Although cryptocurrencies like Bitcoin and Ethereum demonstrate the revolutionary potential of the blockchain, they’re held back by their high volatility. Unlike fiat currencies like the US Dollar or Japanese Yen, whose values are relatively stable, cryptocurrencies experience substantial price movements in a couple of hours.
An example of this is Bitcoin’s 40% price drop on March 12, 2020, from $7,900, Bitcoin’s value dropped to $4,600, alarming traders and investors. Ethereum also experienced a dramatic value plunge on June 21, 2017, from $319 to a shocking $0.10 within mere seconds. The drop occurred as a result of a multimillion-dollar sell order, which brought attention to crypto’s extreme volatility.
Whether you’re an active crypto investor or an interested financial market enthusiast, in this blog post, you’ll get to explore the forces that drive digital currencies’ high volatility. Here are the reasons why cryptocurrencies are more volatile than their fiat counterparts:
The Speculative Nature of Digital Currency Traders
A lot of traders in the crypto markets are constantly looking to take small profits here and there. That’s why you’ll find an unusually large number of scalpers and day traders looking to benefit from short-term price shifts in the digital currency market. Most of these traders use lagging technical indicators like MACD and Bollinger Bands to make their decisions.
In contrast, fiat currency traders in the foreign exchange market tend to buy and hold assets for long-term appreciation. When you have a large number of traders that almost never react to price movements, the market will be a lot less volatile.
A small percentage of traders also gamble with crypto since they believe that they can win quick profits without getting embroiled in the drama of crypto’s price swings. The speculative nature of crypto traders is fueled by the fact that the market never ‘sleeps’. The market is traded 24/7, which allows retail traders and institutions to react instantly to new information and market conditions. The result of this never-ending trading environment is high volatility since there can be a high volume of trades in a short span.
Apart from technical analysis, speculative traders make many of their trading decisions based on market sentiment, which makes crypto highly sensitive to news. Once there’s positive news about a major corporation adopting a specific cryptocurrency, it sparks an increase in the coin’s price.
For instance, when Tesla revealed in an SEC filing on February 8, 2021, that it bought $1.5 billion worth of Bitcoin, the coin’s price shot up to $46,000 from $38,000 in a matter of hours.
Traders evaluate market sentiment using social media platforms like Twitter and Reddit. Gen Zers and Millennials make up a significant percentage of crypto traders, and several of them have discussions on social media. There are social media share buttons that can make information spread quickly. The Retweet feature on Twitter increases the number of post impressions, and this can affect the opinion of several traders in a short while.
One example is the so-called ‘Elon Effect,’ which has crypto traders watching out for Elon Musk’s tweets about cryptocurrencies to buy. A single Elon Musk tweet about Dogecoin on April 15 sent the coin skyrocketing 260%.
Fear of Missing Out (FOMO)
Fear of Missing Out (FOMO) is the apprehension felt when an individual believes they aren’t in the loop on an exciting crypto price uptrend. It starts out when a crypto asset increases in value and there’s high attention paid to the coin. When speculative investors spot the news on social and traditional media, they begin to feel like they’re missing out on potential gains.
Hence, they begin to invest money in the buzzing digital currency, which makes the price rise even higher within a short period. At some point, the price of the token becomes much higher than its real value, creating a bubble. Once the bubble pops, the price of the asset drops rapidly, leading to increased volatility during both the uptrend and downtrend.
One key example of this is Bitcoin’s 2017 price increase from roughly $1,000 at the start of the year to almost $20,000 in December.
Low Regulation and Market Maturity
Although the fact that cryptocurrency usage isn’t restricted by borders is a benefit, it promotes the lack of global consensus on how to regulate them. The key reason for the low regulatory environment in the crypto sector is that it is relatively young compared to other financial instruments.
Bitcoin, the first cryptocurrency, was created in 2009, and people still ask questions about its creator’s identity. In comparison, fiat currencies, as we know them, have existed since the breakdown of the gold standard during the Great Depression in the 1930s.
Many government agencies worldwide are still unsure how to regulate cryptocurrency. While some have banned cryptos, others have actively encouraged and supported them.
The uncertainty surrounding crypto’s regulation affects investor confidence, which triggers immediate price swings in the digital currency market. The moment a regulatory agency in a big economy announces restrictions or rules on crypto, it can trigger panic trades in the market. In 2021, China began subduing crypto mining activities, citing financial stability reasons, which led to a drop in the Bitcoin hash rate and a subsequent drop in the crypto market capitalization.
On the other hand, fiat currencies have a defined regulatory framework, which ensures that there is little to no price movement from regulatory announcements. They’re supported by central banks and economic frameworks that make them highly predictable and, thus, stable.
The fact that cryptocurrencies haven’t existed nearly as long as fiat currencies affects their tendency to be manipulated by big investors. In the digital currency space, it is common to hear the term ‘whales’. Whales are entities that hold obscene amounts of a specific cryptocurrency and can influence the price of that coin by making large buy or sell orders.
Low market regulation also means that bigger investors can create pump-and-dump schemes, in which the price of a coin is artificially inflated and subsequently dropped after the investors dump their coins.
Global Economic Events
Digital currencies tend to react more intensely to global economic events than fiat currencies. When there’s economic instability, like a financial market crash, investors place money in cryptocurrencies, and this shoots prices up.
Geopolitical events like trade wars can also trigger volatility in fiat currencies. However, the volatility effect is stronger on cryptocurrency prices. Conflicts in regions of the world can make investors turn to cryptocurrencies as a hedge against instability in conventional financial markets.
Macroeconomic trends like changes in inflation and interest rates make cryptocurrency prices more volatile. There’s a negative correlational relationship between interest rates and the price of cryptocurrencies. In essence, the lower the interest rate announced by central banks, the higher cryptocurrency prices tend to go.
When interest rates are low, people tend to invest in riskier assets like cryptocurrency, which can trigger price volatility in digital assets. On the other hand, high interest rates can cause investors to withdraw their funds from cryptocurrencies, causing the price to fall.
Technological Developments
Technological developments in the crypto space can set off volatility in the digital currency market.
When investors feel that a specific cryptocurrency will get better in terms of security and efficiency, it boosts confidence. If the crypto project team delays the launch of a new product or technology, investors could view it as a sign of trouble and trigger a huge sell-off.
For instance, Ethereum 2.0, which shifted away from the proof-of-work consensus mechanism to the more efficient proof-of-stake consensus mechanism, sparked a rise in its token price.
Another technological development that impacts cryptocurrency price volatility is the security of a blockchain or platform. Once users discover a bug in the blockchain protocol, it could negatively impact price since hackers can exploit it. One notable example is the Mt Gox exchange hack in 2014, which saw high Bitcoin volatility after 850,000 Bitcoins were stolen from the platform.
The rise of anonymous casinos has also highlighted another positive feature of crypto adoption. Since casino gamers have realized that these platforms provide secure and private gambling, the user base of these anonymous casinos has increased, contributing to the crypto price volatility.
Tech advancements like decentralized finance (DeFi) and non-fungible tokens (NFTs) have created new avenues for increased crypto volatility. The DeFi system upgrades the existing financial system with its decentralized protocols, while NFTs represent ownership of a real-world asset.
By increasing liquidity in the crypto market, DeFi platforms can lead to higher volatility due to large volumes of trades. NFTs can lead to crypto volatility since their prices can rise or drop based on how valuable they are.
