Why do crypto prices fluctuate so much?

Authored by Makara
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Makara

Published August 26, 20218 mins
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Year after year, pop psychology books like Predictably Irrational and Nudge claim that humans don’t behave rationally. That can’t be you, you think. But then you find yourself buying Dogecoin just because everyone else is, or dumping Bitcoin at 4 a.m. because the price dropped 3%. As hard as you might try to act like a dispassionate computer, emotions always creep into your investing decisions. And when they do, it’s typically in response to an aspect of finance that is constant in the crypto universe: volatility.

Ups and downs exist in all markets, but in crypto they can be stomach-churning. Take Bitcoin’s wild ride that began in March 2017, when its price shot from $976 to $20,879 in just nine months—before crashing less than two years later, with lots of terrifying bounces in between. In a sillier example, Dogecoin dropped $70 billion in market cap in the month after Elon Musk called it a “hustle” on Saturday Night Live. You see this type of movement all over the crypto ecosystem: meteoric price rises followed by devastating crashes, all wrapped in mind-bending day-to-day fluctuations.

Why Is Crypto so Volatile?

Horizons ETFs CEO Steve Hawkins has said that Bitcoin is “more volatile than volatility itself.” While that statement would give any linguist a headache, we do get what he’s going for. Price fluctuations are inherent in every token—even relatively stable ones like Bitcoin. That’s just what happens in a still-new market that lacks gatekeepers and embraces constant innovation. In crypto, volatility is, as they say, a feature, not a bug.

While the inclusivity of crypto is a good thing—and one of the reasons it was created in the first place—a lack of traditional financial gatekeepers opens the markets to inexperienced investors. These people often take bigger risks (and use more credit) in the hopes of a large windfall. And with more to lose, they also tend to behave more irrationally when the market shifts. Also, as a new asset class, crypto has many fewer participants than traditional markets, with a lot less money in circulation. This means relatively small purchase orders can have outsize effects on price. If a whale offloads a big chunk of technology stocks, it won’t sink Amazon or Apple. In crypto, however, an investor who makes a large Ether order can swing the entire market.

There are other reasons crypto fluctuates so much: Unlike gold, U.S. dollars, or a stock, tokens don’t often have company-derived or government-bestowed value. There usually aren’t investor updates on the health of the company, meaning buyers are on their own to determine the true value of crypto investments, so hype and rumor tend to have much more power. Good or bad news, when it’s repeated often enough or delivered by the right (or wrong) person, can pump up the price of a token or deflate it. If enough people believe, then it’s basically true.

Legacy financial systems have measures in place to try to limit volatility. There are regulations to keep out bad actors: The Federal Reserve’s “dual mandate” includes the maintenance of stable prices and the New York Stock Exchange has built-in trading halts to prevent panic-selling or manic-buying when prices change by a certain amount—for an individual stock or across the market. Crypto doesn’t have any of these things. The only thing controlling the digital asset market is human rationality—or the irrationality that often overtakes it.

Is Volatility Good or Bad?

While regulations do their best to cap volatility in order to prevent debilitating loss, they ignore the other side—the possibility of oversize gains. This potential is part of what has drawn so many early investors to crypto. Those who are willing to endure the risk can do very well if the market goes their way, provided they aren’t too leveraged and have the deep pockets required to cover any losses if it doesn’t. But what’s good for speculation isn’t always so great for functionality. People who believe that new financial products built on blockchains will eventually replace our current financial system worry that high volatility makes crypto a poor long-term investment. Price inconsistencies can also spook new users—slowing the widespread adoption that crypto needs to become a true medium of exchange. Think about it: If you were a car salesperson, why would you list a vehicle’s price in a currency that might drop significantly in value before you’d even convinced the customer to spring for rust protection?

Your feelings toward volatility are always going to be a matter of personal perspective. If you can tolerate risk (and if your investment is something you are actually willing to lose), you could be very happy here. For others, the solution may be to invest a smaller proportion of their overall portfolio or invest in a diversified basket of cryptocurrencies. There’s room for both types of investor—and so many more.