Crypto is notorious for its volatility. While investment managers in traditional finance battle for each basis point with tooth and nail, a crypto trader may watch their portfolio wax and wane by 20% with each passing hour. But why is crypto so inherently volatile, and why, when things are rough, does it crash so much harder than other assets? Read on to find out—our answers could even explain why crypto is going down right now.
What is crypto backed by?
A lot of people think that crypto is inherently worthless. Charlie Munger, Warren Buffett’s number two, wishes cryptocurrencies had “never been invented,” and Buffett himself called Bitcoin “rat poison squared.” At the center of criticisms like these is the assumption that cryptocurrencies are not backed by anything, and that sellers mislead investors into thinking that they are.
Let’s break that down. Cryptocurrencies, it should be said, are a dime a dozen. Anyone can create a cryptocurrency whenever they like, and if you’re creating a token on a blockchain like Ethereum or Binance Smart Chain, you don’t even need to source an independent network of miners to validate your transactions, since the miners and validators attached to blockchains like Ethereum, Solana, or Binance Smart Chain will do that work for you.
Market psychology
Since the cost of minting a new cryptocurrency can be very low, it is not unreasonable to argue that these networks can be launched without anything other than a speculative purpose, whose worth is dependent on nothing but market psychology. Meme coins, like Dogecoin and Shiba Inu, are volatile for precisely this reason. They are social currencies whose value is dependent on, to a large extent, how much people value a joke–in this case, a chubby Shiba Inu worth tens of billions of dollars.
A lot of analysts dismiss market psychology within the cryptocurrency markets, which may explain why a lot of people express surprise about its volatility. Accepting that market psychology is an important piece of the puzzle can provide insight into the volatility of tokens.
Take ConstitutionDAO, a decentralized autonomous organization that wanted to buy a physical copy of the United States Constitution. The DAO failed, but even when the DAO offered refunds on the $47 it had raised, the token continued to rise–albeit with a great amount of volatility. Part of the reason for this rise was that people enjoyed the story of ConstitutionDAO–it’s a fascinating tale of a fair launch, an ambitious project and community organization. But when the relevance of that story faded away—when people got bored—the token crashed. If you try to analyze ConstitutionDAO as you would a stock, the economy makes no sense—it produces no revenue and does not pay out anything to its holders. However, understood through the lens of “narrative economics,” ConstitutionDAO’s crypto market crash makes perfect sense.
Miners…or the lack of them
Some people, among them Microstrategy CEO and Bitcoin hoarder Michael Saylor, like to understand Bitcoin as a “money battery.” The theory is that, since you can mine Bitcoin from anywhere with a stable internet connection, the entire Bitcoin network is a portable store of value that can produce revenue from anywhere on Earth.
This conception relies on the argument that Bitcoin’s price is a function of all the computational power ever exerted to mine Bitcoin. Bitcoin mining is vital to securing the network but it costs money—you have to pay for mining machines and the electricity to run them. Crucial to this metaphor is that mining Bitcoin continuously adds to the security of the Bitcoin network; the number of mined Bitcoin is a symbol of how robust the network is.
If a healthy network of Bitcoin miners contributes to the stability of Bitcoin’s upward trajectory, it stands to reason that a sudden lack of miners would cause Bitcoin to crash. Unfortunately for investors, this has often been the case.
The January 2022 cryptocurrency crash has already been partly attributed to the shutdown of the internet in Kazakhstan, which became a Bitcoin mining hub due to the prevalence of cheap electricity. Bitcoin’s price crash in early 2021 is largely attributed to China’s decision to ban Bitcoin miners. This temporarily throttled the hash power backing the network, and called into question the future of Bitcoin mining. The Bitcoin drop recovered months later when Chinese miners relocated abroad.
Smaller markets are more volatile
Although meme coins like Shiba Inu and Dogecoin are very large, more are launched each day to try and topple them. Lots of these coins have tiny markets that are incredibly sensitive to minute developments, like, say, a tweet from Elon Musk – and many more are little more than scams. Take the fastest rising coin on CoinMarketCap on the day this article was written in January 2022: , a coin called Shiba Hunter. Just a week after its launch, the coin’s price rose 4394.10%, swelling to a market cap of $16 million. Its time in the limelight was short-lived, however; the coin cratered after its developers enforced a 98% tax on sales. By March 2022, its market cap had fallen to just $89,702. The grim fate of Shiba Hunter and so many meme coins like it are a reminder of the short-lived life-cycle of many meme coins.
