Why is Crypto So Volatile?

The cryptocurrency market is notoriously volatile. Significant and unpredictable price swings that would be considered headline news in traditional financial markets are a regular occurrence in the world of crypto. This volatility can be both a blessing and a curse for traders and investors, as large gains can be made quickly, but they can also be taken away just as fast. In this article, we will explore what volatility is and what factors influence it. We will also consider some of the investment implications of crypto volatility and what you should bear in mind if you are thinking about investing in the crypto space.  

What is Volatility?

Volatility is a measure of how much the price of any particular asset fluctuates over time. High volatility is associated with larger and more frequent price movements, while the opposite holds true for low volatility. 

It is often used as an indicator of risk, with high levels of volatility indicating greater risk - and greater potential for both profit and loss over shorter periods of time than comparatively less volatile assets. 

Volatility can be caused by a wide range of factors, including changes in market sentiment, economic indicators, and geopolitical events. It is also affected by supply and demand, with higher demand leading to price increases and vice versa. 

Crypto Volatility VS Traditional Markets 

While all financial markets are subject to volatility, the cryptocurrency market is notable for its extreme price swings. One need only look at the price chart of Bitcoin over recent years to see that wild price rallies are often followed by equally dramatic crashes.

One of the main reasons for this is because the cryptocurrency market is relatively young and immature. Despite being around for over a decade, crypto is still a new asset class compared to everything else in financial markets. As such, it is widely considered to be highly volatile and, therefore, more risky than its more established peers. By contrast, stocks are considered to have a wide range of volatility, from the relative stability of large-cap stocks (like Apple or Google) to often erratic “penny stocks”. Bonds sit even further down the volatility and risk curve, as these low-volatility assets typically see less dramatic price swings over time. 

Factors affecting Crypto Volatility

There are many factors that can affect the volatility of the cryptocurrency market. Some of the most important include:

Price Discovery 

New ideas and concepts typically require a period of time to become established and accepted, and this is also true for cryptocurrencies. As an asset class, the crypto market and its investors and speculators are still navigating this early stage of rapid growth. Many crypto assets have only been in existence for a short period - so they are still in price discovery. As a result, the market is still in the process of determining their fair value, which leads to price fluctuations.

Despite gaining significant global attention in recent years and experiencing faster adoption rates than other innovative technologies such as the Internet, crypto still lacks the same level of widespread acceptance as traditional assets like stocks or commodities. As the market continues to mature, increased acceptance will likely follow. However, until investors have a clearer understanding of how cryptocurrencies will be utilised in the long term, price discovery will remain a significant contributor to volatility in the crypto market.

Immature Markets

The rapid growth of the crypto industry has its unique challenges, with several financial products and instruments still being in their early stages of development. Unlike traditional assets such as stocks, gaining exposure to crypto is complicated for traditional investors', which makes the market highly retail-focused. While institutional adoption of crypto is on the rise, derivative products and other hedging methods are still in their nascent stages, constraining investors' ability to manage their exposure to crypto.

Supply and Demand Dynamics

The relationship between supply and demand has a significant influence on the fluctuations and price shifts of assets, especially in the crypto industry, where distinct supply dynamics exist for several digital assets.

The scarcity of certain assets creates circumstances where a sudden rise in demand can propel prices upward, resulting in greater volatility. The most famous example of a digital asset with a fixed supply is Bitcoin, which has a limited number of 21 million coins.

These effects can be intensified when large holders, commonly referred to as "whales", buy or sell substantial amounts of a specific asset, potentially causing its value to soar or plummet. The cryptocurrency markets are not yet sophisticated enough to absorb these supply and demand disruptions without significant impact on the market. Due to this, smaller market cap assets are often viewed as more vulnerable to whale movement, making them riskier and more unstable.

Market Sentiment 

The crypto market is highly sensitive to swings in investor sentiment, which can cause drastic fluctuations in price. This volatility is exacerbated by the relative immaturity of the market, which enables positive or negative news to spread like contagion. The prevalence of individual retail investors in the crypto market further compounds this sensitivity to shifts in investor sentiment, as they are typically less informed and more impressionable than institutional or experienced investors.

Given the speculative nature of crypto assets, many retail traders and investors are drawn to the market by the prospect of high returns. This "Fear of Missing Out" (FOMO) can create a self-perpetuating cycle of demand, driving up value of an asset to unsustainable levels and causing significant price movements.

Lack of Regulation

The crypto market is not comprehensively and clearly regulated by any government agency, like traditional financial markets. Lack of regulation means that not all crypto assets offered on exchanges have undergone thorough scrutiny and evaluation by regulatory authorities. In some cases, certain assets may have been issued without prioritising consumer protection and risk management, which could contribute to the overall volatility of the crypto market. Therefore, it is possible that the high volatility associated with the market could be attributed, at least in part, to these assets, rather than the entire market.

24/7 Trading

The crypto markets trade 24/7, unlike traditional markets such as NYSE, which follow a fixed schedule on weekdays. With the lack of regulatory measures in place, there are no circuit breakers to moderate price swings as observed in conventional markets. Circuit breakers are measures taken by exchanges to mitigate upward or downward volatility caused by excessive buying or selling. In the absence of such safeguards, the unbridled nature of the crypto market can lead to heightened volatility.

Investment Considerations

The crypto market is in its nascent years as an asset class and is still in the process of establishing itself in the financial landscape. The volatility that has characterized its early years is not a flaw, but rather a natural feature of the rapid growth and adoption the crypto industry has experienced in such a short space of time.

Though intimidating at times, this volatility presents both challenges and opportunities for traders and investors alike. Over time, many of the factors contributing to volatility will become less significant, as more players enter the market, such as institutional investors and regulators. As the crypto market continues to mature and develop, it is likely that volatility will diminish in the future.  

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