoin. What better time to own a decentralized currency that holds its value?

Yet the world’s most famous cryptocurrency has lost more than 37% of its value so far this year, falling to almost $26,000 earlier today. Just six months ago, Bitcoin was hitting an all-time high around $69,000.

By way of comparison, the S&P 500 has dropped about 17% since the start of 2022. Why is BTC seeing such steep losses in 2022?

Bitcoin Is a Risk Asset Now

Risk assets are investments that experience a significant amount of volatility in the usual course of the market. Stocks, commodities and high-yield bonds are considered risk assets, because you can expect their prices to move up and down frequently under almost any market conditions.

Until recently, Bitcoin was considered a store of value that was somewhat immune to fluctuations in the value of risk assets. That’s no longer the case. Today, BTC has fallen prey to the sorts of factors that move the value of risk assets—things like inflation, stock markets and Fed monetary policy.

“The reason that this particular decline is occurring right now is because [crpyto] market narratives have shifted from risk-on to risk-off,” said Dr. Richard Smith, author of the Risk Rituals Newsletter. “Liquidity is drying up as the Fed and other central banks start to taper excess stimulus, and also as regular folks start to realize that Covid-19 is winding down, that we are going to go back to work and that we’re not all buying NFTs and moving into the metaverse tomorrow.”

But there’s another, even more esoteric factor at work in cryptocurrency markets recently, which has helped push Bitcoin even lower.

Terraform Labs Breakdown

Terra (LUNA) saw a major disruption over the weekend, losing 90% of its value, causing chaos in cryptoland.

LUNA is the native token on the Terra protocol. It’s part of the peg mechanism for TerraUSD (UST), the other native token on the Terra protocol. Until recently, UST had been a relatively popular stablecoin.

The purpose of a stablecoin, as the name suggests, is to provide a “safe” crypto asset that maintains a stable valuation. They are managed by pegging their value to the price of a fiat currency, such as the U.S. dollar. The goal is for the stablecoin to maintain the same value as its peg—one coin should always be valued at one U.S. dollar, for instance.

The most popular stablecoins, Tether (USDT) and USD Coin (USD), maintain their pegs by owning large reserves of U.S. dollars and other assets to back them up and keep their value from fluctuating wildly like some other cryptocurrencies. But UST works in tandem with LUNA in a totally different fashion—it’s an algorithmic stablecoin.

UST is down more than 30% this week, bringing into question the validity of algorithmic stablecoins.

It also appears the Luna Foundation Guard was trying to prop up UST with Bitcoin before the weekend run occurred. Earlier this month, the Luna Foundation Guard (LFG), the nonprofit which supports the Terra blockchain, acquired $1.5 billion in Bitcoin to a total of around $3 billion in reserves as part of its larger strategy of reaching $10 billion in Bitcoin this year.

On Monday, the LFG said it would lend out hundreds of millions of dollars worth of Bitcoin to defend the peg of stablecoin UST.

Bitcoin Had a Rough Start to 2022

Bitcoin ended 2021 up nearly 70%. That’s a fantastic return for any asset class. Nevertheless, a 70% annual return represents something of a comedown for Bitcoin, after gaining more than 300% in the lockdown-ravaged year of 2020.

In 2022, investors are in a risk-off mood, embracing “a general flight to safety across the board in most asset classes,” said Alex Reffett, co-founder of wealth management firm East Paces Group. “Collectively, investors have shown more interest in value based investments and less in speculative stocks and alternative ‘store of value’ investments.”

One reason is the Fed, which has delivered back-to-back rate hikes to combat levels of inflation unseen in the U.S. for forty years. Analysts expect the central bank to continue tightening rates well into 2023.

When the Fed raises interest rates, it has the effect of lessening demands for more growth companies, like tech stocks and speculative risk assets like Bitcoin. Judging how much demand for crypto will remain with all the liquidity drying up is an open question.

“We have no historical precedent for how Bitcoin and other cryptos might act if we enter a sustained period when central banks actively drain liquidity,” said Interactive Brokers’ chief strategist Steve Sosnick. “Those tend to be difficult times for investors, and riskier assets tend to underperform safer ones.”

Bitcoin Has Become a Volatile Beast

Adding to the equation are the market disruptions caused by Russia’s invasion of Ukraine.

“Geopolitical concerns are driving market volatility in many tradable asset classes, and Bitcoin has proven to be somewhat correlated to broad market movements and less of a direct hedge against equity markets,” said Reffett.

The trouble is that Bitcoin hasn’t proven itself to be much of a hedge against anything. After all, with inflation at four-decade highs, you’d expect a currency that purports to maintain its buying power and be independent of any central bank to gain more followers. If this description applied to Bitcoin, wouldn’t demand be off the charts?

Instead, Bitcoin appears to find adherents when the price is rising, and produce doubters when sellers dominate—just like a risk asset.

In fact, Bitcoin has seen eight 50% drops from a prior all-time high since 2009. “Anyone that isn’t ok with a decline of at least 50% should not be in Bitcoin,” said Dr. Smith. “Falls of 50% are completely normal for Bitcoin. It’s the price of admission.”

Should You Own Bitcoin?

Buying Bitcoin used to be something reserved for tech-savvy first adopters, and a genre of journalism briefly rose into existence to explain to perplexed readers how to trade dollars for Bitcoin and then trade Bitcoin for something normal, like pizza. (In hindsight, the pizza was very expensive.)

Over the years, Bitcoin has become more mainstream and easier to buy through relatively secure exchanges like Coinbase. Today, staid, level-headed money managers like the folks at Minneapolis-based money management firm the Leuthold Group make the case that a percentage point or two of your portfolio can go to Bitcoin.

“At some point the market will figure out the value of crypto and incorporate that information into a high level of price for those assets,” wrote economist Tyler Cowen in a Bloomberg column. “From then on, expected rates of return will be—dare I say—normal.”

By investing in Bitcoin now, you’re expecting that the speculative craze hasn’t diminished and you’ll be able to once again sell it later on for much more than you paid. But recent history should be that such plans, while tantalizing, are never easy to achieve.

You never quite know when the thrill of speculatively investing will be gone.