So far this year cryptocurrencies have been on a swift downturn, increasingly in line with equity market moves. What's behind this correlation? And what should investors watch out for next?

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Welcome to Thoughts on the Market. I'm Sheena Shah, Lead Cryptocurrency Strategist for Morgan Stanley Research. Along with my colleagues bringing you a variety of perspectives, today I will be talking about the crypto bear market. It's Tuesday, May 24th, at 2 p.m. in London. 

Bitcoin is down 55% from its November 2021 high, and currently trades at around $30,000. Over that same period, crypto market capitalization has lost over $1 trillion. All the while, Bitcoin's correlation with the equity markets has risen to new highs. So what is going on? Who is selling and what should we watch out for next? 

In 2018, retail investors were dominant in crypto markets, participating in 80% of trading volumes on Coinbase, the large crypto exchange. Today, the story couldn't be more different, with only 1/4 of trading volumes on Coinbase being with retail investors. Institutions, and more specifically crypto institutions, appear to have taken over, many of which are simply trading with each other. We think retail investors are more likely to buy and hold, but institutional investors are willing to both buy and sell crypto, if it means they can make a return. And because institutional investors are sensitive to the availability of capital and therefore interest rates, they trade crypto somewhat in sympathy with the way equities are traded. This shift in the type of market participant is key to understanding why crypto markets are selling off at the same time as the equity markets are experiencing a downturn. 

Cryptocurrency prices rose rapidly in 2020 and 2021, attracting a new set of investors. Bitcoin rose 10x from March 2020 to its first peak in April 2021. Ether, the second largest crypto, rose even more, over 40x in a similar period. The stimulus provided by central banks and governments throughout the pandemic was the key driver of the crypto bull market. As the Federal Reserve indicated late last year that it plans to raise interest rates and reduce the size of its balance sheet, crypto markets began to weaken. 

The downturn is now starting to have a broader impact on the crypto ecosystem. In mid-May a stablecoin called Terra Dollar, or UST, lost its peg to the U.S. dollar, which meant it was no longer trading at $1 USD and instead trades closer to $0 USD. UST lost its peg as it was backed by cryptocurrencies, which themselves were losing value, and because market makers no longer trusted the ability of the stablecoin to retain its dollar peg. There was a negative spillover into Bitcoin and other cryptos, with the largest stablecoin called Tether briefly losing its dollar peg intraday. Tether is the other side of half of all bitcoin traded on exchanges, so its stability is extremely important for the broader crypto market. The dollar asset reserves that backed Tether will continue to be scrutinized and questioned by market participants. Stablecoins are used to create leverage in decentralized finance crypto systems, and that leverage is now falling as crypto traders, that may have bought Bitcoin or other cryptos, have faced margin calls. 

In general, the elevated prices were traded on speculation, with limited real user demand. NFT and digital land prices are next areas to watch. Of course, many are looking for signs of a market turnaround. The retail investors may have been outnumbered by institutions, but they haven't gone away. The downturn may continue if central banks persist in their policy of tightening, but the strong hands of these retail investors have historically served as a support to falling prices. 

Thank you for listening. If you enjoy thoughts on the market, share this and other episodes with a friend or colleague today.