Market volatility is a common trend when it comes to cryptocurrencies. The past couple of years have indeed been a rough ride for millions of investors. While some made their fortune investing into cryptocurrencies, many have lost large sums since the start of 2018.
However, Bitcoin and other cryptocurrencies are not made to be volatile, but to serve their purpose. While certain cryptocurrencies have a purpose to provide certain utility to people, others are designed to act as digital money. To understand why cryptocurrencies are volatile, we have to know and understand the factors surrounding the market at the moment.
What is Volatility
In traditional finance, volatility the statistical measure of the dispersion of an asset’s price. Volatility is used to describe the price fluctuation of an asset over time. An investment is volatile if its price moves up or down constantly and aggressively. The cryptocurrency market is the definition of a volatile market.
Adoption and maturity
Bitcoin and cryptocurrencies, in general, are a relatively new concept and a new asset class when compared to other traditional asset classes. For it to reach its full potential, a cryptocurrency has to have a large user base. The larger the user base, the less volatile it will be and the safer it will be. People have to learn about the concept of cryptocurrencies and how it will affect them before investing. Only after they fully grasp the concept of cryptocurrencies will Bitcoin and other cryptocurrencies become less volatile. With more people using cryptocurrencies, prices will even out and volatility will decrease to a point where it will become negligible.
An average cryptocurrency investor is not a financial expert and has little to no experience with investing in traditional assets. This makes concepts such as “fear of missing out” and “fear, uncertainty, and doubt” have an even bigger impact on this market in particular.
When speaking about adoption, we have to mention the maturity of the concept. A young market backed by new technology is by nature much more volatile than well-established traditional investments that had the time to mature. Cryptocurrencies are currently going through a similar “infancy” period that internet-related companies had to go through in the 1990s. New technologies take the time to get perfected and have a high probability of failing.
News reports that scare cryptocurrency supporters are one of the reasons for increased volatility in the market. With an average investor being fairly uneducated of how the markets work, each bad portrayal of cryptocurrencies by the news sparked a wave of “FUD”.
News reports about hacking incidents, cryptocurrency being banned in certain countries and people with questionable past being in the middle of the industry instill a negative reputation of cryptocurrency markets in the minds of people. At the moment, cryptocurrencies are extremely vulnerable to all the bad press and news. However, volatility is also increased by overly-optimistic news as well. News portals are trying to cater to the on-average short attention spans of their millennial readers which make them write outrageous (and often fake or without any factual proof) biased texts.
There is no denying that cryptocurrencies have been a place where frauds occur more often than with other markets. The market has mostly seen two types of fraudulent activities:
- Ponzi schemes;
- Hacks and security breaches.
Ponzi schemes are a well-known occurrence in markets ruled by greed. As long as people that lack knowledge of the markets try to get rich as fast as possible by investing in cryptocurrencies, Ponzi schemes will exist.
Ponzi schemes are a form of fraud in which the company promises quick returns to the first investors from money invested by later investors. The most famous Ponzi scheme in cryptocurrencies was the notorious Bitconnect. Their “high-yield investment program” promised enormous returns to their investors. They used and abused their native BCC token to pay out their old investors which automatically attracted the new ones. Bitconnect was, of course, not the only Ponzi scheme organization out there. Many have attempted (and succeeded) to defraud people of their cryptocurrency portfolios by creating “high-yield investment programs”.
This kind of activity sparks up volatility by attracting more and more money from people that are easily affected by news and that know close to nothing about the technology, finances or investing. Most of the people investing in this kind of projects are into get rich quick schemes, which always end up the same way.
Hacks and security breaches
Cryptocurrencies gain in volatility when an aggressive event strikes the space. There have been several occasions where extreme volatility spikes happened due to security breaches and hacks. Almost all of these hacks and breaches did not happen to the cryptocurrencies themselves. Rather they occurred on exchanges that stored the crypto.
One good example of increased volatility due to a hack is the infamous Mt. Gox hack. The hack that caused the then biggest cryptocurrency exchange to close the doors to their business made 850,000 Bitcoins just “evaporate”. Later on, 200,000 Bitcoins were somehow found and retrieved, and are now handled by a trustee which sells them at will. The Mt. Gox trustee was one of the reasons for increased volatility as he reportedly sold the Bitcoin on the open market in large batches rather than over-the-counter.
Market size and liquidity
Although cryptocurrencies have received a great deal of attention from investors as well as technology supporters, the market as a whole is still young. When looking at the size, it cannot even be compared to traditional markets such as forex. The market size affects volatility greatly.
Small markets mean that smaller forces influence the price both ways. Bigger markets can handle bigger market orders much more gracefully and without much of a price impact. However, the overleveraging of the cryptocurrency markets, as well as its size, greatly affects its volatility.
