Cryptocurrencies have brought a new dimension to the financial world by introducing decentralized, borderless, and programmable assets. However, unlike traditional fiat currencies, these assets are subject to high volatility. While fiat money is relatively stable due to the influence of central banks, regulation, and deep liquidity, cryptocurrencies can surge or crash by double digits in a single day. Therefore, investors, traders, and interested parties need to understand why these digital currencies are so significant compared to fiat currencies. Let’s break down some key factors:
Why Fiat is Comparatively Stable
Before the crypto side, let’s take a quick look at what stabilizes fiat.
- Deep Liquidity: The foreign exchange market is dominated by large players, including banks, institutions, funds, and central banks with hedging mandates. Thus, the fund flow is less hot money and more mean-reverting flow.
- Policy Backstops: Central banks use monetary policies, including primary tools like open market operations, adjusting interest rates, and setting bank reserve requirements, to damp disordered moves.
- Coordinated hours: Despite being global, most ventures have defined trading hours, robust market surveillance, and widely adopted risk control.
Let’s deep dive into some of the key factors that drive the crypto market volatility.
Speculative Nature of Digital Currency Traders
One of the primary factors contributing to variation in cryptocurrency prices is the manner in which traders conduct their business. It is crucial to understand that the majority of people enter the crypto space with the intention of making quick profits, which makes the market very much similar to gambling.
It is different from traditional financial markets, where many participants trade for hedges and global commerce, while institutions and regulatory frameworks create stability.
Additionally, crypto offers high-leverage derivatives (perpetual swaps, margin, and futures) of 10x, 50x, or even 100x, meaning a 1-2% move in the underlying can liquidate positions. An overleveraged market is at risk of an uptrend and a cascade sell-off when liquidation triggers.
24/7 Trading and Global Influence
A cryptocurrency market is an open market where transactions are conducted 24/7, unlike traditional stock markets, which operate at specific times. This makes it clear that cryptocurrencies are constantly in a state of continuous trading and, therefore, are always affected by global events, news, and investor sentiment.
New information regarding companies, products, or services, changes in legislation, or any geopolitical occurrences can cause a sentiment shift within the same day and within minutes adjust the price. There is no central authority that can adjust or cap prices during periods like these, and the market remains open 24/7, making it sensitive to global events.
Supply Constraints and Scarcity Dynamics
Some of the digital currencies have a fixed quantity with a maximum number of coins that shall be created. For example, Bitcoin has an established maximum supply limit of 21 million coins.
This is different from standard money, such as a dollar or euro, wherein banks can print more notes and adjust the money flow in the economy through rate manipulations.
Many tokens are launched with low circulation and lockup, making the markets sensitive to demand shocks. The fixed availability of these products allows prices to rise significantly when demand is high, while low demand can drive a sharp downward swing in price.
This scarcity feature, combined with random shifts in users’ demand, is being a major cause for significant fluctuations observed within the cryptocurrency market. This rigid tokenomics makes crypto more prone to volatility compared to the fiat system.
Low Regulation and Market Maturity
Cryptocurrency is a relatively new industry and lacks strict regulatory guardrails that stabilize the traditional financial markets. Absence of oversight makes the sector vulnerable to price manipulation, pump-and-dump schemes, or even speculative bubbles.
As there are no standard regulations, retail investors are left with little protection and often act in response to rumors and news. However, as global regulations mature towards crypto and stable rules are implemented, the volatility will slowly come down.
Nevertheless, one of the significant issues that affects the volatility of cryptocurrency as of now is still insufficient regulation.
Technological Developments
Being a tech-driven asset class, cryptocurrencies are often exposed to major developments, innovative cycles, and security risks. Events like network enhancement, forks, scalability improvement, or the emergence of new technologies can have significantly impacted the cryptocurrency markets.
For instance, when there is a news report about a security breach, hacks, or exchange failure, investors may panic and sell their coins, creating a quick panic selling. Similarly, anticipated development (like Bitcoin halving and Ethereum upgrades) can boost market sentiment, and investors will rush to buy these assets.
It is rare for fiat currencies to face this level of technological disruption.
Concentrated Ownership and Liquidity Gaps
Unlike Bitcoin and Ethereum, a majority of major cryptocurrencies are yet to gain institutional interest or a concrete HODL sentiment from a majority of investors. On-chain data reveals that many cryptocurrencies are held by a relatively small number of large wallets.
According to analytics platform IntoTheBlock, Shiba Inu concentration by large holders had recently hit 78%. While this may indicate conviction from large players in the SHIB, a potential risk of a sharp swing exists if these investors decide to move their funds.
In addition, liquidity is fragmented across centralized and decentralized exchanges. Thin order books mean prices move sharply when large trades occur. On the contrary, the fiat currencies benefit from trillions in daily liquidity to keep prices stable.
Bottom Line
The volatility of digital currencies relative to traditional currencies may include factors like speculative trading activities, global adoption, restrictions on the number of currencies that can be produced, lack of regulation, and advancement in technology.
Although these variations present high opportunities to make high revenues, they also present greater chances of losses. Increased regulations, advances in technology, and market maturity that will be observed in the next few years may result in lower volatility within the cryptocurrency market.
Yet, those who operate in the sphere of cryptocurrencies need to be aware of these aspects and the ways to manage them for the near future at least.
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