What is a crypto contagion? Is it dangerous?

The crypto industry is full of buzzwords and terminology, but some carry more weight than others. A crypto contagion, for example, is a terrible sign in the market and can cause a lot of damage.

So, what is a crypto contagion, and has one already taken place?

What is a crypto contagion?

The crypto market is entirely digital and primarily online, so news travels quickly when something happens. Many crypto traders constantly check for live updates and sometimes interact with each other to learn trading tips, hear the news and get advice.

The crypto market is also very volatile. All cryptocurrencies are subject to daily fluctuations, some of which may cause significant price increases or decreases. The interconnectedness of the crypto world, along with its continuous volatility, is what makes crypto contagion possible. But what does this mean?

Simply put, a crypto contagion occurs when a single negative industry event causes a chain reaction, sending ripples throughout the market. Let’s look at a theoretical example to better understand how this works.

Let’s say a simple Ethereum-based project with an embedded ERC-20 token is exposed as untrustworthy. Perhaps the project owners have committed previous financial crimes, which have now come to light. With the project’s reputation in tatters, the investors bail.

At this point, investors dump the project’s ERC-20 token (which we’ll call Token A) to minimize losses before the value drops completely. This mass sale reduces the price of Token A.

When other investors hear about this Ethereum-based scam project, they may also get cold feet about other ERC-20 tokens they’ve invested in (which we’ll call Token B and Token C), triggering another mass dump. This will then affect the prices of Token B and Token C, which may even cause more doubt and disruption.

Crypto contagion can be caused by just about anything, but there are a few well-known culprits, including regulatory changes, industry fraud, and problems in the traditional financial market. Even a prominent figure’s criticism of the market, or their decision to dump a particular coin, can easily lead to contagion.

How dangerous is crypto infection?

As you may have already guessed, crypto contagion can be catastrophic. Although these incidents may start small, there is no end to how damaging they can be. Think of it as a line of dominoes. Some or all of the rest may follow if one falls, depending on how one hits the next.

Because crypto prices are so prone to fluctuations, crypto contagion is dangerous. Without safety support and insufficient regulation, the risk of infection has an even greater chance of extensive financial loss.

If one smaller token crashes, this can affect a handful of other small tokens; thus the consequences cannot be too serious. But when discussing popular coins like Bitcoin and Ethereum, a price crash can lead to a number of negative effects for investors and platforms.

Crypto contagion can last for days or weeks, but can last much longer. So let’s get into some of the most serious crypto contagions that have taken place in recent years.

The biggest crypto contagions

Many crypto contagions have occurred, some small, some across the entire market. So let’s get into some of these earlier cases, starting with the Terra disaster.

Terra Labs collapses

In May 2022, Terra Labs, a key player in the crypto game at the time, hit rock bottom when its main cryptocurrency, Terra Luna (LUNA), and its stablecoin, TerraUSD (UST), both collapsed.

This crash was caused by a dump of TerraUSD when the Anchor protocol reduced the interest rate for UST stakes. With a lower, variable interest rate, many saw no reason to keep UST with Anchor. In fact, many saw no reason to keep it at all.

After the massive TerraUSD dump, the burn/coin balance between LUNA and UST fell apart, as not enough LUNA could be burned to offset UST’s price drop.

The result? Both Terra Luna and TerraUSD saw big price crashes. From this, people started selling their LUNA to hedge against losses, exacerbating the price drop experienced by the popular cryptocurrency. But things didn’t stop there.

When the Terra Labs fiasco took place, investors began to question the legitimacy and reliability of cryptocurrency. On top of this, the collapse coincided with the US Federal Reserve’s decision to raise interest rates to hedge against inflation. By combining these two factors, a market crash was almost inevitable.

In May 2022, thousands of cryptocurrencies suffered. Bitcoin, the market’s most valuable asset, fell from $39,000 to $20,000 in less than a month. Things were similarly bleak for Ethereum, with its price falling by nearly $2,000. Across the board, things were terrible, and the market lost billions in value.

The bankruptcy of FTX

Another example of a significant crypto contagion is the market crash that followed the bankruptcy of FTX, a once-leading cryptocurrency exchange founded by Sam Bankman-Fried. In November 2022, FTX filed for bankruptcy after a wave of customer withdrawals caused the company’s liquidity to plummet.

General crypto nervousness, including the still low prices of many coins after the May 2022 crash, contributed to this amount of withdrawals. On November 6, Binance’s Changpeng Zhao decided to liquidate the company’s holdings of FTT, FTX’s own cryptocurrency.

Binance also pulled out of a last-minute deal to buy FTX on November 9, 2022, claiming that FTX was beyond repair, leading to further suspicion and doubt among investors. These combined factors came together to seal FTX’s fate.

After the bankruptcy filing, some bad news came out about Bank man-Fried, including the fact that he used FTX funds to pay off risky investments made by Alamada Research, a crypto trading firm and hedge fund he co-founded. This controversy sparked yet another mass sell-off in various cryptocurrencies, with investors unsure who to trust. After all, if a major crypto exchange is at risk, who is really safe?

Many major cryptos experienced yet another drop in price during this contagion, although most had not yet recovered from the May 2022 crash. This is yet another example of how easily chain reactions can occur in the crypto industry.

Crypto infection is not uncommon

Crypto contagion is not only hugely harmful; they are also quite frequent. Only in 2022 did several infections take place. One does not know if contagion will become more common in the future, especially if cryptocurrency continues to be as fragile as it is now.

We may have already seen the biggest crypto contagion, or a more serious event is yet to come. As is often the case with crypto, only time will tell.