Few other investments are as volatile as crypto. The price swings can appear random, which may make you think twice before investing.
Bitcoin (BTC) started 2020 with a price of about $7200. By the start of 2021, the price had climbed to $29,375. It eventually reached $65,000 per BTC before settling around $36,000.
So, why does the price change dramatically? Here is a closer look at the main reasons why cryptocurrency is so volatile.
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Overview of Factors That Influence Crypto Price
The cryptocurrency market is subject to many of the same factors that influence volatility in the stock market, including supply, demand, and availability. Some of the main issues that influence crypto prices include:
- The number of competing currencies
- The cost of mining crypto
- Supply and demand
- Availability of crypto on exchanges
- Regulations of cryptocurrencies
- Backing of major institutions and governments
The crypto market experiences exaggerated volatility compared to other markets due to limited liquidity.
Liquidity refers to the availability of cryptocurrencies. Most cryptocurrencies, including Bitcoin, have a limited supply.
Any fluctuation in price is likely to have a larger impact as cryptocurrency has less liquidity. The number of Bitcoins is capped at 21 million.
The rate of production for new Bitcoins also gradually slows, which limits supply and drives demand. Unlike the stock market, the crypto market is not backed by a wide range of derivative markets.
The stock market offers a wide range of derivatives, including futures contracts and options. These side markets help support the overall stock market, which limits volatility.
Bitcoin is the most recognizable cryptocurrency, but there are now over 4000 cryptocurrencies. When one crypto becomes more popular, it takes funds away from other cryptocurrencies. This keeps prices down.
Cryptocurrencies are not widely available to consumer investors. Only a handful of exchanges support buying and selling crypto while you can find hundreds of brokers and brokerages willing to handle your stock trades.
Regulations and Lack of Backing Keep Cryptocurrency Prices Volatile
The price of cryptocurrency is linked to its acceptance as legal tender. Regulations that allow or prohibit the sale of crypto also influence its price.
For example, prices tend to drop when a government announces that it is cracking down on crypto mining. Prices start to rise when a government announces plans to adopt crypto.
The crypto market also currently lacks the support of major institutions and investment firms compared to the stock market. The lack of support increases the volatility of cryptocurrencies compared to fiat currencies.
Fiat currencies are backed by governments. Each fiat currency is strictly controlled through a series of policies. Cryptocurrencies are decentralized and open to everyone. Limited controls and policies keep crypto volatile.
Will Cryptocurrencies Become Less Volatile
Some of the largest publicly traded firms have invested billions of dollars in Bitcoin and other cryptocurrencies in the past year.
Financial institutions are also starting to accept crypto. In March 2021, Morgan Stanley announced plans to provide access to several major cryptocurrency funds.
Support from major companies, banks, and governments helps increase the acceptance of crypto as a practical asset.
These changes may lead to less volatility. In the meantime, we can expect the prices of Bitcoin and other cryptocurrencies to continue swinging wildly.