Regulation
What Makes Cryptocurrencies More Volatile Than Fiat Currencies
While cryptocurrencies like Bitcoin and Ethereum demonstrate the revolutionary potential of blockchain, they are hampered by their high volatility. Unlike fiat currencies like the US dollar or Japanese yen, which have relatively stable values, cryptocurrencies experience significant price movements within hours.
On March 12, 2020, the price of Bitcoin dropped 40% from $7,900 to $4,600, alarming traders and investors. On June 21, 2017, the value of Ethereum also dropped dramatically, falling from $319 to $0.10 in just a few seconds. This drop occurred following a multi-million dollar sell order, which drew attention to the extreme volatility of cryptocurrencies.
Whether you are an active crypto investor or a financial markets enthusiast, in this blog post you will learn about the forces that lead to the high volatility of digital currencies. Here are the reasons why cryptocurrencies are more volatile than their fiat counterparts:
The Speculative Nature of Digital Currency Traders
Many traders in crypto markets are constantly looking to make small profits here and there. This is why you will find an unusually high number of scalpers and day traders looking to profit from short-term price movements in the digital currency market. Most of these traders use lagging technical indicators like MACD and Bollinger Bands to make their decisions.
In contrast, fiat currency traders in the forex market tend to buy and hold assets with a view to long-term appreciation. When a large number of traders almost never react to price movements, the market will be much less volatile.
A small percentage of traders as well playing with crypto because they believe they can make quick profits without getting caught up in the drama of crypto price fluctuations. The speculative nature of crypto traders is fueled by the fact that the market never “sleeps.” The market is traded 24/7, allowing retail traders and institutions to react instantly to new information and market conditions. The result of this never-ending trading environment is high volatility, as there can be a high volume of transactions in a short period of time.
Aside from technical analysis, speculative traders make most of their trading decisions based on market sentiment, which makes cryptocurrencies very sensitive to news. Once a positive news story about a specific cryptocurrency being adopted by a major company is released, the price of the cryptocurrency increases.
For example, when Tesla disclosed in an SEC filing on February 8, 2021, that it bought $1.5 billion worth of BitcoinThe price of the coin rose from $38,000 to $46,000 in a matter of hours.
Traders gauge market sentiment using social media platforms like Twitter and Reddit. Gen Z and millennials make up a large percentage of cryptocurrency traders, and many of them have discussions on social media. There are social media share buttons that can spread information quickly. The Retweet feature on Twitter increases the number of post impressions, which can affect the opinion of multiple traders in a short period of time.
An example is what is called “Elon effectwhich prompts cryptocurrency traders to monitor Elon Musk’s tweets about which cryptocurrencies to buy. A single tweet from Elon Musk about Dogecoin on April 15 caused the coin to skyrocket 260%.
Fear of missing out (FOMO)
Fear of missing out (FOMO) is the apprehension felt when an individual thinks they are unaware of an exciting uptrend in crypto prices. It starts when a crypto asset rises in value and a lot of attention is paid to the coin. When speculative investors discover the news on social and traditional media, they start to feel like they are missing out on potential gains.
Therefore, they start investing money in the hot digital currency, which drives the price up even more in a short period of time. At some point, the token price becomes much higher than its real value, creating a bubble. Once the bubble bursts, the asset price drops rapidly, leading to increased volatility during both the uptrend and downtrend.
A key example of this is the increase in the price of Bitcoin in 2017, from around $1,000 at the start of the year to almost $20,000 in December.
Low regulation and market maturity
Although the fact that the use of cryptocurrencies is not limited by borders is an advantage, it promotes the lack of global consensus on how to regulate them. The main reason for the weak regulatory environment in the crypto sector is that it is relatively young compared to other financial instruments.
Bitcoin, the first cryptocurrency, was created in 2009, and people still have questions about its use. identity of the creatorBy comparison, fiat currencies as we know them have been around since the collapse of the gold standard during the Great Depression of the 1930s.
Many government agencies around the world are still unsure how to regulate cryptocurrencies. While some have banned cryptocurrencies, others have actively encouraged and supported them.
Uncertainty surrounding crypto regulation affects investor confidence, which triggers immediate price fluctuations in the digital currency market. As soon as a regulator of a major economy announces restrictions or rules on crypto, it can trigger panic trading in the market. In 2021, China started master cryptocurrency mining activitiesciting financial stability reasons, which led to a decline in the Bitcoin hash rate and a subsequent decline in the market capitalization of cryptocurrencies.
On the other hand, fiat currencies have a defined regulatory framework, which ensures that there is little to no price movement following regulatory announcements. They are backed by central banks and economic frameworks that make them highly predictable and therefore stable.
The fact that cryptocurrencies haven’t been around as long as fiat currencies has an impact on their proneness to manipulation by large investors. In the digital currency space, it’s common to hear the term “whales.” Whales are entities that hold obscene amounts of a specific cryptocurrency and can influence the price of that coin by placing large buy or sell orders.
The weak regulation of the market also means that larger investors can create pump-and-dump schemes, in which the price of a coin is artificially inflated and then lowered once investors dump their coins.
Global Economic Events
Digital currencies tend to react more intensely to global economic events than fiat currencies. In times of economic instability, such as a stock market crash, investors put their money into cryptocurrencies, which causes prices to rise.
Geopolitical events such as trade wars can also trigger volatility in fiat currencies. However, the effect of volatility is stronger on cryptocurrency prices. Conflicts in certain regions of the world can prompt investors to turn to cryptocurrencies as a hedge against the instability of conventional financial markets.
Macroeconomic trends such as changes in inflation and interest rates make cryptocurrency prices more volatile. There is a negative correlational relationship between interest rates and the price of cryptocurrencies. In essence, the lower the interest rate announced by central banks, the more cryptocurrency prices tend to increase.
When interest rates are low, people tend to invest in riskier assets like cryptocurrencies, which can trigger volatility in digital asset prices. On the other hand, high interest rates may cause investors to withdraw their funds from cryptocurrencies, thereby causing prices to fall.
Technological development
Technological developments in crypto can trigger volatility in the digital currency market.
When investors feel that a specific cryptocurrency is going to improve in terms of security and efficiency, it builds confidence. If the cryptocurrency project team delays the launch of a new product or technology, investors might see this as a sign of trouble and trigger a sell-off.
For example, Ethereum 2.0, which switched from the proof-of-work consensus mechanism to the more efficient proof-of-stake consensus mechanism, triggered a surge in the price of its token.
Another technological development that impacts cryptocurrency price volatility is the security of a blockchain or platform. Once users discover a bug in the blockchain protocol, it can negatively impact the price as hackers can exploit it. A notable example is the Mt Gox exchange hack in 2014, which saw high Bitcoin volatility after 850,000 Bitcoins were stolen from the platform.
The increase in anonymous casinos also highlighted another positive aspect of crypto adoption. Since casino players realized that these platforms offer secure and private gambling, the user base of these anonymous casinos has increased, contributing to the volatility of cryptocurrency prices.
Technological advancements such as decentralized finance (DeFi) and non-fungible tokens (NFTs) have opened new avenues for increased volatility in cryptocurrencies. The DeFi system enhances the existing financial system with its decentralized protocols, while NFTs represent ownership of a real-world asset.
By increasing liquidity in the crypto market, DeFi platforms can result in higher volatility due to large trading volumes. NFTs can cause crypto volatility since their prices can rise or fall depending on their value.