Crypto contagion: what it is and how to protect an investor

How to correctly form your investment portfolio? What are the typical mistakes in balancing a portfolio? The modern investor must consider a multitude of factors to secure their assets. Today, we will discuss just one of the dangers — we will learn what crypto contagion is and how to handle it properly.

What is crypto contagion?

Crypto contamination is a market situation where a negative phenomenon associated with one cryptocurrency causes problems for other similar assets.

The initial trigger can be anything: a hacker attack, legal actions by authorities, vulnerabilities in software code, and so on. In any case, the point is the same: the problem of one cryptocurrency causes people to panic, and they start selling not only it but also other coins that are somehow associated with it, causing a domino effect in some particular crypto sectors.

It’s a good time to give practical examples for clarity.

Three examples of crypto contagion

1. Privacy coin case

The regulators’ attack on Monero, which has increased protection against wire transfer tracking, has led to it burying the entire fast-growing privacy coin sector, which previously seemed very promising.

In 2021, Monero began to be removed from leading exchanges. Then, along with XMR, the likes of DASH and ZEC began to be delisted. As a result, by the end of 2022, all known privacy coins were removed from almost every exchange: Dash (DSH), Decred (DCR), Firo (FIRO), Monero (XMR), Verge (XVG), Zcash (ZEC), and Horizen (ZEN).

Although the exchanges officially justified the removal “due to increased regulatory pressure on cryptocurrencies with increased anonymity (AEC),” only Monero was actually in trouble. But the exchanges decided to remove all of their counterparts to avoid potential problems. This is a classic example of crypto contagion, with Monero’s criminal problems dragging down the entire privacy coin sector with them.

2. SEC vs. PoS case

We have another example right in front of us right now. The SEC is threatening to recognize Ethereum as a security and has already banned the staking service on several exchanges.

Let’s say Ethereum is recognized as a security, as SEC Chairman Gary Gensler wants it to be. It is very likely that this could cause a crypto contagion. How? The SEC’s main argument against ETH is its move to Proof-of-Stake (PoS). If that’s the main motive behind the decision, it begs the question: why would other PoS/staking-based coins be able to avoid the same recognition? In fact, case law just says that all who have “equally sinned” are equal before the law.

Therefore, the decision to declare Ethereum a security will cause the blocking of a large sector of the crypto market and, as a consequence, the collapse of analogues’ prices. Along the chain, other PoS coins will also face problems: Solana, Tezos, Toncoin, Avalanche, Cardano, and so on.

3. USDC case

Another case is related to the recent problems with the USDC. Suppose some major stablecoin lost its peg to the dollar. Panic over one stablecoin can easily lead to a mass exodus of investors from similar coins. Multiple requests to exchange stablecoins for other assets would begin. In fact, that’s exactly what happened during the recent problems at USDC: the price of Bitcoin then strengthened significantly due to a spike in demand from runaway stablecoins.

If such a contagion is not quickly stopped, as USDC did, then stablecoin issuing companies will have no money left, and they will start to fall one by one, creating a collapse of the whole industry.

Cryptocurrency protection

It’s impossible to protect yourself 100% from contamination of adjacent assets, but it’s definitely possible to limit the risks.

An important way for investors to protect themselves is through asset diversification. This can be a variety of strategies, from Tim Draper’s suggestion to invest at least in fundamentally different cryptocurrencies, to investing in completely different sectors of the economy, such as stocks, bonds, amd real estate (as a supplement to crypto).

The second important addition is to constantly study the news background in the market as a whole as well as for individual cryptocurrencies. And in accordance with the identified trends, proactive risk management is important. The need for such monitoring comes from the very fact that we are aware of the danger of cryptocurrency contamination, which we described in detail in this article. And even if the problems are not with your asset, seeing the possible chain of contagion gives you the opportunity to get ahead of events so you can sell the asset safely in advance.

If crypto companies balanced their portfolios correctly and understood the risks of contagion, the collapse of FTX, for example, shouldn’t have dragged dozens of other independent projects down with it. The good news is that while some exchanges closed following FTX, a great many exchanges correctly assessed the risks and were able to survive when the giant exchange caused a massive market contamination, triggering a cascade of bankruptcies and an avalanche of despair.