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News: Crypto market is witnessing a crash right now. But, Crypto assets like Bitcoin have been subject to wide fluctuations in their prices since their inception. The current downturn is not the first of its kind.
As crypto assets are digital assets, the rate of return is sensitive to changes in the global liquidity condition.
Why Crypto is popular?
It is an asset that allows people to keep their money outside the formal financial system and make it accessible so that it can be used anywhere in the world.
Why there was a marked rise in Crypto prices in recent years?
The phenomenal rise in the price of Bitcoin in recent years has dwarfed the fluctuations in its price in the past.
The popularity of Bitcoin is obvious from the price differentials with Ethereum and Litecoin.
The rise in the price of crypto assets began at the onset of the pandemic, as people with excess funds parked them in crypto assets. This made sense given the lack of investment opportunities on account of the uncertainty arising from lockdowns.
What are the factors behind the recent downturn in Crypto market?
As the COVID-19 spread slowed down, people started to move their funds out of crypto assets and into more lucrative real investment opportunities arising from a recovering economy. This led to the eventual decline in prices.
The halt in withdrawal by Celsius especially led to panic among investors, as this company is supposed to be one of the biggest crypto lenders.
Major reason
Recently, there have been changes in the price of an important class of assets: government bonds issued by the governments of developed countries.
– Many central banks across the developed world have been raising their policy interest rates to combat rising inflation.
– Debt raised by developed country governments, especially the U.S. but also by U.K. and Germany, is an important class of assets because these are deemed as safe assets across the world.
– As the central banks of these countries raise their policy interest rates, the rate of return is also expected to go up, motivating large institutional investors to buy more of these.
Accordingly, these investors would get out of some current investments and use the newly realized liquidity to buy these safe assets.
Why the demand for safe assets has increased?
The world over, demand for safe assets has increased as many developing countries have grown fast and accumulated enormous foreign exchange reserves.
These countries then demanded USD-denominated assets to preserve the value of their portfolios.
Events like the pandemic only increased the demand further for safe assets.
Unfortunately, the supply of safe assets has not kept up with this demand, as the developed countries that produce these assets have grown at a much slower rate.
Way forward
Given that there is generally a shortage of safe assets, it is likely that the demand and prices of crypto assets will change frequently as institutions look for alternatives with slight movements in the rate of return on safe assets.
Overall, investors must understand the nature of crypto assets and their demand and not ignore the interconnectedness of financial markets at the global level.
Source: This post is based on the article “Crypto came tumbling after” published in The Hindu on 23rd June 22.
