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Why are cryptocurrencies so volatile?

graph illustrating crypto volatility

If you read the media, crypto holders are perceived as a collection of very very nervous investors who think something like: “Oh no, China is considering flanging the ETF variables of Bitcoin! Must… sell… at… loss….”, then they run to their computer, log in and sell.

The daily news cycle demands every change in the price to be given an explanation related to what happened that day. Very rarely do the headlines admit: “we don’t know why that happened”.

Basically, anyone who still owns crypto is probably used to bad news by now and is bedded down for the long term. So what other reasons are there behind all this price movement?

Most of the reasons cryptocurrency is so volatile can be explained by it being new.

Because it’s new:

  1. It’s smaller relative to the wealth of the individuals trading
  2. It’s technically immature
  3. It’s not regulated enough, so it’s prone to bad actors, scams and naïve investment schemes
  4. Traditional finance is now involved, and (ironically) acts more like that twitchy, nervous investor than any actual investor. (“OH NO, THE FEDS HAVE PUT UP INTEREST RATES 0.002.5%! WHAT IF MY CLIENTS FIND OUT I BOUGHT BITCOIN? SELL SELL SELL!”)
  5. The people in crypto have a bigger appetite for risk and volatility, and by exploiting that they amplify it.

Small Market Caps

Crypto has a market cap of just under a trillion dollars. A market cap is the total value of all coins in the ecosystem. If I issued a trillion coins tomorrow on Ethereum and then bought one for $1, my coin’s market cap would be worth $1 trillion.

Anyway, the point is, that the traditional financial markets are worth thousands of times more than the crypto market, which means that big players can have an even bigger impact, and even medium trades that wouldn’t shift the traditional markets can shift a crypto one.

Having a much bigger crypto market cap would certainly mean that “whales” (large crypto holders) have much less ability to move the market.

Some coins are so small, that one guy with a million dollars can pump or dump at will: and that’s not a regulated process. Projects launched with a vision to change the world end up being tools of rich guys at play.

Technical Immaturity

Crypto is always trying new things, and they don’t always work. Technology failures can create flash crashes, for instance. Huge losses can happen because of small technical mistakes. One reason why sticking to tried and tested crypto is a good idea. Let’s hope the Ethereum upgrade is successful!

Naïve Economic Plans

Decentralised finance is full of half-baked platforms, hacks, dodgy smart contracts and scammy business ideas that aren’t new, but are new in crypto. When these plans collapse, the ecosystem suffers.

A combination of technical immaturity and naïve economic plans was behind the recent Terra collapse.

This unstable stablecoin/crypto combination tried to create money out of thin air by balancing two worthless things together and hoping people would trade them. Which they did. The problem for the crypto ecosystem is that the returns it was offering on deposits (20%) were so tempting that DeFi lenders who should have known better bought into it. When it collapsed, they lost big-time – a process of unwinding that’s still going on today.

Yield Farming

Moving assets around in ever more complex circles to create income is fine as long as you can do maths, and as long as one of the parts of your circle doesn’t fail catastrophically.

In crypto, failures happen fast. Someone has the bright idea to let people stake their ETH and spend it too, and there’s another bright idea to put it somewhere else, betting on its value… it’s an unregulated recipe for disaster that makes you appreciate safety-first DeFi providers like AQRU.

Traditional Finance

Oddly, the involvement of traditional finance is also implicated in the volatility, because in a crunch, traditional finance will dump its crypto first – it’s perceived as more “optional”, and the markets are open 24/7 so it can be done urgently. This makes traditional financiers into the quivering nervous investors we met at the start.

Derivatives and Options (basically: gambling)

There are many places where you can place bets on crypto assets going up or down. This is the “derivatives” market. If there’s a single reason why crypto will survive this downturn, it will be a useful tool for derivatives traders to make money.

One of the differences in crypto, though, is that you can magnify your bet by 10 or even 100 – this is called “leverage” and involves borrowing assets temporarily to make your bet. While the EU would prefer 2-4 leverage, crypto goes way further than that.

With a bet like this, everything is fine when things are going the right way. But if they go the wrong way, then the more leverage you have, the quicker you can lose it all, in a process called “liquidation”. When a bet is liquidated, bitcoin is forcibly bought or sold on the open market. If lots of positions get liquidated at once (which is common), then the order books at exchanges are rapidly used up, and the price goes up or down within a shocking space of time (usually within half an hour – only automated trades could act this quickly and together).

Order Books: what happens when assets are dumped quickly?

An exchange order book is two lists: one of the people wanting to buy the asset at various prices, and one list of people wanting to sell. There are two kinds of orders: “limit” orders, where the buyer or seller specifies the price they want to sell at and “market” orders where the buyer/seller doesn’t care.

The headline “price” of the asset is the price it last sold at.

If you get a ton of market orders in the same direction, then they’re thrown at the order book in turn using up the orders and setting a new headline price. If this happens quickly enough, then the price plummets or rockets until the selling/buying stops and there’s a slight bounce-back as new orders come in to fill the sudden gap. Then the price stabilises for a while, but there might be more action because the new price might trigger a whole new series of liquidations a few hours later.

Is this ever going to stop?

In a word, no. Not while you can get 10 to 100 times leverage, anyway. Regulation might deal with that, but in the meantime, you might as well enjoy it and hope the gamblers betting on bitcoin going down get what’s coming to them!

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