Volatility is the degree to which an asset fluctuates in value.
If an asset is highly volatile, it can be prone to sudden, extreme price fluctuations.
At the other end of the spectrum, the value of an asset with low volatility remains relatively stable. Its price increases or decreases steadily and only within a fairly defined range. Sudden, extreme movements are rare.
Cryptocurrency markets are considered to be somewhat volatile, with prices skyrocketing and crashing at a moment’s notice. One example people like to quote is Bitcoin: it was worth over $20,000 at the end of 2017, only for its value to drop by 65% between January and February 2018.
As in other markets, volatility in cryptocurrencies is largely influenced by the laws of supply and demand, which in turn are shaped by real world events.
Certain events — or even rumors or speculation — drive up demand. And high demand increases value, especially if there isn’t enough supply to meet it.
The opposite is also true. If something happens that makes cryptocurrencies seem less desirable, more people will want to sell off their holdings and less people will want to buy. And if supply is high and demand is low, value will go down.
In cryptocurrencies, the effect of supply and demand is amplified — and, so, volatility is higher than it is in traditional assets — for three main reasons:
The value of cryptocurrencies is highly dependent on ‘network effects’
At the risk of stating the obvious, the success or failure of a cryptocurrency depends on how many people are willing to use it. If more people pay for their purchases in a cryptocurrency — and more merchants are willing to accept it as payment — its value will increase. But if a cryptocurrency doesn’t generate interest, it’s essentially valueless.
Use of cryptocurrencies is becoming more widespread, but we’re still a long way away from reaching critical mass. As a result, a fair amount of cryptocurrencies’ value is speculative, which makes them more prone to rumor-based price fluctuations.
They’re still relatively new
While there’s growing evidence that the market is maturing, it’s still early days. It’s only recently that institutional investors have started looking at cryptocurrencies as a legitimate asset class with the potential for steady returns.
The lack of a strong network of institutional investors also makes the market illiquid. And lack of liquidity tends to worsen volatility, because it takes longer for investors to offload their holdings.
The average investor profile
Cryptocurrency investments have low barriers to entry — anyone with an internet connection and some cash to spare can open a wallet and start trading. Meanwhile, institutional investors have historically been wary of buying crypto-assets.
The upshot is that the average cryptocurrency investor is fairly inexperienced. And this means they can panic in situations where professional investors would hold their nerve.
- Bitcoin suffered its biggest ever decline in September 2018, when it lost 80% of its value. The event is known as The Great Crypto Crash of 2018. In comparison, when the Dot-Com bubble burst in 2002, the decline was a slightly lower 78%.
- Since 2018, cryptocurrencies have turned a corner. Bitcoin in particular has been the stablest it has ever been, with its value staying mostly between $9,000 and $10,000 in the first part of 2020 (though it did drop 39% in March, when the first wave of Covid-19 lockdowns hit).
- Institutional investment in cryptocurrencies has also started gaining traction. At the end of 2020, long Bitcoin — where investors bet on Bitcoin’s value going up — was the third “most crowded trade”, ahead of traditional positions like long gold and long corporate bonds.
Want to know more?
This article is a deep dive into the issues that make Bitcoin — and cryptocurrencies more generally — such a volatile asset class.
The Covid-19 pandemic has been a litmus test for cryptocurrencies, particularly when it comes to their value as alternative ‘safe haven assets’. This article discusses how this unprecedented event took Bitcoin from being “a fringe investment, disparaged by the likes of billionaire investor Warren Buffett…” to being “…the centre of conversations among big investors and Wall Street firms.“
The METACO view
“Bubbles are an essential stage in any market’s development, because they generate the funds needed for the next, more productive stage. As the market matures and attracts more institutional investors, the value of crypto assets will stabilize and the focus can finally shift to the exciting possibilities these new assets can unlock — specifically a more democratic, accessible, and transparent financial system.“