Will bitcoin and the broader crypto market crash (again)? Or crash farther? I think the place to start thinking about this is why are crypto markets so volatile in the first place? And perhaps more importantly, is that volatility a bad thing?
I believe there are a few reasons for all the volatility in crypto markets. We’ll start with the most obvious ones and work our way to the least obvious.
1. Lack of agreed upon valuation methodologies
Buying a stock is buying a piece of the future earnings of a company. Equity analysts all agree that a discounted cash flow analysis is the proper method to value equity in a business, even if they disagree about what factors should go into the model.
In crypto, there is no agreed upon valuation methodology and it’s likely that the valuation models that do exist are misleading if not flat out wrong. As a result, price is much more sentiment driven, with positive sentiment driving price up more aggressively and negative sentiment driving price down more aggressively than in other markets. There is no benchmark like P/E ratio to bound these movements.
This is compounded by the fact that compared to a market like U.S. equities, much more of the crypto market is made of retail investors with less experience that are more likely to make emotional decisions — selling at the bottom and buying at the top.
2. Whale “splashing”
Because the distribution of ownership among many crypto assets is very concentrated compared to other assets, it’s easier for large individual holders (so-called whales) to move markets through buying or selling in large quantities — “splashing.”
We’ve seen these sort of movements contribute to volatility in the past . For example, the Mt. Gox Trustee selling $400 million worth of Bitcoin. Or, when early bitcoin holders that had become bitcoin cash supporters sold large amounts of bitcoin in an attempt to cause a “flippening” and overtake bitcoin in November 2017.
A subset of whale splashing are the infamous “Pump-N-Dump” groups where a group of whales coordinate to bid up the price of a certain token causing other investors to flood in out of FOMO then sell at the top, fleecing unsophisticated speculators.
3. Liquidity (or lack thereof)
Compared to traditional markets like U.S. equities, most crypto markets are very shallow. Despite tremendous growth in 2017, total crypto market capitalization is still in the hundreds of billions of dollars, the size of a single company on the S&P 500 and much smaller than the S&P in its entirety ($23 trillion).
It’s also likely that the real daily trading volume for the volume of the crypto market is much smaller than current estimates suggest. There’s evidence that some major centralized exchanges may be lying about their volume statistics.For others, there are means, motive, and opportunity, though no hard evidence exists.
We know that the volume of decentralized exchanges is legitimate (though tiny and even then there could be wash trading to inflate volume statistics). Regulated exchange (GDAX, Kraken, Gemini) volume is likely to be real, but the rest of the volume reported by exchanges is doubtful at best.
The result is large amount of slippage, and thus volatility, even on relatively small trading volume. According to a study, “trading pairs of major cryptocurrencies like NEO and IOTA which boast market caps of over $3 [billion]can slip by more than 10% merely with a sale of $50,000.”
The prior three reasons why crypto markets are so volatile, should improve over time. Better valuation models will be developed, token distribution will become less concentrated and as the market cap of the space grows, liquidity will improve.
4. Programmatic supply
The volatility of Bitcoin and the crypto market more generally are a result of the fact that the supply (and thus the monetary policy) of crypto assets is determined programmatically.
For any typical commodity, a change in demand will cause a change in production.
If you grow avocados and the price of avocados goes up 100%, you (or someone else) will grow more avocados in the next season, driving the price down.
If supply increases and decreases alongside demand, the change in price will be much milder.
Compare this to a scenario like most cryptocurrencies, where the supply schedule is programmatically determined and there is no producer able to respond to price changes.
Because the supply schedule is fixed, more demand has to result in higher prices.
