Crypto Market Cycles: What Causes Markets to Rise and Fall

Author: Tulip King; Compiler: Block unicorn

Foreword:

• @BanklessVC's disgusting behavior clearly shows that we have entered a predatory, PvP (player-versus-player) market phase. Protect yourself and your gains.

• I suspect that this cycle has peaked and is currently a natural pullback as the crypto market attempts to release pain - but this pain may last for a while.

• Coins like virtuals, ai16z, and heyanon may hit new all-time highs in the recovery, but they will be subject to narrative risk - please continue to reassess your worldview.

What drives the market up?

The reason for the market's rise is that new money has flowed into the market, which is obvious. From now on, I will discuss the concept of new money flowing into the market in conjunction with the "wealth effect". We should all want the crypto industry to create real value (wealth) in the world and share in the fruits of monetary expansion. This can be achieved in several ways:

1. Creating Wealth Through Innovation (Airdrops)

Airdrops have become a powerful mechanism for redistributing value in crypto markets, creating significant wealth effects that benefit a wide range of participants. The Uniswap airdrop in September 2020 set the standard, distributing 400 UNI tokens (worth ~$1,400 at launch) to over 250,000 addresses, with a final total value of over $900 million.

Jito Airdrop is an important catalyst for the early bull market of Solana altcoins

The Jito airdrop in December 2023 distributed 90 million JTO tokens with a total value of $165 million, and some users reaped up to $10,000 in returns by transferring only $40 worth of JitoSOL. The Jito airdrop helped drive the growth of Solana's total locked value (TVL) and promoted increased on-chain activity. This wealth effect stimulated the adoption and development of the broader Solana ecosystem, similar to the catalytic effect of Uniswap's UNI token on DeFi growth.

Jupiter's token distribution method further demonstrates the democratizing potential of airdrops. They plan to distribute 700 million JUP tokens, covering more than 2.3 million eligible wallets, which will become one of the most widely distributed airdrops in crypto history. Jupiter's airdrop strategy aims to promote the growth of its ecosystem by incentivizing long-term participation and governance participation. These airdrops have shown remarkable efficiency in expanding market participation.

That's what I'm talking about

The wealth effect is not limited to direct economic gains. These airdrops have transformed users into stakeholders, enabling them to participate in governance and protocol development. This mechanism creates a virtuous cycle: the benefited participants reinvest wealth into the ecosystem, further driving market expansion and innovation.

These strategic distributions have proven to be powerful market catalysts, sparking broader bull cycles in their respective sectors. Uniswap’s airdrop ignited the DeFi summer of 2020, with its distribution sparking a wave of innovation in the decentralized finance space. Similarly, Jito’s December 2023 airdrop served as a turning point for the Solana ecosystem, driving TVL growth and catalyzing unprecedented on-chain activity. This surge in liquidity and market confidence set the stage for the subsequent altcoin explosion and led to significant growth. These airdrops effectively acted as economic stimulus for the entire ecosystem, creating self-reinforcing cycles of investment and innovation that defined their respective market eras.

2. Increased Wealth (Marginal Buyers)

When a market experiences a positive catalyst like a strategic airdrop, it attracts previously sidelined participants who bring in new capital and enthusiasm. The influx of these marginal buyers creates a virtuous cycle of market expansion and innovation.

Airdrops trigger positive FOMO, driving new and existing users to participate more deeply in the market

After witnessing successful airdrops and subsequent market momentum, investors on the sidelines began to deploy capital, transforming from spectators to active market participants. This shift from cash to crypto assets represents real new money entering the ecosystem, not just a transfer between existing participants.

Large financial institutions are increasingly driving this shift, including companies such as BlackRock, Fidelity, and Franklin Templeton, which are creating products that connect traditional finance with digital assets. Their participation helps legitimize the market and provides a more convenient entry point for sideline funds to enter the market. This expansion creates a positive-sum environment, with new participants contributing to overall market growth.

Unlike a zero-sum trading environment, a market fueled by new participants creates a real wealth effect by expanding liquidity, increasing development activity, and broadening adoption. This positive feedback loop attracts more wait-and-see capital, further fueling the growth of the ecosystem.

3. Creating Wealth Through Leverage (Multiplier Expansion)

At the end of a bull market, leverage becomes the primary driver of price increases, marking a transition from value creation to value multiplication. As the market enters the price discovery phase, traders increasingly use leverage to amplify their positions, creating a self-reinforcing upward momentum loop.

When Bitcoin enters a price discovery phase above its all-time high, leverage ratios rise sharply as traders seek to maximize their risk exposure. This creates a chain reaction in which borrowed stablecoins fuel further purchases, pushing up prices and encouraging more leveraged positions. This multiplier effect accelerates price volatility.

The increasing leverage also creates systemic fragility in the market. As more traders take leveraged positions, the likelihood of cascading liquidations also increases, especially as borrowed stablecoins become more expensive and difficult to access.

The rise in stablecoin borrowing costs is a key indicator that the market is entering its final phase. This represents a critical shift from organic growth to leverage-driven expansion, where no new value is created - just existing value is amplified through debt.

The heavy reliance on leverage during this phase creates an unstable situation where sudden price fluctuations can trigger large-scale liquidations, leading to rapid price corrections. This fragility indicates that the bull market is coming to an end as the system becomes increasingly dependent on borrowed funds rather than underlying value creation.

What causes the market to fall?

It is also obvious that the market falls because money flows out of the market. This is essentially a reverse wealth effect, where speculators take advantage of the animal spirits of the market, smart money takes chips from the table to lock in profits, and the foolish are liquidated.

1. Wealth is extracted from the market

The crypto ecosystem regularly goes through cycles of value extraction, where savvy operators devise schemes to drain capital from enthusiastic market participants. Instead of productive innovations that distribute value, these schemes systematically remove liquidity from the market through a variety of predatory mechanisms.

