The famous volatility of cryptocurrencies is one of the factors that prevent them from mass adoption. At the same time, this feature gives unique opportunities to traders with a high-risk tolerance. In this article, we explore the reasons why cryptocurrencies are so volatile.
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Lack of Utility Value
As you know, cryptocurrency is a purely digital thing with no physical representation. It means its value is not supported by something tangible and usable. Therefore, the real-life value of a cryptocurrency is hard to measure. Rather, the price of each particular coin depends on the so-called speculative value that, in its turn, depends on how many people believe in it. Say, if millions of people suddenly decide some coin has a bright future, the demand for it and its price will skyrocket. If this community changes their vision of the future for some reason, the price will plummet. Normally, it’s not so dramatic. There is a broad range of sentiments between these two extremes, depending on many factors. Any of these sentiments may have an impact on the perceived value of cryptos and their market price.
For example, there’s such a thing as momentum. When the price of the coin goes up, it makes even non-believers buy it in the hope of a further rise. But when the price starts falling, the majority of such traders seek to dispose of the coin asap before its price reaches the bottom. It makes the fall faster and deeper.
It’s a Relatively Small Market
Though cryptocurrency has been around for over 10 years and received a lot of coverage, this market is still young and rather small. The total market capitalization of “digital gold” at the time of writing is $219 bln. The amount seems impressive until we compare it with the value of traditional markets. For instance, real gold has a market cap of $9 trillion. Feel the difference.
How does a market size correlate with volatility? The smaller the market, the more sensitive it is to minor impacts. Imagine a traditional market as a huge ocean cruiser. It takes a big wave for the passengers to feel the ship moving. But when your vessel is small and light, a strong breeze is enough to make you rock and roll.
The Market Is Actively Developing
The cryptocurrency market and the underlying blockchain technology are still “under construction”. It means breakthrough crypto projects emerge every year. Their developers promise to solve such urgent problems as scalability and interoperability and it creates a lot of turbulence.
We all remember Libra, the controversial Facebook coin announced last June. There was a lot of speculation on how this new coin will affect the price of BTC and other digital currencies, but so far Libra hasn’t been launched. Another example would be GRAM, the token by Telegram. The ICO was a huge hype, but then the project faced some problems with the US Securities and Exchange Commission: the founders failed to register the early sale of tokens in due time. Telegram has been fighting this legal battle since last October, and now some investors are ready to withdraw their funds.
These two examples bring us to the next reason why cryptocurrencies are volatile. It’s the lack of regulation.
No Consistent Regulation
Cryptocurrency can have many advantages over traditional money but it lacks consistent regulation. In some cases, you can see it as an opportunity, because this legal unclarity provides tax loopholes.
But in general, the lack of a well-designed regulatory framework slows the adoption of cryptocurrencies. It discourages institutional investors: pension and insurance funds, money managers, etc. These organizations are unwilling to operate in the gray zone, as they seek a transparent infrastructure and stability. Unlike retail investors, they cannot afford to risk their clients’ money to support a revolutionary idea.
The problem may be solved by making the current crypto regulation more consistent and understandable — both for individuals and businesses. Right now, the legal status and taxation of cryptos vary greatly across countries. When a market is global, young, and under-regulated at the same time, any rumor or manipulation can cause a considerable price change.
Among other factors, some big market players (whales) can buy large amounts of a certain crypto and then manipulate its price. There are several ways to do it. For instance, you may start a rumor that will make the price of the crypto rise or fall, depending on your goal. Or you may apply the tactic called “pump and dump”. In this situation, a whale gradually accumulates some coin, increasing (pumping) its price and thus attracting more new investors to it. As soon as the manipulators are content with their profits, they dump the price.
Also, some malicious crypto exchanges may manipulate the market by inflating their trading volumes, temporarily shutting down due to “hacker attacks”, etc.
Low Barrier to Enter
One of the crypto market pros is a low barrier to entry — any person with basic computer skills can trade cryptocurrencies. Such a level of inclusion would be impossible in traditional markets like real estate. A beginner with a few dollars in his pocket just cannot enter it. But in the world of crypto, almost everyone is welcome.
On one hand, it’s a good thing that attracts more new participants and allows the community to grow. But there is a darker side, too. A beginner lacks an understanding of the market and formal financial education. Often, they don’t have a clear idea of what cryptocurrency is and how it functions. Therefore, it’s hard for amateurs to assess the potential value of a new coin — it’s enough that the developer calls it revolutionary.
As many institutional investors prefer to stay away from cryptos, it makes the average market participant even less educated and experienced. This is one of the reasons why cryptocurrencies are so sensitive to any rumor, hype, news, or manipulation. in circumstances where a seasoned professional trader would keep calm and patient, inexperienced and undisciplined people follow their instincts and emotions. It results in rollercoaster price movements.
Why Cryptocurrencies Are Volatile: Conclusion
The question “Why cryptocurrencies are so volatile?” is one of the most important for the first-time investors and traders. Hopefully, we managed to make the main reasons clear.
Please note that volatility is not good or bad per se. Everything depends on your risk tolerance, trading strategy, and objectives. In any case, it’s important to understand what stands behind it.