Liquidity ties to the market size and how large market orders affect the price and is defined as the ease of buying or selling an asset on a certain market. Liquidity is often tied to the market volume, as more market makers mean bigger liquidity.
The more people trade cryptocurrencies, the more stable they are in price. However, the cryptocurrency market in the current state is not liquid enough to support large market orders and possible market manipulations through them. If we take a look at the individual altcoin markets, we can see that they are extremely small compared to the individual currency markets.
It isn’t necessary to say that a low liquidity market suffers from sudden and aggressive fluctuations in prices, as a single large order can significantly influence the price upwards or downwards.
When talking about liquidity problems and the size of the cryptocurrency market, one has to mention the market manipulation that is happening on the market. Another way of influencing the price and swaying it in the desired direction is by controlling the market sentiment. Many traders with large enough capital can influence the cryptocurrency market by using the strategy called spoofing.
Simply put, spoofing means listing a big buy or sell order which is not meant to go through. But rather show up on as a sell or buy wall of buyers or sellers, which will affect the market sentiment in the short term. This way, the market manipulators guide the price one way or another. After the market acknowledges the large-sized position and realizes that the price point may not be broken, it moves the opposite way. As soon as it sways the market in the correct direction, the order is taken down.
While market order spoofing is happening for quite a while in Bitcoin and altcoin trading, it has not affected the price in the long-term. As far as the general public knows, this form of market manipulation was never done in such an obvious way that the whole long-term trend changes its direction. Using this manipulation strategy affects volatility in the short term, but to say that it affected the market in a big way would be far-fetched. Still, it is a thing to acknowledge when thinking about volatility in cryptocurrencies.
As the cryptocurrency market is still young and investors have no real price anchor, the only thing that drives the values up or down is speculation. Normally, the value of an asset is determined by its utility and adoption, but cryptocurrencies markets are currently not operating that way.
At the moment, speculation is what leads any trend upwards or downwards, as it is almost impossible to quantify the values of any cryptocurrency based on traditional fundamental analysis. Therefore, it seems to be the only way to value any cryptocurrency by speculatively betting on the future use cases, adoption and traction instead of using any form of fundamental metrics.
Markets guided by speculation are, of course, volatile by its nature.
Lack of institutional investors
Based on the survey done by Fidelity Investments, 22 percent of surveyed institutional investors have already purchased cryptocurrency. If this survey accurately represents institutional interest as a whole, this is a remarkable increase from near-zero institutional investment in 2016. However, the amount of money coming in from institutional investors to the cryptocurrency markets is negligible. That is, when you compare it to how much they invest in other markets.
Even though institutions are more and more interested in cryptocurrency investing, lack of regulation and the lack of ETF’s make it a bit harder for them to get ahold of a large number of cryptocurrencies the easy way. As time passes, institutions will dip their toes more and more into cryptocurrency markets.
With the lack of institutional investors, price stability might be lacking. Even though institutions want high returns on their investments, they don’t like extremely volatile assets. This is, of course, due to potential losses that they might suffer. When people stay away from high volatility assets such as cryptocurrencies, crypto markets suffer by being even less stable. The more institutional “big money” comes into the playing field, the more stable cryptocurrencies will be price-wise.
Misconceptions about what affects volatility
There are a lot of little things that influence the volatility of the cryptocurrency markets. In fact, no one can really grasp or calculate the impact of a single factor. However, many factors that have no impact on the volatility often appear as though they do.
One misconception that is spoken-of the most is that the lack of regulation affects the volatility of the markets.
Lack of regulation
There are no regulations on cryptocurrency markets by any government or institution. Yet this factor does not affect the volatility of the markets themselves. Many people connect high volatility to the lack of regulation, which is not correct. Cryptocurrency markets have self regulations in the form of consensus and require no government body to enforce rules over it.
If a government or an institution would regulate the cryptocurrency markets, it would defeat the purpose of the cryptocurrency itself. Some of the main attributes of cryptocurrencies are decentralization, as well as self-regulation.
Is market volatility good?
After recognizing what affects the volatility in the cryptocurrency markets, one might ask whether the volatility is a good or a bad thing. Volatility means different things to different people in the markets. We can look at it from two standpoints:
- Trader’s standpoint;
- Investor’s standpoint.
When looking at the volatility from the trader’s standpoint, volatility is good. Of course, the level of volatility that is good depends on the person’s tolerance for risk. A risk-averse individual would avoid high-volatility trades. That’s because they value stable investments more. However, cryptocurrency traders are often risk-takers.
If we take a look at the perspective of an investor, volatility is not necessarily a bad thing. But it is certainly not a good thing either. An investor cares about preserving their wealth more than trading just to turn a quick profit. Also, investors support the technology and want to see it get adopted and succeed.
Cryptocurrencies are a new asset class which may revolutionize the world in the future. However, in the meantime, the cryptocurrency markets remain volatile. People should trade and invest with caution and try to keep their risk tolerable.