Why are crypto markets so volatile?
June 2, 2021 by Prachi Rusia

Volatility is a natural market phenomenon. A certain amount of price downturn in any financial market is bound to happen over a period of time. If the asset has sound fundamentals, the price eventually bounces back. In fact, this cycle is considered healthy by market analysts. 

No asset can just keep going up in value without seeing corrections on the way. This creates opportunities for traders to time the markets and book profits. These transactions also keep the market moving.

No matter what market you are in, all go through the same up and down phases. The market goes up, reaches a peak, and then comes crashing down. This cyclical movement is called a market cycle. It is usually the result of market moves by large institutional investors, and traders must keep an eye on them to grab profit-making opportunities. It is periodic in the sense that as one cycle finishes, the other follows.

Understanding Market Cycles - Market Phases & Different Types | Mudrex Blog

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Most traditional markets experience such cycles periodically. Historically, every time we’ve seen a market crash, it has taken several years for it to bounce back. For example, the Wall Street Crash of 1929, also known as the Great Depression, lasted over four years. Similarly, the financial crisis of 2007-2008 had devastating effects on the world’s economy for years to come.

Why swing so much?

Like any financial market, the cryptocurrency market, too, is subject to such market swings. In fact, one of the reasons why people stay away from cryptocurrencies is their volatility and maybe because they think they have no intrinsic value (we’ll get to that later).

Indeed, crypto markets are not for the faint-hearted. We have never witnessed a market as volatile as this one in the history of humankind. It has crashed over 80% three times in the last ten years. 

The Bitcoin Crash of 2021 Compared to Past Sell-Offs

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But, before we try to understand why the markets swing so much, it’d help to define your position as an investor. Are you entering this market as a HODLer (long-term investor for 8-10+ years) or trader? We’ll consider you’re going ahead with the former. Statistically, being a trader in this market isn’t the best idea unless you know what you’re getting into.

Accumulation wallets are at an all-time high. According to a report by Digital Asset Data, close to 11 million Bitcoin have not moved in over a year. The traders are turning into HODLers. Here are some of the reasons for this shift.

  • Humans are emotional

The crypto market can be extremely sensitive. The trading volume and returns of Bitcoin are deeply associated with emotional factors. For example, you read a tweet from Elon Musk, and you panic about protecting your assets (circa. 2021). You get a piece of news regarding government legislation, and you follow suit. Emotions affect the total return variation process, which in turn influences the financial market, causing extraordinary price movements. 

In its early years, too, Bitcoin has witnessed its fair share of bad actors causing headline news, leading to fear in investors. For instance, when the Tokyo-based crypto exchange Mt. Gox (responsible for 70% of bitcoin transactions) announced bankruptcy in 2014 after getting hijacked, the price of Bitcoin plunged by 20 percent.

  • No middlemen

Unlike most financial markets, there are no brokers to convince you not to sell in the crypto market. The trader has complete control over their assets at all times, leading to some erratic selling or buying, causing sudden price fluctuations.

  • Role of media/press in forming public perception

Since the crypto market is relatively new and there is a lack of reliable information around the space, it is highly prone to media trials. Traders and investors are always on the lookout for any make-or-break news that might have a considerable impact on the market and make decisions accordingly. 

If there is any positive news, buying activity tends to increase, causing a price surge. Similarly, if there is any negative press around the market, investors are more likely to act upon their holdings, causing a selling panic, resulting in price decline. This oscillation fuels price volatility more than anything else.

  • Absence of regulatory oversight

The fate of cryptocurrencies in several major countries is largely unknown. While most governments worldwide are struggling to put together a regulatory framework for adopting cryptocurrencies, some are yet to decide upon the status of their legality. In the wake of such a lack of clarity, the government’s positive or negative sentiment can fuel market volatility. 

For example, since 2018, the Indian government’s stance towards cryptocurrencies has changed drastically. It went from being completely against them to now devising a regulatory framework for them! Such extreme fluctuations discourage institutional investors from entering the market. The presence of institutional investors in a market ensures market stability and efficiency, and while a market is unregulated, it is likely to witness significant price swings.

  • The game-theoretic nature of cryptocurrencies

One of the most common reasons people lack trust in the crypto market is that they believe that cryptocurrencies have no intrinsic value. This is because, unlike stocks, bonds, and other precious commodities, one cannot value cryptocurrencies using a standard discounted cash flow or demand analysis. They fall under a separate category of monetary goods whose value is determined game-theoretically, i.e., each individual will value the asset based on his/her understanding, thus causing volatility. 

This brings us to another question.

Are all financial markets equally volatile?

Not really. If we compare the crypto market with the stock market, numerous other factors lead to the extreme volatility of the former. The major one being that, unlike the stock market, the crypto market is global. Cryptocurrency trading happens globally. Hence, any event/happening in one part of the world can influence the market as a whole. On the other hand, stock markets are usually region-specific and aren’t affected by geopolitical happenings. Thus they are comparatively less volatile. 

Additionally, the stock market is time-bound and is open to trade for a fixed number of hours in a day. On the other hand, the crypto market is accessible 24×7, giving it a bigger window for price volatility. The absence of brokers and brokerage fees in the crypto market is another significant reason for its extreme price fluctuations. 

Can we expect the volatility of crypto markets to tone down in the future?

Adopting a stringent regulatory framework, public awareness, and diverse investors stepping their foot in the crypto market might stabilize the price volatility to a great extent. As better technology makes its way into the crypto space, its efficiency and general public acceptance are bound to improve. 

Even though the market is likely to exhibit such extreme volatility in the future, experts hope that it will start mimicking the volatility patterns of other mainstream assets. This will make it predictable to an extent, reducing the damages caused by extreme volatility. 

The market is so fast-paced that a better understanding of the market is the only thing that can keep anyone afloat.