Even larger markets aren’t quite as big as they seem. A huge chunk of Bitcoin is lost forever, meaning that the actual market cap is a fraction of the size of the one you might find on CoinMarketCap. One measure that attempts to capture Bitcoin’s actual value is “realized market cap.” According to this metric, Bitcoin’s market cap, as of January 12, 2022, is $809 billion, while its “realized” market cap is $460 billion. When old Bitcoin—that which is thought to be forgotten about or lost—is reintroduced into circulation, it can skew the market and alter the price of Bitcoin, causing a crypto dip.
That said, the Bitcoin market is still larger than any other cryptocurrency market—it is twice as large as Ethereum, dominating about 40% of the overall market. So, the fate of the largest coin can drag other coins down. Take a look at this 30-day volatility chart for coins from across the board from the year preceding January 12, 2022. It features Bitcoin, Ethereum, XRP, Monero, Algorand and Polkadot—all major coins of varying market caps. As you can see, volatility for all the coins generally follow the same trend over the past year, but volatility itself is far larger for some coins—particularly those with smaller markets caps. For most of the chart, Bitcoin and Ethereum, the two largest coins, are the least volatile, while smaller coins like DOT, ALGO, and LINK are closer to the top.
Leveraged traders compound volatility
The cryptocurrency market is full of leverage—where people borrow money to increase the size of their positions. It is not uncommon for major exchanges to offer leverages of up to 120x.
That means that when the price of crypto crashes, some traders will get liquidated from their positions, forcing them to sell the crypto they hold on the open market. When this happens to enough people at once—as is the case in the crypto market—the market crashes even harder. On-chain analytics firm CryptoQuant noted that when Bitcoin crashed in January 2022, the estimated leveraged ratio was at 0.224, an all-time high.
Regulators
The remarks of regulators, as well as the policies they implement, can spark cryptocurrency crashes. We have already touched upon the Chinese crypto mining ban, but other instances of regulatory action have caused crypto drops. Crypto stumbled in the summer of 2021 when Joe Biden’s administration passed a landmark infrastructure bill that held decentralized applications liable for tax reporting. Crypto crashed in the autumn when China declared all cryptocurrencies illegal (again).
Specific coins fall in relation to more targeted regulatory actions. For instance, privacy coins like Monero, Zcash, and Dash fell after Australia, Japan, and South Korea banned them from exchanges. The price of Bitcoin on South Korean exchanges actually trades at a premium to Bitcoin elsewhere because of tight capital controls in the country. XRP fell dramatically at the end of 2020 and for much of 2021 after the U.S. Securities and Exchange Commission filed a lawsuit alleging that Ripple Labs held $300 million worth of illegal securities sales to keep the price of XRP buoyant.
Each protocol will have its own travails and triumphs. In 2021, Bitcoin soared following the successful launch of Bitcoin Futures ETFs in the U.S.—a signal that institutional investors could flood into Bitcoin with regulatory approval.
Scams, hacks, bugs, and strange token designs
It is a mistake to believe that all cryptocurrencies rise and fall purely due to exogenous market forces. Some cryptocurrencies crash because they are based on faulty code. US dollar stablecoins like Basis and Empty Set Dollar fell from their pegs after their algorithms failed to maintain a stable value.
Hacks can also destabilize trust in the currency or drain the wallet of funds that would otherwise maintain stability. Indexed Finance, a protocol that created cryptocurrency index tokens, collapsed after a hacker stole $16 million of assets that were backing its indexes—the index tokens crashed almost immediately.
Some coins are designed to be volatile. Ampleforth and Based Money are stablecoins that use a “rebase” function to get their currencies to $1. This relies on a protocol that burns and mints tokens to heave the tokens back to their peg—with dramatic results. Since its launch in mid-2019, Ampleforth has ranged from $0.48 to $3.26.
Macroeconomic events
Although some analysts maintain that Bitcoin is decoupled from major economic events, it tracks major financial indices, which in turn are reflections of the global economy. Rising or lowering index rates, excessive Federal Reserve printing and rising inflation can all cause Bitcoin to rise and fall. Even though governments do not control the coin, investments into high-risk assets are affected by things like interest rates and currency fluctuations, and the health of the stock market.
To quote River Financial: “The health of the global economy is one of the largest factors in the price of most assets, and Bitcoin is no exception. During expansions and other times of economic prosperity, people have more wealth to allocate to financial assets. The greater demand generally increases prices.”
