Why is Crypto So Volatile? Understanding Market Movements

It’s no secret that crypto markets are highly volatile. Significant price swings that would be considered major events in traditional financial markets are a regular occurrence in the world of crypto.

But is this volatility a feature or a bug? While most investors accept that crypto asset prices can fluctuate, few understand the reasons behind it. This article elucidates why crypto is so volatile, so that investors can better understand the risks and opportunities it presents.

What is Volatility?

Volatility in financial markets refers to how much the price of an asset has increased or decreased over a period of time. High volatility is indicated by larger and more frequent price movements, while the opposite holds true for low volatility.

Generally, the more volatile and unpredictable an asset is, the risker it’s considered to be as an investment. This brings with it more potential to offer either higher returns or higher losses over shorter time periods than comparatively less volatile assets.

Comparing Crypto Volatility to Traditional Markets

Despite being around for over a decade, crypto is still a new asset class in financial markets. It is widely considered to be highly volatile and, therefore, more risky than its established counterparts. Stocks, by contrast, are considered to have a wide range of volatility, from the relative stability of large cap stocks (like Google and Berkshire Hathaway) to the often erratic penny stocks. Bonds sit further down the volatility curve, as they typically see less dramatic upward and downwards movements over time.

Crypto market volatility is in a different league altogether. You just need to glance through historical price charts to see that skyrocketing peaks and depressive troughs occur at an extreme pace in crypto prices compared to prices of assets in mainstream markets.

Using Bitcoin (BTC) as an example below, you can see BTC has witnessed over eight 50% corrections in its 13 years of existence. But, at the same time, it has also managed to recover from each correction to make new all-time highs.

Many of the reasons for price volatility in mainstream markets hold true for crypto markets as well. Speculation and news events such as COVID-19 can fuel price swings in crypto and mainstream markets alike. However, the effects of these events are often exaggerated in crypto due to the unique features which characterise the immature nature of the digital asset space.

Factors affecting Crypto Volatility

Price Discovery

All new concepts take time to settle and be accepted and the same holds true for crypto. The asset class, the market, and its investors/speculators are still finding their feet during this early high growth phase. Bitcoin has only been around for 13 years, and most crypto assets have been live for a much shorter period of time - so they are still in price discovery. This means that prices will fluctuate as market participants try to come to an agreement on the fair value of digital assets.

While crypto has gained global notoriety in the last few years and experienced adoption rates faster than other innovative technologies (like the Internet), the asset class is still not as accepted as traditional assets like stocks or commodities. Growing acceptance and maturity of the market go hand in hand. Until investors gain more certainty in crypto’s long-term future utility, price discovery will continue to be a major driver of crypto volatility.

Immature Markets

Rapid growth comes with growing pains. Many of the financial products and instruments within the crypto ecosystem are relatively underdeveloped. Compared to assets like stocks, crypto is very difficult for traditional investors to gain exposure to (which is why it is so retail heavy). Though institutional adoption of crypto is increasing, derivative products and other ways of hedging are still in their early stages, so investors are constrained in how they manage their exposure to crypto.

The relatively small size of the crypto market also yields less depth for large traders. At present, the total crypto market cap is just over US$1.1 trillion. By comparison, the gold market cap is currently US$11.75 trillion and the total U.S. stock market is valued at circa US$45 trillion. Whereas a few major stock exchanges such as the New York Stock Exchanges (NYSE) dominate traditional markets, crypto liquidity is fractured across many different exchanges. Therefore, it is difficult for large players to enter or leave the market at ‘size’, without moving the market.

Supply and Demand Dynamics

The distribution between supply and demand plays a major role in the volatility and price movements of any asset. However, it is particularly nuanced in the crypto space due to the unique supply dynamics of many digital assets.

The limited supply of certain assets often creates conditions where sudden increased demand can put upward pressure on prices, increasing volatility. The most famous example of a fixed supply digital asset is Bitcoin, which has a limited supply of 21 million coins.

This pressure can be compounded further when large holders - often called whales - buy or sell significant quantities of a particular asset, potentially sending its price soaring or tumbling. The crypto markets are not yet efficient enough to absorb these supply and demand shocks without significant market impact. Smaller market cap assets are particularly susceptible to the movement of whales and so are often seen as more volatile and risky.

Sentiment

Crypto markets are particularly susceptible to swings in investor sentiment. The immaturity of the overall crypto market means that positive or negative views can spread like a contagion. This is largely due to the investor base within crypto, which is dominated by individual retail investors. These investors are typically less informed and more impressionable than sophisticated traditional investors.

A great example of this is when Tesla bought Bitcoin in Jan 2021 and the markets reacted with exuberance and over-optimism, which led to BTC’s price rallying to an all time high of around US$69,000 in the months that followed.

The FOMO (Fear of Missing Out) factor is prominent with speculative assets like crypto as investors often hear stories of prices rising during a bull market and people making money, causing them to enter the market and then tell their friends and family. This can create a positive reflexive feedback loop with high (but unsustainable) demand for an asset, causing major price movements.

Lack of Regulation

Regulation is an important factor affecting market volatility. The crypto market is not comprehensively and clearly regulated by any government agency, like traditional financial markets. The unique digital and decentralised characteristics of cryptocurrencies present a major challenge for regulators globally.

The lack of clear and consistent regulation, means that not all crypto assets available for purchase at exchanges have necessarily been scrutinised and vetted by any relevant regulatory body. In such cases, where certain assets have been issued without the highest degree of consumer protection and risk mitigation in mind, the high volatility associated with crypto may be somewhat attributable to these assets in particular, rather than the market as a whole.

24/7 Trading

Crypto markets don’t sleep.

Unlike traditional markets that trade between set hours on a Monday-Friday schedule, such as the NYSE, the crypto market is always live for trading. Coupled with the lack of regulation, this means there are no circuit breakers like in traditional markets.

Circuit breakers are interventions used by exchanges in order to dampen volatility upwards or downwards, whether it be due to excessive buying or selling activity in the market. With no training wheels in place, crypto’s free market dynamics are susceptible to high volatility.

Closing Thoughts

The crypto market is still in its formative teenage years as an asset class. Like most teenagers, it is relatively underdeveloped, immature, and highly volatile. This volatility is a feature, rather than a bug, of crypto’s high growth phase, presenting both challenges and opportunities for traders and investors alike.

As time goes on, many of the factors that drive volatility will likely become less relevant. We are already witnessing the introduction of different players into the market, with increased institutional participation and regulatory oversight beginning to expand globally. As this asset class evolves and matures, it is likely that we will see reduced volatility in the future.

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