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What if one day this market crashed and the Bitcoin price dropped to zero?

The recent growth of the crypto market has been an astounding one. Just about a year ago, there were just over 6,000 projects listed on CoinMarketCap. However, the number today is 11,149. With each passing day, the number of projects continues to increase. Furthermore, the market capitalization also exploded from $330 billion to nearly $1.6 trillion — equivalent to Canada’s nominal GDP. In addition, there are also over 100 million active crypto wallets, which is three times higher than in 2018. But, have you ever wondered, what if one day this market crashed and the Bitcoin price dropped to zero?

What if the Bitcoin price went to zero?

As BTC became more and more accepted, institutional investors also started to keep an eye on crypto. The number of institutions accounted for 63% of transactions, up from 10% in 2017.

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Skybridge, a hedge fund run by Anthony Scaramucci, is a prime example. The fund started investing in cryptocurrencies in November; it launched a $500 million Bitcoin fund in January. The exposure of 26,000 clients, ranging from the rich to large funds, is growing. Bitcoin accounts for 9% of the value, up from the original 5%, and the dedicated fund is now worth around $700 million.

However, this maturity has not been able to tame the dizzying ups/downs that are so characteristic of the cryptocurrency market. Bitcoin price has dropped from $64,000 in April to $30,000 in May. At press time, the price is hovering around $38,000 despite having just dropped to $29,000 on July 29. But these ups and downs don’t seem so pleasant to seasoned traders. Let’s imagine that one day, the price will drop to zero. Will experienced traders and investors still keep their composure at that time? This is the opinion of The Economist.

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BTC at press time | Source: TradingView

The reason can come from many factors. For example, bugs from within the system or a major hack of some leading exchange (like the Mt. Gox back in 2013). Even factors such as the restraint of the regulators or suddenly investors have some other concern or the market reaction from central banks raising interest rates.

Allianz’s Mohamed El-Erian, a renowned wealth manager, says there are three types of investors:

  • Fundamentalists: They believe that Bitcoin will one day replace government-issued currency
  • Tacticians: The one who thinks the Bitcoin price will go up as more people invest in
  • Speculators: Those who want to gamble make quick profits

If the price collapses, this will be a huge disappointment for the first group. But this is also the group least likely to sell-off. Of course, the third group will be the first to flee. They will even quickly take profits even though only a few small FUD news appears in the market. To prevent the market from falling into a panic sell-off, prices falling to zero quickly, the second group must be persuaded to stay.

Obviously, this bearish momentum will disrupt the crypto economy. Bitcoin miners will have less incentive to keep working. This causes transaction verification and BTC supply to be halted. Investors may also sell other coins/tokens. That is a common situation when BTC plummets more than 5% – 10% on the day. At that time, the altcoin market was also a “bloodbath.”

And then this earthquake will destroy a considerable amount of wealth. Investors who hold Bitcoin for longer than a year, buying BTC at a low price, are less likely to suffer losses.

The biggest losses will fall to buyers less than a year ago, with an average price of $37,000. This is a group of institutional investors, including hedge funds, university endowments, mutual funds, and several other large companies.

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Once there, the price storm will wipe out private investments in crypto companies like exchanges ($37 billion since 2010, data from PitchBook) as well as the value of crypto-listed companies (worth about $90 billion). Payment companies like PayPal, Revolut, and Visa will lose a large part of their thriving business, which will lower their valuations. Companies that have fueled the crypto boom, such as Nvidia, a chipmaker, will also be affected. All in all, perhaps around $2 trillion could be lost from this initial shock, which is a little more than Amazon’s market capitalization.

Not only crypto is affected

The contagion can spread through several channels to other assets, both cryptocurrencies and traditional ones. A channel is a leverage. 90% of the money invested in Bitcoin is spent on derivatives such as smart contracts. Most of these are traded on major exchanges, such as FTX and Binance. Moderate price changes will prompt exchanges to liquidate customer assets, causing coin prices to drop quickly. Exchanges will suffer huge losses due to defaults.

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The rush to meet margin calls in cryptocurrency—the collateral of choice for leveraged derivatives—could force punters to dump conventional assets to free up cash. Granted, they might give up trying to meet those calls since their crypto holdings would no longer be worth much, which could contain the sell-off. But other types of leverage exist, where regulated exchanges or even banks have lent dollars to investors who then bought bitcoin. Some have lent dollars against crypto collateral. In both cases, borrowers nearing default might seek to liquidate other assets. The extent of leverage in the system is hard to gauge; a dozen exchanges that list perpetual swaps are unregulated.

But “open interest,” the total amount in derivatives contracts outstanding at any one time, provides an idea of the direction of travel. This has grown from $1.6 billion in March 2020 to $24 billion today. It is not a perfect proxy for total leverage, as it is not clear how much collateral stands behind the various contracts. But forced liquidations of leveraged positions in past downturns give a sense of how much is at risk. On May 18 alone, when Bitcoin prices lost almost a third of their value, they hit $9 billion.

Another channel called “stablecoin” will also be affected. Because converting USD to BTC is slow and expensive, traders who want to get profits and reinvest quickly often trade in stablecoins, pegged to the USD or EUR. The largest in the stablecoin market is Tether (USDT). On some cryptocurrency platforms, they are the primary medium of exchange.

Issuers return their stablecoins with piles of assets, rather than like money market funds. But they are not only, or even mostly, held in cash. For example, Tether says 50% of its assets are held in commercial paper, 12% in secured loans, and 10% in corporate bonds, funds, and precious metals. This mental decline could lead to a sell-off into stablecoins, forcing issuers to sell their assets to repurchase them. In July, rating agency Fitch warned that a sudden mass buyback of Tether could affect the stability of short-term credit markets.

But a worse case is not hard to imagine. Low-interest rates have made investors accept more risk. A crypto price crash could cause them to lose out on other assets. In recent months, the correlation between Bitcoin price and meme stocks, and even the stock market in general, has grown. That is partly because punters reinvest profits gained from traditional stocks into cryptocurrencies and vice versa. The sell-off will begin with the most leveraged bets — usually individuals and hedge funds — in high-risk sectors: meme stocks, junk bonds, etc., with downward pressure on prices, making risky assets less liquid and possibly causing an overall decline. If that sounds improbable, remember that the S&P 500, America’s main stock index, fell by 2.5% in a day after retail punters are infatuated with GameStop, a video-game retailer, wrong-footed a few hedge funds.

At that time, the general market turmoil will occur. Of course, to get to a crisis like this, the BTC system and the market will need many things going wrong. But the extreme scenario suggests that leverage, stablecoins, and sentiment are the main channels through which any crypto downturn, big or small, will hit hard. And this shows that cryptocurrencies are becoming more and more intertwined with conventional finance. Goldman Sachs now plans to launch a crypto exchange-traded fund. Meanwhile, Visa has also launched a debit card that pays customers rewards in BTC. As the crypto sector expands, the potential for broader market disruptions also grows stronger.

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