Cryptocurrencies Just Hit a 4-Month Low -- Here's Why

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Last year, the cryptocurrency market was virtually unstoppable. Having begun the year with a meager market cap of $17.7 billion, the combined value of all virtual currencies soared almost $600 billion by the time the calendar flipped to 2018. This increase in market cap of more than 3,300% represents what's likely the greatest single-year return for an asset class in history.

Uh-oh, cryptocurrencies are plunging

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Unfortunately, the party for crypto investors came to a rather abrupt halt in early January. After peaking at an $835 billion market cap, virtual currencies have since been mired in a downtrend. This past weekend, the aggregate cryptocurrency market cap hit a greater than four-month low at $251.7 billion, according to data from CoinMarketCap.com. We have to go back to before Thanksgiving to find the last time the combined market cap of this burgeoning asset class was so low.

You might be wondering, "What gives?" And trust me, by no means are you alone. Most folks are probably scratching their heads and wondering why virtual currencies are plunging to four-month lows. The answer likely lies with some combination of the following four catalysts.

1. An increasing amount of regulation

First, recent weakness in cryptocurrencies can be blamed on an increasing amount of proposed or suspected regulation. For example, South Korea beefed up anonymity regulations at the end of January. In order for South Koreans to add funds to cryptocurrency exchange accounts from linked bank accounts, those banks would first need to verify the identities of those users. Since anonymity has long been a lure of virtual currencies, this push toward transparency isn't sitting well with all investors.

In addition, a number of the world's largest social media sites in the world, including Facebook (NASDAQ: FB), have halted cryptocurrency and initial coin offering advertisements. In the words of Facebook's product management director Rob Leathern, "We've created a new policy that prohibits ads that promote financial products and services that are frequently associated with misleading or deceptive promotional practices, such as binary options, initial coin offerings and cryptocurrency." Given that Facebook owns four of the top seven social media sites based on monthly active users -- Facebook, Messenger, Instagram, and WhatsApp -- this ban on crypto-related ads could put a dent on viewership and crypto cash inflow.

Ultimately, however, this increase in regulation is needed to help validate digital currencies as a new asset class. As much as investors may dislike this uptick in regulation, it should help build trust with investors and regulators.

2. The realization that cryptocurrencies aren't a store of value or stock market alternative

Next, the recent stock market correction -- the first since January 2016 -- has debunked a number of theories about cryptocurrencies.

For example, it had been proposed that cryptocurrencies were an alternative investment to the stock market, and that when stocks decline, investors would seek safety in digital currencies. However, it's been more or less the opposite. As stocks have sunk into correction territory – i.e., a decline of at least 10% from recent highs -- virtual currencies have generally plunged alongside them.

By a similar token, cryptocurrencies were considered by some to be a store of value, much like gold. When the U.S. dollar is sinking, investors holding cash typically aren't happy. Rather than watch their cash devalue relative to other global currencies, they often seek the safety of gold, which is a finite resource. In other words, the gold that has been mined and is still below ground is all there will ever be on this planet.

Cryptocurrencies like bitcoin were viewed in much the same way. Bitcoin is a perceived-to-be finite resource with a maximum limit of just 21 million tokens. However, when the dollar dropped and the market dipped, investors flew out of cryptocurrencies like bitcoin and toward more traditional go-to investments, like gold, debunking the store-of-value thesis.

3. The blockchain technology proof-of-concept conundrum

Another issue the crypto market is dealing with is the proof-of-concept conundrum, or as I like to call it, the Catch-22 of blockchain technology.

For those unfamiliar, blockchain describes the digital, distributed, and decentralized ledger that's responsible for recording all transactions without the need for a financial intermediary, like a bank. It's expected to be a game-changer in the financial services industry where transaction fees can be high and payments can take up to five business days to be validated and settle. With blockchain, banks are removed from the equation, thusly lowering transaction fees. Meanwhile, remittances can be settled almost instantly, even in cross-border transactions. It's also worth noting that blockchain has a growing number of non-currency applications, too.

While this all probably sounds great on paper, the buzz about blockchain seems far less appealing when you realize that all of the ongoing testing is confined to small-scale projects and demos. Here's the Catch-22: Businesses are unwilling to jump onboard and use blockchain in the real world if the technology hasn't proven its ability to scale. Yet, the technology can't prove its ability to scale in the real world until enterprises give it a chance.

Beyond this proof-of-concept conundrum, blockchain isn't necessarily of benefit to all industries or sectors. Further, some industries would have to completely tear down their existing infrastructure and start anew with blockchain, which would be a costly and time-consuming process.

In short, the blockchain buzz is proving, thus far, to be a lot of hype with little real-world substance.

4. Tax implications

Finally, various tax implications are to blame. For instance, profit-taking is one reasonable explanation for the recent weakness in virtual currencies, especially those that emerged from bitcoin's shadow in the second half of 2017.

Another tax-based implication is the Internal Revenue Service (IRS) cracking down on crypto-based tax evasion. The recently passed Tax Cuts and Jobs Act eliminated a commonly used tax loophole known as "like-kind exchanges" that allowed crypto investors to sell one virtual currency, such as bitcoin, and reinvest those funds in other cryptos, such as Ethereum or Ripple (i.e., a like-kind exchange). Having now altered the language in the new tax bill, all crypto sales must now be reported as a capital gain or loss to the IRS, including situations where consumers use their virtual currencies to buy goods and services. The sheer complexity of the tax implications of cryptocurrencies, coupled with the new-found vigilance of the IRS, might be coercing folks to stay on the sidelines.

Given these aforementioned catalysts, it wouldn't be at all surprising if 2017's top-performing asset class continued to push lower.

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Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool owns shares of and recommends Facebook, but has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.