Why are Cryptocurrency Prices so Volatile?
By: Shaan Ray
Tags: Blockchain Technology, Bhq Contributors, Cryptocurrency, Crypto, Bitcoin

Understanding the differences between fiat currency values and cryptocurrency prices is important to better understand these asset classes.

The Basics of Fiat Money and Cryptocurrencies

Fiat Money

The value of fiat money (a legal tender issued by a country’s central bank and backed by its national government) is determined by the issuing authority and by parties that trust that currency and transact in it. The central bank controls the flow of currency and thereby indirectly controls inflation.

Cryptocurrencies

Cryptocurrencies are not legal tender: national governments and central banks neither issue nor back it (with some proposed exceptions, such as Venezuela’s Petro). The supply of a cryptocurrency is often either fixed or capped. This theoretically reduces the potential for inflation.

Cryptocurrencies are also often decentralized, in that nobody can control the mechanisms built into them. However, there are often developer groups and foundations providing support for certain cryptocurrencies and platforms. These groups sometimes serve as checks on major destabilizing events.

Both cryptocurrencies and fiat money can be used as mediums of exchange to buy products or services, or as stores of value.

Reasons for Cryptocurrency Volatility

Reason 1: A New Class of Assets

Cryptocurrencies are a relatively new asset class, and they are still evolving. By some measures there are 100,000 new users of cryptocurrency every day. This novelty means that people do not yet know how to value cryptocurrencies, which leads to volatility in cryptocurrency prices.

Reason 2: Thin Markets

Since the size of the cryptocurrency market is limited (its value is estimated to be between $260 billion and $900 billion), changes in investor sentiments can have outsized impacts on cryptocurrency prices. The foreign exchange market, on the other hand, has daily trading volumes of around $1.7 trillion. The spread (the difference between the price at which the market buys and the price at which the market sells) can be pennies or less for foreign exchange, but can be measured in dollars for many cryptocurrencies. Emotions drive market prices. Since cryptocurrency markets are relatively small, prices may be more sensitive to positive or negative media reports.

Reason 3: Technical Purpose

Blockchain technology can be used for cryptocurrencies, for other uses, or both. Therefore, while Bitcoin is used only as a cryptocurrency, Ethereum tokens are used to build other apps. The price of an Ethereum token therefore depends partly on trust in the Ethereum ecosystem’s continued dominance, and partly on the purpose for which the token was created and the real-world problem it intends to address. This can lead to more complex valuations that change rapidly.

Changes in Cryptocurrency Prices Over the past 18 Months

As the original, largest, and most prominent cryptocurrency, Bitcoin often serves a proxy for the cryptocurrency market. Prices of other cryptocurrencies have often risen and fallen in tandem with that of Bitcoin. Last year, Bitcoin became mainstream, even while major Asian economies such as Japan cracked down on cryptocurrency.

At the beginning of 2017, Bitcoin’s price was below $1000 and its market capitalization was below $15 billion.

Over the course of the year, Bitcoin’s price surged in value to $15,000, despite periodic drops on negative news (such as after the SEC blocked the introduction of a Bitcoin ETF, the forking of Bitcoin into classic Bitcoin and Bitcoin cash, and China’s ICO ban). In December 2017, the market capitalization of Bitcoin was approximately $235 billion.

The mania of 2017 gave way to a selloff in early 2018, as the price of Bitcoin plunged to $7,000 by February. The first half of the year has been characterized by massive volatility in Bitcoin’s price.

There are many potential explanations for the correction of Bitcoin prices in 2018. One is that people who bought at a low price sought to realize their gains, setting off a selloff. Another is the ironic possibility that as people learned more about cryptocurrencies, they started purchasing Bitcoin’s competitors (colloquially known as altcoins), such as Litecoin, Ripple, and Zcash, instead of Bitcoin. Ad sanctions by Google on cryptocurrency may also have played a role in the decline.

Bitcoin’s price is approximately $6000 at the moment, and its market cap is approximately $110 billion.

Accuracy of Cryptocurrency Price Predictions

Bitcoin price predictions have been all over the map. Bitcoin optimists such as John McAfee (McAfee Associates), Jim Cramer (CNBC), and Bobby Lee (CEO BTCC Exchange) have predicted that Bitcoin’s price would breach the $1 million mark in a few years.

Tom Lee (formerly JP Morgan’s chief US equity strategist) has taken a more moderate stance, predicting a Bitcoin price of $25,000 by end-2018 and $125,000 by 2025.

Bitcoin pessimists include boutique investment bank GP Bullhound, which has predicted a 90% crash by the end of 2018. At the extreme end are Harvard professor Kenneth Rogoff’s prediction that Bitcoin will eventually shrink to $100 and GoldMoney CEO Roy Sebag’s projection that Bitcoin’s price will drop to $0 in the long term.

Bitcoin and altcoin prices will depend on various factors, including the availability of alternatives and the development of cryptocurrency regulation in major economies.

Bitcoin and altcoin price volatility serves as a cautionary tale: to generate sustained interest among investors and the general public, blockchains should seek to provide value (beyond the merely theoretical), solve real-world problems, and create durable value.