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Why is Crypto so Volatile? A Beginner Guide
Swen Keller
In the crypto world Swen has consistently found success through his effective communication skills and the unique ability to navigate the details.
Cryptocurrencies (such as Bitcoin) are known for their high volatility, and several factors contribute to this phenomenon. With a history barely over a decade old, cryptocurrency is not only the fastest-growing financial sector today but also a highly volatile industry.
The extremely volatile conditions in this specific market significantly impact individual traders, institutional investors, and tech entrepreneurs in the space – all players that measure profits by the dollar.
Investors and developers need significant knowledge about the dynamics of this volatility to navigate the inherent risks associated with price fluctuations in the newly emerged crypto industry and asset class. This article will provide readers with an answer to the question – why is crypto so volatile?
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Volatility in Crypto Markets
Volatility is the measure of price movements of any asset over time. If the price fluctuates frequently and has steep ups and downs, the asset is said to be highly volatile. In general discussions, the term “volatility” usually refers to “historical volatility”, i.e., past price movement observed during a certain time period. The prediction of the expected price movements (price volatility) in the future is called “implied volatility”.
High-volatile assets are generally considered riskier investments, as they have a greater potential for both profit and loss. Cryptocurrencies, due to extremely rapid price hikes and drops throughout their history, are considered a highly volatile asset class.
For instance, from December 2020 to January 2021 alone, Bitcoin’s price surged more than 110%, jumping from $18,000 to $38,200. Similarly, from April 2022 to June 2022, the total capitalization of the cryptocurrency markets decreased by more than 60%, losing a whopping $1.27 trillion in less than 90 days.
This volatility has captured the attention of both seasoned traders and newcomers to the world of digital assets, inducing the need to understand the reasons behind such price instability.
Factors Contributing to Crypto Volatility
The following are the fundamental features of the crypto market that add to its inherent volatility.
Decentralization
One of the biggest factors leading to extreme volatility in the markets is one of the core principles of blockchain technology, i.e., decentralization. Unlike a traditional fiat currency or a conventional corporate enterprise, crypto projects or blockchain platforms are not owned by a single individual or group. Instead, the entire project is owned and run by the community of users itself.
While decentralized governance offers several benefits, such as transparency, security, and a trustless environment, there are some drawbacks to it as well. The absence of central authority more than often leads to confusion regarding the crypto project’s future. Unlike centralized enterprises, the roadmap and strategic plan for future developments are not defined from the get-go.
Instead, changes and upgrades to the project’s working are suggested and implemented along the way.
For example, Ethereum – the second most popular cryptocurrency – was not meant to be shifted to the proof-of-stake mechanism in its latter year at the time it was launched. Rather, this decision was proposed several years after the public launch of the coin. Bitcoin Cash – another well-known crypto project – was created through a hard fork that split the existing Bitcoin blockchain.
The hard fork occurred after some participants of the community proposed a set of new rules for the platform. Hence, the decentralized form of governance often leads to unpredictability and uncertainty on the development side, which then cause unstable crypto prices.
Lack of Regularity Framework
The regulatory landscape plays a significant role in all financial markets, affecting everything from market sentiment to price volatility. As a young market, the crypto sector has always suffered from the lack of a thorough regulatory framework established by federal bodies. As a result, any statements, actions, or even rumors of impending regulations on initial coin offerings (ICOs) and the legality of the exchanges from any government in the world heavily impact the price of Bitcoin and the overall crypto market.
Moreover, the lack of global consensus on how to regulate cryptocurrencies also contributes to heightened market volatility. Some nations, like El Salvador, embrace blockchain technology and this newly emerged asset class. Whereas other countries, such as China and Saudi Arabia, are rather strict and have imposed an absolute ban on cryptocurrencies due to concerns over money laundering and potential risks to financial stability.
In such an uncertain and speculatory atmosphere, the mere possibility of a ban can lead to panic selling, causing prices to dump heavily. Conversely, a single confirmation that the cryptocurrency industry will remain legal and accessible to the population can inject a boost into the market, causing positive price swings.
Absence of Fundamental Valuation Metrics
The lack of traditional valuation metrics that are prevalent in established financial markets is another prominent factor leading to crypto volatility. Unlike stocks and bonds, cryptocurrencies do not have easily quantifiable indicators that many investors typically use to assess the intrinsic value of any asset.
The most common valuation metrics include price-to-earnings ratios, price-to-book ratios, and discounted cash flow models. These metrics are based on well-established financial principles and historical market data and cannot be applied to cryptocurrencies, most of which are just a few years old new projects.
Moreover, crypto projects defy the general categorization within the traditional valuation frameworks used for stocks, bonds, and other traditional markets. For example, Ether – the native crypto token of the Ethereum blockchain – started as a security, since the company was trying to raise development funds through its sales.
However, once the blockchain platform was launched, its utility increased to a currency as well as a commodity. In the case of Bitcoin, the project was released as a medium of peer-to-peer transactions. But with time, crypto investors have started treating it as a store-for-value asset.
The unique nature of cryptocurrency assets, combined with the inability of traditional valuation metrics of typical asset classes to cover cryptocurrencies, makes this new market more susceptible to speculative-driven price movements.
Market Manipulation
Market manipulation is an issue in all financial classes, and the cryptocurrency sector is no exception. However, due to the already-discussed decentralized and ill-regulated nature of these assets, this investment sector is highly prone to various forms of market manipulation, most importantly pump and dump scams and whale manipulation.
Pump and dump have been one of the most infamous forms of crypto manipulation in recent years. In this case, manipulators and scammers bump the prices of a token artificially by spreading fake news and false information. Consequently, it creates a sense of FOMO among retail investors, who jump onto the trend and put their money in. As soon as the token’s price peaks, the manipulators sell their holdings, causing the crypto to dump.
In the case of whale manipulation, individuals or entities with substantial holdings of a particular cryptocurrency (crypto whales) manipulate the price in their favor. They have the ability to execute large trades that directly affect the supply or demand of the asset. These trade trigger panic selling or buying among smaller traders, further contributing to unexpected price swings, all in pursuit of the dollar.
Final Thoughts
High volatility in the cryptocurrency sector is a serious concern from the investor’s point of view. Although short-term volatility may benefit investors by quickly increasing the value of their investments, in the long run, the cryptocurrency industry needs to solve the issue of volatility in order to become an established sector like stocks and bonds.
FAQ
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As more investors enter the cryptocurrency market and institutions adopt technologies like Bitcoin and Ethereum, the cryptocurrency space will become less volatile with time. However, it is difficult to define the exact time frame.
The stock market experiences some form of volatility, affecting even the more established shares like those of Apple and Microsoft, as well as penny stocks that tend to fluctuate a lot. But when it comes to cryptocurrencies, most of the projects are considered highly volatile – especially new projects or tokens.
The volatility in the cryptocurrency market can be mitigated by diversifying your portfolio and putting the majority of your investments in more established projects with real-life utility. You can also adopt a variety of investment strategies to stay safe during bad weather. Avoid tokens with high risk and be careful when trading leveraged crypto products.
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