The most disgusting part of the Bankless story is that they drained thousands of SOL from the ecosystem for only 2 SOL

The recent Aiccelerate DAO launch showcases this evolution - despite the support of high-profile advisors like the Bankless founder and industry veterans, the project was immediately criticized for dumping tokens after insiders received them without a lock-up period. Even high-profile individuals can become vehicles for rapid value extraction.

Celebrity tokens also embody this predatory behavior. These projects effectively transfer wealth from retail buyers to insiders through malicious smart contracts and coordinated dumps, killing the altcoin cycle. These extraction events undermine market confidence and disincentivize legitimate participants. Instead of building a sustainable ecosystem, they create a cycle of distrust that harms the maturity of the broader crypto ecosystem.

I have discussed this before in the Messari Newsletter

Rather than reinvesting profits into ecosystem development, these schemes systematically drain liquidity from the market. The extracted funds often exit the crypto ecosystem entirely, reducing the total available capital for legitimate projects and innovation.

The evolution from obvious scams to sophisticated operations backed by celebrities represents a worrying trend. As established institutions engage in rapid value extraction, it becomes increasingly difficult for market participants to distinguish between legitimate projects and sophisticated frauds.

2. Only sellers

Are you surprised that BAYC topped after only 3 months?

When the market began to fall, a key asymmetry emerged - the gap between mature players who realized the market changes and retail investors who still believed in the bull market thesis. During this stage, the market is not characterized by the entry of new capital, but by the systematic withdrawal of liquidity by experienced operators.

Professional traders and investment firms began to reduce their risk exposure while maintaining public optimism. Venture capital firms quietly liquidated positions through the OTC market and strategic exits, protecting capital while avoiding market impact. This practice creates a false sense of stability even as large amounts of capital have exited the system.

Smart investors began withdrawing liquidity from DeFi protocols and trading venues. This subtle but steady loss of liquidity created increasingly fragile market conditions, even though the effects were not immediately visible to the average observer.

It looks like some smart investors are taking their chips off the table

Denialism: While experienced players can reap profits, retail investors often still believe dips are temporary buying opportunities. This cognitive dissonance is reinforced by:

• The information cocoon of social media sustains the bullish narrative

• The attachment to the unrealized gains of the bull market

• The misinterpretation of the “diamond hands” mentality

Most retail investors miss the best exit points, hold on to the initial declines, and try to justify their decisions. When the downside becomes apparent, a lot of value has been lost, panic grows, and selling pressure intensifies.

The steady withdrawal of professional capital creates deteriorating market conditions, with each subsequent sell order having a more pronounced impact on price. The deterioration in market depth is often not detected until large price moves expose underlying vulnerabilities.

Unlike the positive-sum environment driven by new entrants in a bull market, this phase represents pure value destruction as capital systematically exits the crypto ecosystem and remaining participants are left to absorb mounting losses.

3. Leverage Explosion (Liquidation Chain Reaction)

The final phase of market capitulation reveals the devastating effects of excessive leverage, as Warren Buffett famously said: “Only when the tide goes out do you discover who’s been swimming naked.” The most dramatic crashes in crypto markets are a stark illustration of this principle.

The unraveling began in June 2022 with the collapse of 3AC’s $10 billion hedge fund. Their leveraged positions, including $200 million in LUNA and a large exposure to the Grayscale Bitcoin Trust, triggered a series of forced liquidations. The fund’s failure revealed an intricate web of interconnected loans, with over 20 institutions impacted by its default.

The collapse of FTX further illustrates the dangers of hidden leverage. Alameda Research borrowed $10 billion of FTX customer funds, creating an unsustainable leverage structure that ultimately led to the collapse of both institutions. The revelation that 40% of Alameda’s $14.6 billion in assets was held in illiquid FTT tokens exposed the fragility of their leveraged positions.

Old research by @Saypien_

These collapses triggered widespread market contagion. 3AC’s collapse led to the bankruptcy of multiple crypto lenders, including BlockFi, Voyager, and Celsius. Similarly, the collapse of FTX had a domino effect across the industry, with many platforms freezing withdrawals and ultimately filing for bankruptcy.

The continuous liquidations revealed the true depth of the market. When leveraged positions were forcibly liquidated, asset prices plummeted, triggering further liquidations, creating a vicious cycle. This exposed how much of the apparent stability of the market was supported by leverage rather than real liquidity.

The receding tide revealed that many of the supposedly sophisticated institutions were actually swimming naked, with insufficient risk management and excessive leverage. The interconnectedness of these positions meant that one failure could trigger a system-wide crisis, exposing the fragility of the entire crypto ecosystem.

Looking Ahead - Narrative Risk

The title of this post is a bit provocative. My gut tells me that this is just a healthy, albeit painful, market whipsaw. We will bounce back. Price targets for Bitcoin in particular remain quite high - but I have taken my chips off the table, locking in Bitcoin gains that I am willing to carry into the next cycle, if this is truly the end. Remember, no one went bankrupt on earnings.

I have written many times about the importance of following the market narrative and not holding onto old coins. The longer this market is down, the more the narrative will change. If the market fully recovers tomorrow morning, I expect virtuals, ai16z, and virtuals-based tokens to continue to win. But if the market recovery takes longer, then you should keep an eye on the newer coins to see if they can attract new inflows.

You should understand that I am telling you not to have a holding bias and not hold your coins into a downturn unless you really have a strong conviction. Even if they make new all-time highs, I bet you will miss out on a lot of potential gains by not converting to the new coins in time.

The only reason people post Fibonacci charts is to convince themselves (and others) that they can sell at a higher price.