Understanding Cryptocurrency Drops And Market Volatility

Volatility is one of the inherent properties of cryptocurrencies. Their value tends to fluctuate at a higher rate compared to other tradable assets or fiat currencies. For example, on February 21, 2020, BTC hit historic highs of $58354.14, and a couple of days later, it was down 26%. 

We have to note that the value of a cryptocurrency solely depends on its demand. Where cryptocurrencies are legal, their classification varies depending on the jurisdiction. Some countries have classified them as money, other commodities, and other tradable securities. Typically, you’d expect that the value in any of these classes fluctuates depending on the economic laws of supply and demand. i.e., when supply exceeds demand, price falls, and when demand exceeds supply, the value increases. But this is not the case for cryptocurrencies. 

Demand plays the most significant role in determining the volatility of cryptocurrencies. When demand falls, the price decreases, and when it rises, the price increases. That is because most cryptocurrencies have a finite supply. More so, crypto mining is slow, implying that very few coins are added into circulation. 

What Factors Affect Crypto Market Volatility?

Sensational news headlines

One of the biggest causes of crypto volatility has always been sensational news headlines. Unlike other assets, cryptocurrencies have no fundamentals, so traders and investors cannot analyse financial statements to see how crypto performs. This means that the pricing of cryptocurrencies is entirely arbitrary and are based on market sentiment. 

For example, on February 8, 2021, Tesla announced that it had purchased BTC worth $1.5 billion. Within minutes, every media outlet had picked up the headline. Consequently, BTC gained about 14% in less than 90 minutes. Such sensational headlines drive up the demand for cryptocurrencies because association with reputable global organisations or celebrities increase their legitimacy.

As the adoption rate increases, so does the value since supply remains finite.

Such sensational headlines also create an irrational fear of missing out (FOMO). Cryptos became popular as a result of social contagion. An argument can be made that majority of retail crypto investors do not understand the concept of cryptocurrencies. Most people buy and sell because they see other people doing that, not because they understand the inherent properties of the value of cryptos. 

That means when you see people buy cryptocurrency, you also get in on the action so that you aren’t left out. The same goes when you notice headlines that people are selling.

Low liquidity 

The cryptocurrency market is still nascent. It is not as developed as other markets such as stock trading or the forex market. This means that the crypto market suffers increased liquidity problems. This means that of the total number of cryptos in circulation, a low percentage is in circulation. 

Crypto whales dominate the Crypto market. These are investors – both individual and institutional – who own control of significant portions of a particular cryptocurrency. For example, there are almost 18.6 million bitcoins in circulation, but less than 25% is actively traded in the market. Bitcoin whales hold their portfolios in cold storages as a store of value, not for speculative trading. This practice severely distorts the market dynamics. For example, in the forex market, a buy or sell order worth hundreds of billions can easily and quickly be absorbed without distorting prices since there is enough liquidity.

Low liquidity in the crypto market makes it easy for the market price to be skewed. If a crypto whale decides to initiate a sell order of the crypto holding, the demand in the market won’t be sufficient to absorb it. This, in turn, creates an irrational fear among small scale crypto holders who start a panic sale

Similarly, the thin order books in the crypto market also mean that large buy orders cannot be filled easily. That is because there aren’t enough cryptos in the market. Consequently, this would create an irrational exuberance in the market leading to a frenzy of buys. Both these instances lead to extreme market volatility. . It is only natural to assume that large scale holders of a particular asset have insider information regarding a particular asset.

Speculative Trading

Over the years, the crypto derivatives market has grown to surpass the spot market. It now accounts for about 54% of all crypto transactions. Although derivatives have made the price discovery process more efficient, they have allowed leveraged buying and short selling. Traders can take significantly large positions that they would in the spot market.

Since cryptocurrencies are interchangeable and traded on crypto exchanges, speculative traders bet on whether prices will go up or down. At any moment, there’s always a tug of war between buyers and short sellers. As we’ve mentioned earlier, the buy and sell orders appear in the order book. 

Typically, buyers accumulate their positions attempting to push prices higher while short-sellers accumulate the short positions attempting to push prices lower. We do not expect the volatility in cryptos to go away any time soon. Provided you understand how it comes about, you will learn how to benefit from it.