Why are cryptocurrencies so volatile?

Death, taxes, and volatile cryptocurrency prices.

We all know what is certain – death and taxes. But lately, it seems cryptocurrency price volatility is too. Why do cryptocurrencies (or tokens, coins, cryptos) such as Bitcoin and Ethereum see massive price changes so quickly?

This is an important question, as most institutional investors have singled out volatility as the largest barrier to investment.

Crypto crash: After nearing record, Bitcoin plunges | Crypto | Al Jazeera

Typical stock prices are evaluated by predicting future earnings. Commodities, such as oil and sugar, are priced based on a changing supply and demand curve. These provide investors with measurements for investment decisions.

  • No similar tools to evaluate crypto exist.
  • Only one government enforces the acceptance of Bitcoin as legal tender (El Salvador)
  • Crypto can’t fuel your car like oil or conduct electricity like copper.

The value of certain cryptocurrencies is based entirely on faith. Faith takes the form of supply and demand – currently the sole determination of Bitcoin’s worth. In essence, faith is manifested in how many are willing to buy or sell at current prices. If people lose faith in Bitcoin, they sell. If potential buyers also lose faith, the demand fails to meet the supply, dropping the price. This cycle quickly plunges Bitcoin’s price downwards.

As we’ve seen over the past year, the opposite also occurs; Crypto prices can rise dramatically in a short time. All it takes is one major service or product provider to announce Bitcoin as an acceptable form of payment to drastically drive up the price of it. Remember the effect of Elon Musk’s February 2021 announcement that Tesla was accepting Bitcoin as a form of payment? It pushed up the price of Bitcoin by almost 20%. And then reflect on the significant price drop for Bitcoin after Elon Musk’s May 2021 announcement that Tesla would no longer accept Bitcoin (albeit for environmental reasons). This is just one example of the causes of Bitcoin’s price volatility.

Numerous factors create the “perfect storm” of price instability. This article explores the few key factors affecting the faith in, and demand for, cryptocurrencies.

News articles – Stories with the greatest impact involve government regulation, large-scale hacks, and illegal transactions. Government regulations render cryptocurrencies less valuable as they become more difficult to use, purchase, or sell. Hacks of large exchanges illustrate the risks of such a decentralized, uninsured system, creating fear in both current and potential investors. When cryptocurrencies are found in illegal transactions, such as darknet marketplace Silk Road, regulators are pressured to protect consumers and stop any illicit activity. Crypto exchanges, unlike traditional markets, never close. Speculators continuously monitor headlines for the next big story. When something emerges, the fastest profit, while the slowest lose.

Emerging market – The market for cryptocurrencies remains significantly smaller than traditional markets. Smaller markets are less liquid due to a lack of institutional investors and large trading firms. The crypto market is also yet to produce a widely adopted derivatives market. Derivative markets mitigate volatility by adding liquidating and hedging opportunities. Rapid buying and selling occur in traditional markets as well. However, the effect of price swings is exaggerated in crypto. Due to the low barriers to entry, the average investor in crypto is far less experienced and educated than in other markets. The crypto markets are thus vulnerable to hype, fear, uncertainty, doubt, and outright manipulation.

Fixed quantity – Liquidity is hampered by the fixed quantity of Bitcoin currently in existence and the maximum number that can exist. Bitcoin has a stipulation—set forth in its source code—that it must have a finite supply. For this reason, there will only ever be 21 million bitcoins produced. This, along with a depreciating supply curve and inaccessible wallets, reduces the liquid supply of Bitcoin.

Regulatory guidance – A lack of clear cryptocurrency regulations contributes to volatility, as institutions and ETFs are less willing to hold a large number of Bitcoin or other crypto given the risk of future legislation.

Security issues – Faith in the security and long-term sustainability of Bitcoin is undermined by any exposure of vulnerabilities, leading to investors rushing to compensate. Similar to other cryptocurrencies, Bitcoin is open-source software; anyone can acquire and test the underlying code. This openness ensures flaws are highly publicized.

Fiat fluctuations – Fiat money is government-issued currency, not backed by any commodity (such as gold). Economies across the world are built upon different fiat currencies, which show strength or weakness based on the actions of their governing parties.

If a fiat currency is devalued, investors want to hold less, rushing to move fiat into alternative assets such as Bitcoin.

Volatility itself – The volatility of Bitcoin makes it more attractive to short-term buyers and sellers looking for quick gains. These speculators add volatility by buying and selling often and in large bets.

Margin calls are a large factor in volatility. Margin calls occur when an asset held as security for a loan has decreased in value. When a margin call occurs, the investor must choose to either deposit more money in the account or sell the assets held in their account. Large fluctuations in crypto prices can force automatic sell orders if prices dip below a predetermined threshold, causing greater price decreases.

Large holders – Due to minimal widespread adoption in Bitcoin’s early years, a small number of individuals managed to acquire large proportions of Bitcoin. It is estimated that 50-60% of the available supply of Bitcoin is held by these whales. Whales dramatically affect the price by liquidating or increasing their Bitcoin holdings.

Tax treatment – The innovative nature of digital currency forced government tax collectors such as the CRA and IRS to classify crypto; is Bitcoin a form of currency or is it property? This distinction has enormous effects on the viability of cryptocurrencies.

The CRA and IRS currently classify cryptocurrencies as property, subjecting holders to capital gains tax upon profitable disposition. This complicates purchases with cryptocurrency, as users are taxed on any gain on the value of their crypto when they made their purchase. It is also complicated by the situation when cryptocurrencies are used by their holder as currency and not property.

The global market cap of all cryptocurrencies is approximately $2.5 trillion USD, growing over 1,200% in the past two years alone.

Many see the decision of tax authorities to designate cryptocurrencies as property as a signal of stronger regulation on the horizon. While some regulatory guidance is welcomed, the blockchain community remains hesitant to embrace any regulation stunting growth. The volatility of cryptocurrencies can be reduced by increasing adoption among institutional investors, the creation of derivatives markets, and clear regulations.

Despite widespread interest, cryptocurrencies remain reliant on “faith” and consumer demand, signaling one thing: volatility is here to stay.

This article was written by Marcela S. Aroca and Jacob Robinson, and first published with The Lawyer’s Daily.

It is part one of a multi-part series reviewing the legal implications of cryptocurrency. Our next article explores why cryptocurrencies are different from shares, despite voting powers, dividends, and much more.

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