Updated: Apr 17
The cryptocurrency market can be volatile. Since its launch, cryptocurrencies like Bitcoin and Ethereum have experienced enormous price jumps and drops—sometimes even within minutes—leaving many investors perplexed as to how such volatility can exist at all.
When making an investment in cryptocurrencies, many traders and investors are concerned about the issue of crypto volatility. But why do the values of Bitcoin and other currencies fluctuate? Why is the cryptocurrency market so unstable?
Reasons Behind Cryptocurrency Market Volatility
The future of money is in cryptocurrencies or digital currencies. They are efficient and secure payment methods that are not subject to oversight or interference from the government. The worldwide crypto market valuation is $1.34 trillion at the time of writing, down 35% from 2021.
Trading in the high-risk, high-return asset class of cryptocurrencies necessitates extensive research and comprehension of the underlying technology and market forces.
By design, cryptocurrencies are volatile. The marketplaces for cryptocurrencies are very speculative, and there is no formal regulatory framework in place for their trading. Therefore, compared to equities and bonds, the price of cryptocurrencies fluctuates more. Depending on how an investor views it, this unpredictability can either be beneficial or negative. For instance, you would have received a 1,000x return if you had purchased Bitcoin in 2011 when it was $20 and stayed on them until it hit $20,000 in 2017.
On the other side, if you purchased Bitcoin in 2018 at a price of $10,951 and sold it in 2019 at a price of $3,847, you would have lost about 70% of your original investment. Which raises the question: What causes fluctuations in the price of cryptocurrencies?
1. Supply and Demand
Understanding how the supply of cryptocurrencies varies as more people purchase them and as the mining process continues to produce new coins is crucial to comprehending their volatility. When more people desire to purchase Bitcoin or Ethereum, the value of such coins rises as a result of the increased demand. Since there are fewer coins available for sale than there are buyers, the price of coins rises due to the rising demand and finite supply (there will only be 21 million Bitcoin).
However, when there are more coins accessible, the cost of those coins will decrease as more individuals have the incentive to buy them and more people are eager to sell them. As a result, there is more competition in the market, which may lead to lower prices.
Because of this, cryptocurrencies with a high volume of coins in circulation typically have lower prices than cryptocurrencies with a lesser volume of coins. This is because the price decreases when there are more coins available on the market (indicating lower demand), which is one of the reasons Dogecoin is unlikely to ever hit $1. This holds true for equities, other financial products, as well as cryptocurrency.
2. Speculation and Hype
Hype and speculation are two major elements influencing fluctuations in the price of cryptocurrencies. A new cryptocurrency usually sees an initial surge of excitement when people learn about it for the first time when it initially starts. People frequently rush to buy and sell new coins as a result, which pushes up the price to unaffordable levels.
The enthusiasm and speculation die and finally result in a price fall as the bubble bursts once people start to believe that the coin is overvalued and start losing money on it. Cryptocurrencies frequently experience significant price rises followed by falls. Influencers and famous people also affect how much cryptocurrency prices fluctuate. For instance, Dogecoin fell by 91% after Elon Musk appeared on Saturday Night Live in May 2021.
3. Cost of Production
The hash rate of the network and the power consumption of the network are the two key determinants of the cost of creating tokens. In a proof-of-work system, such as those used in Bitcoin and Ethereum, miners compete to find solutions to challenging mathematical puzzles in exchange for fresh tokens. It becomes harder to mine and less profitable for miners to keep mining a given cryptocurrency as there is more competition for doing so.
If mining becomes ineffective, miners might conceivably give up and migrate to a different cryptocurrency. However, if miners switch to more lucrative tokens or hold onto tokens for a longer period of time, this leads to short-term volatility in cryptocurrency prices. Certain tokens may potentially suffer long-term failure because of this volatility, losing market share over time.
Therefore, as mining expenses rise, the value of the cryptocurrency rises as well. If the value of the currency they are mining isn't high enough to pay their costs, miners won't keep working. A good example is Bitcoin mining, where the price changes according to the number of miners.
The Future Of Cryptocurrencies
The feasibility of cryptocurrencies as a whole has been questioned by many in the cryptocurrency sector as a result of the 2022 bear market. While some proponents of cryptocurrencies are optimistic that markets will eventually stabilize and that cryptocurrencies will continue to appreciate over time, others are more gloomy.
In the end, it will be up to time to determine whether cryptocurrencies will ever realize their full potential as a world currency and payment system or if the technology that underpins them will reach a technological dead end.